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Home » Medicine & Business, Personal Finance, Wealth Management Blog

Physicians of non-profit hospitals are at a disadvantage over their for-profit colleagues when it comes to retirement planning

Submitted by on 01/05/2010 – 3:50 PM

By William L. MacDonald

piggy bankTax-exempt organizations are subject to more stringent IRS rules than their for-profit counterparts in terms of how they can provide nonqualified deferred compensation plans for highly paid employees. Nonprofit organizations should analyze their deferred compensation arrangements to ensure that such arrangements comply with the restrictive tax requirements of Code Section 457.

Code Section 457(f) generally provides that in order to defer an employee’s compensation to a future calendar year, the payment of that compensation must be contingent on the employee performing substantial services through a date in a future calendar year. When such a contingency is no longer present, the compensation will be taxed in the first calendar year. For example, if an organization establishes a deferred compensation arrangement that provides an employee an opportunity to defer compensation, the employee must make an election to receive the dollars deferred at some future date (i.e. 2 years) to avoid current taxation. However, under a typical nonqualified plan in this tax exempt environment, the employee generally will be taxed on the $50,000 in the calendar year that the arrangement is established if the payment of that $50,000 is not contingent on the employee performing substantial services for the organization in the two future calendar years.

So why would an employee defer current income with the possibility of losing it? Certain arrangements are exempt from the substantial services requirement in Code Section 457, including eligible deferred compensation plans under Code Section 457(b), tax-sheltered annuity plans under Code Section 403(b), and qualified retirement plans under Code Section 401(a). However, there are limits on the amounts that can be deferred under these plans. Nonqualified arrangements without limits fall under Code Section 457(f); however, they cause this substantial service requirement discussed above.

Deferred Compensation Alternatives
Fortunately, alternatives are available for tax-exempt organizations that seek to set up such plans for their highly compensated employees, including their employed and contracted physicians. By subjecting employer-paid, tax-deferred compensation to “risk of forfeiture” (discussed later) or by paying the required taxes, tax-exempt organizations can develop workable alternatives for funding nonqualified deferred compensation plans.

Nonqualified deferred compensation plans in tax-exempt organizations, unlike those in for-profit organizations, are subject to Code Section 457. Two types of deferred compensation plans exist under Code Section 457: eligible and ineligible. Under this code, contributions to an eligible plan (403(b)) are limited to the lesser of $16,500 (as of 2009) or 100 percent of an employee’s annual compensation. In general, it is financially advantageous to highly compensated employees to maximize contributions to 403(b) and 401(k) plans. However, maximizing these contributions can be accomplished only at the expense of the Code Section 457 plan.

Non-Profit Organizations Have Few Options for Deferred Compensation
Considering there are few options, employees who choose to maximize contributions to Code Section 403(b), 457(b), and 401(k) plans can participate only in an ineligible Code Section 457(f) plan. Many organizations are taking advantage of the ability to maximize their contributions in both the 401(k) or 403(b) and a 457 plan. This coordination allows a person whose employer has a 401(k) or 403(b) plan and a 457 plan to defer the maximum contribution into two plans instead of being subject to a single limit amount. Thus, a participant can contribute the maximum $16,500 for 2009 into their 401(k) and also the maximum $16,500 into their 457(b). If that person is over age 50, they can also contribute the additional catch-up amount into each plan—meaning an additional $5,000 into the 401(k) and another $5,000 into their 457(b). With an ineligible plan, deferred compensation contributions have no limits. However, they are taxed in the current year unless the plan is subject to a substantial risk of forfeiture.

It is important to understand why tax-exempt organizations are subject to Code Section 457 for both non-elective (employer-paid) and voluntary (employee-paid) deferred compensation plans. For-profit organizations pay taxes on the deferred compensation until it is paid to employees: tax-exempt organizations, by definition, are not subject to this taxation. In addition, the growth of assets held by tax-exempt organizations to fund nonqualified plans is non-taxable because the organization itself is exempt from taxes. By subjecting nonqualified deferred compensation plans to strict forfeiture requirements, the IRS intends to discourage the provision of tax-sheltered deferred compensation to highly paid employees at the expense of all other employees in the tax-exempt organization.

