Excerpted from The Biggest Legal Mistakes Physicians Make: And How to Avoid Them
Edited by Steven Babitsky, Esq. and James J. Mangraviti, Esq. (©2005 SEAK, Inc.)
Download Free 646 Page E-book: The Biggest Legal Mistakes Physicians Make and How to Avoid Them
For many physicians, a tax-qualified retirement plan (such as a pension plan, a profit-sharing plan, or a 401(k) plan) is, or, will over time, become their biggest single financial asset. They will rely primarily on that asset to finance a comfortable retirement. Nonetheless, physicians often make serious mistakes in establishing or operating these plans. These mistakes, while common, are avoidable.
Mistake 1 Not Prioritizing Goals in Connection With the Plan
Physicians often establish a retirement plan without clearly identifying or prioritizing their goals. Is the plan simply being set up as a tax shelter; that is, to enable them to shelter the maximum amount of income from taxation? Is it designed to maximize contributions as quickly as possible with a view toward retirement, or is it designed to facilitate hiring or retaining other physicians or nonphysician staff? Perhaps it is being set up because the physician has reluctantly decided that he or she “has to have a retirement plan” but wishes to do so in the most economical fashion.
Action Step Before establishing a plan, physicians need to identify their goals. In doing so, they need to understand how retirement plans work, the types and advantages of the various retirement plans, and how the different plans relate to the physicians’ goals. These goals must be communicated to a physician’s advisers.
Mistake 2 Failing to Periodically Review the Plan Structure
Just because a particular retirement plan might have been at one time the best suited to achieve a physician’s goals does not mean that it will continue to be so. Over the last 15 years or so, there have been tremendous changes in the various types of retirement plans. For example, revisions have been made in the laws related to 401(k) plans. These changes provide increased flexibility to plan participants and enable physicians to lower their costs for staff participation in the plans. In addition, some physicians and groups are finding defined benefit pension plans to be attractive. Changes in the tax laws permitting significant profit-sharing contributions have eliminated the need to maintain multiple plans in order to obtain a maximum plan allocation.
Action Step Physicians have a right to expect their professional advisers to periodically provide them with advice on new planning opportunities. However, physicians should not assume that their advisers will always initiate giving them this advice. Rather, physicians should ask their advisers from time to time if they should be doing something different that would enable them to meet their goals more effectively.
Mistake 3 Failing to Coordinate the Involvement of Outside Professional Advisers
The use of competent professional advisers is critical in establishing and operating retirement plans. Different advisers provide different types of services. It is imperative that the physician’s advisers know exactly what their role is and that they communicate with each other in a smooth, harmonious fashion. This becomes particularly important as the number of advisers increases. The more advisers who are involved, the more likely it is that problems and miscommunication will occur and that certain matters will slip through the cracks. For example, two advisers might each think that the other is handling the filing of the annual IRS 5500 series report, with the result that neither one files it.
Action Step When establishing a retirement plan, physicians should hold a meeting of all of their advisers and make it clear exactly what they expect from each of them. As new advisers are added, physicians should make certain that their identity and role are promptly communicated to all of the other advisers. If a physician suspects that matters are not being tended to properly, he or she should not hesitate to convene a meeting at which all of the advisers are required to attend to work out any problems.
Mistake 4 Failing to Understand or Abide by Retirement Plan Provisions Regarding Contributions for Employees
In many situations, employees are erroneously excluded from receiving retirement plan contributions because physicians or their advisers have misinterpreted the plan’s eligibility provisions (e.g., participants who terminate before the end of the year, former participants who are rehired). In other situations, employees are given contributions when, under the plan, they are not eligible. Both of these scenarios create serious problems that typically surface long after the mistakes occurred, at which point corrective action is difficult, if not impossible.
Action Step Before the end of each plan year, physicians should prepare an employee census that includes every individual employed at any time during the year. Physicians should then compare each employee’s situation with the plan’s eligibility provisions to determine if the employee qualifies for a contribution. If an employee does not qualify, physicians should make a written record of why not. Physicians should confirm this record with their professional advisers.
Mistake 5 Failing to Meet Fiduciary Responsibilities in Terms of Investment Activities
Even though a retirement plan can be their biggest single financial asset, physicians in busy practices often fail to adequately investigate or monitor the investment performance of the investment managers to whom they have entrusted their funds. These managers should understand the physicians’ goals. If a manager proclaims to have an investment philosophy, the manager should stick with it. A physician’s other financial advisers can be good sources of information on the investment performance of the physician’s investment manager.
