Four tools that provide both asset protection and tax benefits
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As an orthopedic surgeon and an attorney/wealth manager who has worked with more than 1,000 physicians, we know that asset protection and tax planning are two of the highest interest planning areas for orthopedists.
This is not surprising given that many are in the highest tax brackets and, as we have noted in prior articles, this specialty lends itself to potentially high levels of liability exposure. In this article, we will outline four tools which can help to achieve both planning goals.
Qualified retirement plans
Of the four tools we will describe, this is one of two that are likely being used by a significant number of doctors reading this article. Qualified retirement plans (QRPs) include both defined contribution plans, like 401(k)s or 403(b)s, as well as defined benefit plans, such as cash balance plans, which we have covered previously in this column.
From a tax point of view, these tools all provide a current tax deduction against an orthopod’s income, so they are extremely attractive for tax planning. In fact, these tax deductions can range anywhere from the $20,000 range for 401(k)s to $200,000 or more for certain types of defined benefit plans.
In terms of asset protection, these plans often have the highest level of creditor protection under state law. Of course, in all 50 states, there is a variation — and some states provide the highest level of protection only for a limited dollar amount. Nonetheless, for most states, this protection is at an unlimited dollar level. Be sure to check with an asset protection expert on the protections in your state.
Individual Retirement Accounts (IRAs) are technically not QRPs, although IRAs act like QRPs in many financial and tax respects. A Simplified Employee Pension–IRA can provide the same tax deduction level as certain QRPs, while a Roth IRA has a different tax treatment, but is also beneficial. A Roth acts more like a non-qualified plan in that there is no deduction for contributions, but the assets grow tax-free and come out tax-free.
From an asset protection perspective, in many states, IRAs enjoy the same protections as QRPs, but in certain states IRAs are weaker. For example, IRAs in California are limited by statute in terms of their protections, where no such limitation applies to QRPs. Be sure to check with an asset protection expert on IRA protections in your state.
Non-qualified plans
Non-qualified plans are used by orthopedists less frequently than QRPs, and this is generally unfortunate. For tax purposes, non-qualified plans work like Roth IRAs: You get no deduction for the contribution, but the funds grow tax-free in the plan and can come out tax-free at retirement. In fact, most orthopods, when asked, would like to put more into a Roth IRA-type vehicle yet they are ignoring the tool that could achieve this objective, namely, the non-qualified plan.
Non-qualified plans often fund into a permanent life insurance vehicle. Thus, the level of asset protection is dictated by state rules regarding permanent (also called cash value) life insurance policies — see further below.
The other benefit of a non-qualified plan is that it is flexible. Unlike a QRP, the non-qualified plan does not need to be offered to any employees. It can be completely discriminatory. In this way, a practice can sponsor a non-qualified plan just for the physicians, just for partners or just for a few doctors who want to participate.
Primary residence
As with the QRP, it is likely that most readers own a primary home or will in the future. Regarding asset protection, nearly every state protects some or all of a home’s equity from lawsuits and creditor claims. As above, state laws do vary significantly here — ranging from no protection to protection of an unlimited amount of home equity. Be sure to check with an asset protection expert to understand how your state’s homestead law protects home equity.
The tax benefits of home ownership are consistent in all states and include the ability to write off mortgage interest (with limitations), as well as a $500,000 capital gain exclusion for a married couple on the sale of a home ($250,000 for single filers). In addition, local property taxes on a primary home can be deductible against your federal income tax, although that deduction has become more limited in recent years.
Cash value life insurance
As mentioned above, cash value, or permanent, life insurance is shielded from creditors under state law. Once again, these exemptions vary significantly throughout the 50 states.
From a tax point of view, the benefits are also consistent throughout the U.S. since these emanate from the federal tax code. These include the ability for the cash value inside of such policies to grow tax-free, and, if managed properly, to be accessed tax-free. Death benefits paid to beneficiaries are also generally income tax-free under Section 101 of the code.
Further, the Internal Revenue Service allows for the tax-free exchange of these types of policies, using a like-kind exchange. You may have read about such tax-free exchanges when it comes to real estate, but life insurance is another asset class favored with this tax benefit. Using this technique can be beneficial, as one could move cash value from one policy to another over time with no taxation. This might be attractive if costs come down, new policies are more attractive or new features of competing policies are more aligned with your planning. As just one example, David has like-kind exchanged his cash value policies three times in the last 23 years, moving from what he perceived as good policies to great policies and reducing costs along the way.
- Reference:
- Wealth Planning for the Modern Physician and Wealth Management Made Simple are available free in print or by ebook download by texting HEALIO to 844-418-1212 or at www.ojmbookstore.com. Enter code HEALIO at checkout.
- For more information:
- Sanjeev Bhatia, MD, is an orthopedic sports medicine surgeon practicing at Northwestern Medicine in Warrenville, IL. He can be reached at sanjeevbhatia1@gmail.com or @DrBhatiaOrtho.
- David B. Mandell, JD, MBA, is an attorney and founder of the wealth management firm OJM Group. He can be reached at 877-656-4362 or mandell@ojmgroup.com.
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