Maximizing Retirement Savings
Consider the limits discussed above, and let’s take a look at an example. Let’s assume that a 60 year old physician employed by a non-profit hospital is earning $300,000 annually and wants to significantly increase his deferrals during the next five years in anticipation of retiring upon reaching age 65. The physician participates in a Section 403(b) plan therefore he can contribute $16,500 each year. Since he is over age 50, he can also make an additional contribution of $5,000 each year. If his hospital offers a 457(b) plan, he can make an additional $16,500 and the extra $5,000 make up. He may want to think twice about contributions to the 457(b) plan, as those assets are subject to the hospital’s creditors and could be lost if the hospital becomes insolvent.

Under the applicable rules, the physician can be fully vested in the additional deferral in the 457(b) plan, but the deferred amount (plus earnings on the deferred amounts) must remain unfunded or, alternatively, can be funded by the hospital in a “rabbi trust,” the assets of which remain subject to claims of the hospital’s general creditors.

In addition, the physician may defer an unlimited amount of additional compensation pursuant to an “ineligible” Section 457(f) plan. If the physician elected to defer, for example, an additional $50,000 in 2009, such amount would be deducted from the physician’s 2009 income and invested in the plan (typically mutual funds) as the physician and his employing entity determine.

The $50,000 deferral (plus earnings on the deferral) would be subject to forfeiture if the physician voluntarily elects to terminate his employment prior to reaching age 65 (the targeted retirement date previously selected by the physician), the deferred amount and its earnings would not be subject to income tax until it is actually paid to the physician following the physician’s retirement, in accordance with the payment arrangements the physician had previously elected. The problem, as we mentioned above, is that the physician has risk of losing these dollars if he leaves the hospital before a stated date, or the hospital becomes insolvent, therefore, we are not seeing them used as much today.

Code Section 457 Guidelines
Deferred compensation plans that are subject to Code Section 457(f) include defined contribution plans and benefits provided under individual and group agreements. Early retirement incentives can also be subject to Code Section 457(f).

Substantial Risk of Forfeiture
As mentioned earlier, ineligible Code Section 457(f) plans allow for tax-deferred compensation only when the deferred compensation is subject to substantial risk of forfeiture. Voluntary deferred compensation plans typically are not subject to forfeiture. Furthermore, tax-exempt organizations traditionally have provided portable retirement benefits to highly compensated employees. The dilemma in developing nonqualified deferred compensation plans for such employees in tax-exempt organizations is a way to achieve tax deferral for vested nonqualified benefits. There is no official guidance on what constitutes “substantial risk of forfeiture” beyond making the payment of deferred compensation conditional on the “future performance of substantial services.” Because of a lack of official guidance, the interpretation of substantial risk of forfeiture varies, and many look to Code Section 83, which also refers to substantial risk of forfeiture. Generally, deferred compensation that is based either on continued employment for a specified period or on the occurrence of a specific event, such as retirement, is considered subject to risk of forfeiture. Thus, after deferred compensation is vested, it is no longer considered subject to substantial risk of forfeiture. If deferred compensation is vested upon the occurrence of a specific event, such as eligibility for retirement, then eligibility for retirement triggers vesting and taxation of the benefit at that time, even if the employee does not retire.

Is There an Alternative to Code Section 457(f)?
Yes, one alternative is the Professional Security Plan (PSP). The PSP is a wealth accumulation benefit program designed for the highly compensated at nonprofit organizations. The purpose of the PSP is to provide a tax-advantaged savings and investment vehicle without the annual contribution limits imposed on qualified plans, such as the Code Section 401(k) and 403(b) limits, or the restrictions of Code Section 457.

What is the Professional Security Plan (PSP)?
What sets the PSP apart from traditional deferred compensation plans as well as qualified plans is the way participants are taxed. The participant makes contributions with after-tax dollars, but accumulates all earnings on the pre-tax amount. When money is withdrawn from the PSP, it comes out non-taxable.

The 3 Phases of Your Money
To see the advantages of the PSP, it is important to think of your money as having three distinct phases. In planning for retirement income, one should focus on the three phases of retirement income planning: the contribution phase, the accumulation phase, and the distribution phase. Understanding these phases will provide a better appreciation of the PSP’s design.

