We see it often with physicians—a call from a “wealthy on paper” client who suddenly finds themselves trapped with illiquid assets and faced with a short-term need for cash. You might have a net worth of $7 million, but perhaps $2 million is tied up in your primary residence, another $1 million in a vacation home or investment real estate, $2 million in a 401(k) or IRA, $500K in life insurance cash value, and additionally you’ve built $1.5 million worth of potential equity in your practice.
What happens when there’s an unplanned financial emergency such as a healthcare crisis, tuition expenses, an unexpected tax bill or major practice expenditure? How do you tap into those significant assets you’ve accumulated to generate cash flow without experiencing a major loss of market value? While illiquid investments such as real estate, life insurance cash value, private equity investments and hedge funds may offer the potential for enhanced returns, it’s vital that you manage a flexible and diversified balance sheet. This should typically include an appropriate percentage of your wealth in assets that can be converted to cash without heavy penalties, taxes or opportunity costs.
The all-too-frequent question of “Can’t I just leverage my 401(k) or IRA?” rarely sits well with the IRS. Retirement accounts should never be considered “break glass in case of emergency” liquid assets. Not only will cashing out tax-deferred assets trigger an automatic 10% IRS penalty (if you haven’t yet reached age 59-1/2), the income tax that such a transaction generates can be substantial. Perhaps most importantly, depleting these plan assets may have a significant, adverse impact on your ability to achieve important goals later in life. While nearly four in 10 physicians (38%) put more than $2,000 away each month in tax-deferred accounts, three in 10 (31%) fail to save anything each month in a taxable investment account.1
Why cash flow planning matters
After years of undergrad, med school, residency and fellowship—years where your income lagged and your debt exceeded that of peers who pursued law, business or other professional careers—it’s only natural to want to play catch up and buy that big house and nice car when that first $400K salary contract is signed. Thoughts about improving your longer-term financial picture by reducing that sizable debt burden or catching up on your retirement savings often get pushed into the “I’ll get around to that in a little while” category.
May we recommend an alternative—a far more flexible and effective approach that involves developing a thoughtful action plan for managing debt, cash flow and long-term savings. “Optimizing your wealth requires a multitude of various trade-offs,” notes SunTrust Medical Specialty Group advisor Jim Hopkins. “For instance, an example that might meet a client’s needs would be instead of paying back $5,000/month on loan debt, it may be more advantageous to only pay $3,500 and sock $1,500 away in a taxable investment account as a rainy-day fund for quick cash in an emergency or to fund a shorter-term goal or investment opportunity.”
As with any aspect of planning, the sooner you start building liquidity, the more freedom and flexibility you will have down the road. For younger physicians it often comes down to a matter of lifestyle choices. Do you really need the bigger home, the vacation property and the new car right away? Or can you possibly delay those for a few years and focus first on getting your financial house in order? Even if you’re well established in your career and suddenly facing a liquidity crisis, there may still be ways to tap into the assets you’ve spent decades accumulating in order to generate cash without creating a major disruption to your financial plan.
Strategies for avoiding a fire sale
Perhaps you’ve reached a point where your income is peaking, most of your debt is paid off, and you have been diligently investing a sizable portion of your income into relatively illiquid retirement plans, investment real estate, land purchases, life insurance policies and private equity. Where do you turn when and if a sudden unexpected cash crisis arises?
One potential temporary solution is to leverage short-term borrowing against other assets you already own using portfolio-secured lines of credit, equity lines of credit on real estate holdings and/or margin loans.2 This can provide you with a relatively quick and substantial infusion of cash at reasonable borrowing costs, without necessitating the fire sale of illiquid assets. However, in order to create longer-term liquidity and flexibility, the right asset mix and thoughtful preplanning should be done early and reviewed often.
“We often work with established physicians to explore ways to extract liquidity from a variety of assets including equity in a practice or the real estate the partners own,” explains Todd Matthews, another advisor with SunTrust’s Medical Specialty Group. “Whether it’s recapitalizing owner-occupied real estate holdings, creative practice buy-in structures or leveraging the cash value of life insurance there are a variety of ways to stimulate cash flow.” In certain situations, it may even make sense (based on your cash flow needs and situation) to recapitalize personal real estate holdings to generate additional liquidity. As wealth increases, so does the complexity of the deals, and in turn, the liquidity required to be injected and available to support these undertakings.
Increasing wealth brings new opportunities
As their net worth begins to rapidly grow, many physicians begin exploring commercial real estate investment opportunities such as multi-family properties. While essentially an illiquid asset, multi-family properties have the ability to both appreciate like a stock and generate income to enhance cash flow and liquidity—all while delivering portfolio diversification, inflation hedging and overall risk mitigation.
It’s an investment that also presents a host of ancillary tax and estate planning benefits. Because it can be depreciated over time, commercial real estate can offer significant tax advantages. And given its illiquid nature, interest in a property often can be placed in a trust at a discounted value, making it an excellent vehicle for transferring wealth across generations.
Keep in mind, though, that real estate investing can be challenging, and sufficient liquidity is required for maintenance and reserve funds. Just as different bonds have varying credit qualities (from AAA to high yield), different commercial properties come with distinct risk-return profiles that need to be factored into your investment decision. The opportunity for substantial returns is compelling, but extensive due diligence, expertise and guidance should be sought to ensure that the risk-return tradeoff meets your personal needs and expectations.
Where do you start?
The demands of your profession afford little time to sit down and carefully analyze your changing wealth picture and evolving financial needs. Your priorities are your family and your practice—as they rightfully should be. Be purposeful in planning not just for the probable but also for the possible. Having a reasonable liquid reserve needs to be an essential component of every financial plan.