Action Step Physicians should carefully investigate and monitor their investment manager. They should demand regular reporting and meet face to face with the manager not less than annually. Physicians should make sure that the investment manager understands their situation and goals, that they understand the investment philosophy of the manager, and ensure that they are compatible. A physician who has any suspicions about his or her manager should act promptly, never forgetting the adage, “If it sounds too good to be true, it probably is.”
Mistake 6 Permitting Unlimited Individual Direction of Account
To meet the various investment philosophies of difficult plan participants, physician groups often permit broad investment discretion by plan participants. Doing so can create serious problems. Keeping track of all of the assets held in numerous individual accounts managed by numerous advisers can become an administrative nightmare when it is time to prepare annual reports or beneficiary statements. Permitting unfettered individual direction of accounts also runs the risk that plan participants may invest plan assets in prohibited investments (e.g., collectibles).
Action Step Physicians who offer participant investment direction of accounts should consider restricting the rights to a “family” of funds. Unless the practice is very small, physicians should not permit unlimited individual direction of accounts. Also, they should make sure that the nonphysician plan participants have the same level of ability to direct their investments as the physicians and that they are made aware of their options.
Mistake 7 Failing to Adequately Document Retirement Plan Loans or Monitor Loan Repayments
Failing to adequately document retirement plan loans or monitor loan repayments is another common mistake. The Internal Revenue Code has strict rules on loan repayments, and failure to make payments in accordance with the rules and the plan provisions can subject the plan participant to serious adverse financial consequences.
Action Step Physicians should be certain that loans are adequately documented and that the documentation strictly conforms to legal requirements and those of the plan. Also, physicians should create a mechanism for monitoring the payback of plan loans. Requiring that loan repayments be made through salary deductions is one alternative, although eliminating the loan provision from the plan is one way to avoid the issue entirely.
Mistake 8 Failing to Adhere to Plan Provisions and Legal Requirements on Distribution to Beneficiaries
Retirement plans always contain provisions specifying the timing and manner of distributions to plan participants or beneficiaries. For example, those provisions may permit distributions only after the close of the year during which an employee terminates employment, or after one or more years during which an employee has a “break in service.” The Internal Revenue Code’s provisions mandate certain types of distributions and others prohibiting the plan from making a distribution until a participant has made a request to do so. Problems can also arise if the plan contains a vesting schedule. In certain circumstances under federal law, the forfeited amount must be restored if the participant resumes employment within a specified period of time.
Action Step Physicians should be certain to comply with all documentation requirements regarding benefit distributions and that the distributions are made in accordance with the time frames set forth under law or in the plan. If the plan’s provisions on the timing of distributions are different from what a physician has been doing, the physician should either change the plan or change his or her practice. The reallocation of forfeitures should be handled strictly in accordance with the plan.
Mistake 9 Delaying Depositing 401(k) Monies, or Using Plan Assets for Business Purposes
In some situations, employers delay depositing 401(k) contributions into a plan in order to use the funds for a period of time to alleviate cash-flow problems. Taking funds from a qualified plan to meet a short-term financial need of the practice is strictly prohibited under federal law. These actions will cause serious legal liability.
Action Step Physicians should use plan assets only for plan purposes. They should pay elective 401(k) deferrals as soon as they can segregate the amounts from business assets; in other words, as soon as they make the compensation payments.
Mistake 10 Failing to Understand the Long-Term Implications of Deferring Contributions
Most physician groups are cash-basis taxpayers; in other words, their income is recognized upon receipt and expenses are recognized upon payment. Federal tax laws, however, permit a retirement plan contribution to be deducted even if it is not actually made until the following fiscal year. For cash-flow purposes, or as a means to reduce profit, a physician or physician group may want to defer making the contribution until the following tax year. Doing so on a regular basis results in the revenue produced in the subsequent year always being used, in part, to satisfy the prior year’s retirement plan contribution. If a group ceases medical practice, the year in which this occurs would have a doubling up of the retirement plan contribution but a deductibility for only one contribution, which could create a tax liability.
Action Step Any buyout or deferred compensation payment provision involving physician owners should consider any accrued obligation remaining to be paid to the retirement plan. The tax liability that may have to be dealt with if there ever is a doubling up of retirement plan contributions in a single fiscal year should also be considered.
Physicians should avoid these mistakes when administering the qualified retirement plans of their practices.
John T. Mulligan, Esq.
Peer reviewed by:
Michael G. Riley, Esq.