Four ways to use today’s ultra-low interest rates in wealth planning
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As we navigate through this difficult time in the U.S. economy, a few bright spots emerge. One of those is that interest rates, controlled by the Federal Reserve, are at all-time lows.
This trend, of course, reflects a government policy intended to stimulate the economy and allow businesses and individuals easier access to capital. In fact, government officials have indicated this policy will continue for the foreseeable future.
A near-0% interest loan policy certainly benefits big banks, which can borrow at close to 0% and lend profitably, even at low rates. It also benefits big businesses, which can expand their operations with a near 0% cost of capital. Nonetheless, ultra-low rates can also significantly benefit orthopedic surgeons and their families. We outline four ways they can benefit from these rates, starting with the most obvious and popular options, then moving to those that are more complex.
Refinance mortgages
As mortgage rates have now reached all-time lows, many orthopedic surgeons who own homes have either refinanced their mortgage already or have considered doing so. The calculations involved in evaluating the long-term benefit of a refinancing are not complex and can be understood using a simple financial model. In fact, this is the type of evaluation that benefits orthopedic surgeons who are adept at financial modeling — a discipline we emphasized in an earlier column. For those who do not have a good handle on such modeling, several websites have mortgage comparison calculators to use or a mortgage broker can provide this analysis.
Regardless of the resource used, the essence of the analysis is to compare an existing mortgage with a new mortgage offering a lower interest rate. A thorough knowledge of the existing loan terms (such as whether there are prepayment penalties) or potential closing costs to secure the new mortgage is essential. The goal is to calculate the breakeven point, which is the length of time at which paying the new lower-interest mortgage breaks even with the one-time additional costs of changing the mortgage. If the loan term is the same and you intend to remain in the home well past the breakeven point, then refinancing may be a good idea.
Refinance other debt
The same concept for one’s home mortgage can be applied to loans such as practice real estate mortgages, rental property mortgages, practice lines of credit, practice equipment financing, as well as student loans. Knowledge of existing terms and closing costs and an accurate financial model is needed for good financial decisions.
Use premium-financed life insurance
In other installments of this column, we explored the relative strengths and weaknesses of term and permanent life insurance. We also cover these topics in depth in our book Wealth Planning for the Modern Physician: Residency to Retirement. The bottom line is that there are significant tax, retirement and estate benefits offered by permanent life insurance.
Nonetheless, to build up large permanent policies that generate six-figure annual tax-free retirement income, orthopedists generally need to make significant investments into such policies for at least a few years while they work. Many physicians would like the tax-free retirement income but are averse to paying large insurance premiums.
This is where premium financing comes into the conversation. One can finance these policies during the funding phase, only paying a few percentage points in interest, rather than the entire premium. Then, typically 10 to 15 years into the plan, when cash values have grown, the cash value can be used to pay off the loan principal. What then remains is a large debt-free permanent policy that can be used to generate tax-free income through retirement.
This description glosses over a complex and significant transaction with a number of risks and success factors. However, the essence of the strategy remains arbitrage, growing the policy cash values at rates generally around 5% to 7% annually, which is higher than typical premium financing interest rates.
Today, those rates have plummeted. Some banks offer rates below 3%, often with long-term lock options. As such, there hasn’t been a better time to engage in this transaction since it became mainstream.
Loans for gift, estate planning
A core element of much sophisticated estate and gift tax planning is making loans between family members. Unlike loans between unrelated parties, intra-family loans must charge an IRS-specific minimum interest rate to make it legitimate, which is called the applicable federal rate (AFR). The AFR is issued monthly so taxpayers and advisors know how much interest must be charged in these scenarios. In fact, the IRS gives specific AFRs for the short-term rate (maturities of 3 years or less), medium-term rate (3 to 9 years) and long-term rate (maturities greater than 9 years). For October 2020, these were: 0.14%, 0.38% and 1.12%, respectively.
One can imagine all the ways orthopedic surgeons could transfer wealth tax efficiently among family members, trusts, partnerships and the like when the interest rate allowed on long-term loans today is a mere 1.12%.
Often such loans provide tremendous flexibility for individuals who want wealth to transfer to younger family members (or trusts for their benefit), but want a “safety valve” back to them in case they need it. A loan to the individual/trust allows that flexibility. If orthopedist decide they do not need a portion of the loaned assets back, they can forgive the loan using their gift/estate tax exemptions. If they want the assets back, the loan is kept in force and they get the principal and interest, per the loan terms. Either way, through a loan today, the family has built flexibility into its plans and done so for the cost of a tiny interest rate.
Orthopedic surgeons should determine how they can best utilize ultra-low interest rates through a few of the four tactics described here.
- References:
- Wealth Protection Planning for Orthopaedic Surgeons and Sports Medicine Specialists and the newly-published Wealth Planning for the Modern Physician: Residency to Retirement are available free in print or by ebook download by texting OT20 to 47177 or at www.ojmbookstore.com. Enter code OT20 at checkout.
- www.irs.gov/pub/irs-drop/rr-20-20.pdf
- For more information:
- Sanjeev Bhatia, MD, is an orthopedic sports medicine surgeon at Northwestern Medicine in Warrenville, Illinois. He can be reached at email: sanjeevbhatia1@gmail.com.
- David B. Mandell, JD, MBA, is an attorney and founder of the wealth management firm OJM Group www.ojmgroup.com. You should seek professional tax and legal advice before implementing any strategy discussed herein. He can be reached at mandell@ojmgroup.com or 877-656-4362.
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Wealth Protection Planning for Orthopaedic Surgeons and Sports Medicine Specialists and the newly-published Wealth Planning for the Modern Physician: Residency to Retirement are available free in print or by ebook download by texting OT20 to 47177 or at www.ojmbookstore.com. Enter code OT20 at checkout.
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