During the contribution phase, a portion of income is set aside for use in future years. We have always been told that “pre-tax” deferral is better than “after-tax”, but is that always true? By deferring pre-tax, we accept that all distributions at retirement will be taxed at ordinary income. Of course we have no control over the rate in the future. After tax strategies are one reason many people are investing in Roth type arrangements, so they can determine what the tax bite will be now. When you make an after tax contribution into any after tax arrangement, you have more control and full benefit security, since you control the asset.

The next phase is the “accumulation” or “investment” phase. This is when your contributions grow. The old saying not to put all of your eggs in one basket rings true during this phase. Truly, investment diversification is important. However, of greater importance is having your money grow non-taxable. Compounding money tax-deferred is a good thing.

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The final phase is the “distribution” phase. How your tax deferred accumulation is taxed could make all the difference.  The important thing to remember is, “It’s not how much you make, but how much you keep.”  The distribution phase could be the most important phase of your retirement planning. No one knows what income tax rates will be when they retire. Going from a 35 percent tax bracket to a 50 percent tax bracket reduces your retirement income by approximately 25 percent. The PSP distributes income at retirement without taxation, thus taking the future tax risk out of the equation. Based on the history of U.S. and its top income tax rates, how likely is it they will continue to decrease?

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The PSP is an after tax strategy which provides the power of pre-tax savings (discussed later) without the contribution limits or age restrictions of qualified plans. To get the maximum value from retirement accumulation, participants should first maximize their pre-tax contributions into their 403(b), 457(b), and 401(k) plans. The PSP can be a great supplement to compete with your colleagues who work in the for-profit environment.

How does the Professional Security Plan Work?
The PSP achieves its tax-advantaged status as a result of being powered by an institutionally priced variable universal life (VUL) insurance policy generally not available to individuals. Do not confuse this policy with the one you would purchase from your insurance agent or financial planner – it’s much different. First, it’s “institutionally priced,” which means that the policy’s charges are lower than would be the case in comparable retail VUL products.  For example, they have no surrender charges. What also makes the PSP unique as a wealth accumulation plan is the policy’s tax restoration loan feature, which allows a participant to take a non-recourse, “tax replacement” policy loan to make up for the taxes paid on the amount of after-tax deposit.

Here is an example of the mechanics of the PSP. Let us say you were to receive a $100,000 bonus as income. You owe approximately $40,000 in taxes, which leaves about $60,000 left to invest. You could elect to invest the money in mutual funds, and assuming you were to earn 7 percent annual return, you would have to pay taxes on some portion of the gain depending on how the money was invested. Therefore, you would pay taxes each year on your gains. With the PSP, you would deposit the $60,000 in your account, and the policy tax restoration loan feature would increase your balance to $100,000—the pre-tax amount of your bonus.  Assuming you were to earn the same 7 percent return, your PSP account would accrue the gains on the entire $100,000 with no current taxation. Also, any asset reallocation between sub-accounts is not subject to taxation.  Later, you could make non-taxable withdrawals of both principal and interest.  You made an after-tax contribution, accumulated the money tax deferred and all withdrawals are non-taxable as well.  In addition, the PSP provides the participant with a non-taxable life insurance benefit. The policy loan to restore the taxes would be deducted from the policy’s death benefit, along with the capitalized interest. This would reduce the death benefit somewhat, but the approach still compares favorably with the mutual fund investment example, which does not provide a death benefit.

*Assumed 40% tax rate.
** Loan and source of loan is optional.  If chosen, policy loan is non-recourse.

Conclusion

This article has addressed the applicability of Code Section 457(f) plans and many of the implications of Code Section 409A. The new world of nonqualified plans, including 457(f) plans, is very complex. Tax-exempt entities should examine after tax alternatives when retirement planning.  Attracting, retaining, and rewarding personnel, especially physicians, of non-profit organizations has become more difficult and must be addressed if non-profits are to compete with for-profit businesses. The PSP can help level the playing field when it comes to attracting and retaining key talent.


William L. MacDonald is Chairman, President & CEO of Retirement Capital Group, Inc. (www.retirementcapital.com).

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