Avoid these financial missteps

Let's hope you don't notice a resemblance between your own dealings and any of these classic, and costly, blunders.

By Brad Burg

Here's a ripe old tale of a doctor's financial error. You've heard it before—or have you?

"An elderly internist came to see me because his younger partner was accusing him of mismanaging their retirement plan assets," recalls attorney James Lewis Griffith Sr. of Philadelphia. "The older doctor was hopping mad. 'That clown can't sue me,' he said. 'Why, I've kept all the money in nothing but Treasury notes for years. What could be safer? ' "

At that point, Griffith gave the doctor a crash course on the difference between "safe" and "prudent."

"Treasuries certainly are secure, but to keep all of a pension plan's assets locked into a traditionally low-return investment is barely rational," Griffith says. "Any decent mix of securities would have given the doctors far greater earnings over the decade they practiced together; that included times when the inflation rate was well into double digits. Still, the internist couldn't believe he'd be held liable. He kept saying, 'But I was doing my partner a favor.' A judge would have laughed at that."

The younger doctor asked for a $200,000 settlement, but after months of negotiations agreed to $100,000. "He had us over a barrel," says Griffith. "If he'd sued, other plan participants might have added claims, too. And the plan might even have been disqualified. The settlement was cheap."

The mistake here looks obvious. The older doctor ignored standard wisdom. But Griffith says there was a more grievous error: the one made by the younger doctor.

For 10 years, he'd sat passively by while his senior partner made all the money decisions," Griffith says. "The young doctor obviously felt that since he was busy doctoring, he'd let his more experienced partner play businessman. But taking no direct responsibility for your economic well-being and letting the other guy handle it is the biggest financial mistake you can make.

"At least the older doctor erred on the side of safety. But his younger partner made a totally senseless blunder by being unconcerned. The senior man wasn't trying to cheat his partner, but his overcaution led him to shun opportunities that would have realized much bigger rewards with modest risk. Who's to blame? Well, it wasn't only the older doctor."

Before you leap, take a long look

If Griffith's young doctor was foolish to bury his head in the sand while opportunities passed him by, his too-eager opposite was equally unwise.

New York City CPA Ted Tesser tells of a pediatrician with an avid interest in managing her investments, a misplaced self-confidence, and the instincts of a riverboat gambler.

"She wanted it all—now," Tesser recalls. "Mutual funds, stocks, they were too slow for her. At her age, she could have invested, say, in growth stocks and had a sizable nest egg by the time she was 50. But she couldn't wait for incremental growth.

"She wasn't an unsophisticated investor, but she knew just enough to get into trouble. She started buying put options on the Nikkei index, which tracks the Japanese stock market. As a put buyer, she knew she was gambling that the market index would drop, and if it didn't, she'd take a beating." The doctor was prepared for that, yet she didn't know all the rules of the game.

"The Japanese market did fall, running her $10,000 stake up to $30,000 within months. But then the Japanese market zoomed. Now the doctor's bet was wrong, and a few months into the next year, her investment was worth about $5,000. That's when she came to me to do her tax return and learned about the consequences.

"Of course, she knew she'd lost all of her profit and half of her original investment," Tesser continues.

"But I had to fill in the missing part of her story. The puts she'd bought are considered commodity contracts, which for tax purposes had to be 'marked to market' as of year-end. That means you have to treat them as though they'd been sold on Dec. 31, even though you still hold them."

The pediatrician was stunned. She'd already accepted her $25,000 paper loss, but now she heard she'd be taxed on a phantom gain of $20,000 for the previous year.

"So she'd be out of pocket about $6,600 to pay that tax," Tesser says. "To get more cash, then, she sold the puts. At least she could treat the $30,000 peak value as her cost, so the sale did give her a $25,000 loss. But she'd sworn off trading, so she had no gains to use the loss against. She just started deducting it against ordinary income. It took her nine years to use it all that way."

Tesser has a warning for other adventurous doctors. "You don't really know all the risks of an investment until you understand the tax risks."

Unexpected tax consequences have stung many doctors. "Some have faced hundreds of thousands in 'phantom income' when troubled partnerships got banks to forgive debts," says Tesser. The tax rules on that have since changed, but pitfalls are always out there. Say you buy into a mutual fund right before it makes its year-end distributions. You'll have to recognize a gain immediately; in effect, you're taxed on some of the money you just put in. "So check a fund's distribution date before you buy," he counsels. "You can avoid that tax trap simply by buying shares of the same fund a day later."

Tesser's summary: "Before you go into any new investment—even something as ordinary as a mutual fund—consider the tax consequences. And if the deal is at all complex, consult an adviser. Ask him, 'Have you ever worked with a client in a situation like this? If he can't answer Yes and give details, think about going to someone more experienced. It's best to have the benefit of first-hand knowledge before you put a penny in."

Don't undo the protections the law provides you

Maybe you're neither blind to your financial responsibilities nor blinded by the lure of quick wealth. Maybe you're a seasoned investor, like the pair of physicians encountered by attorney Bruce E. Brownstein of Norristown, PA. And maybe you'll make the same financial mistake they made.

Brownstein represented a bank that was owed $100,000 when a restaurant closed its doors. "There were two doctors among the half-dozen investors in the limited partnership that owned the restaurant. As limited partners, those investors were shielded from risks beyond losing what they'd put in, and that's obviously a good shield to have. Yet these investors had pierced the shield themselves by personally guaranteeing the restaurant's loan. When the business folded, the loan was called." The backers of the loan were "jointly and severally liable" for the debt, but that proved academic for all except the doctors. "Some of the investors had inflated their balance sheets, others had hidden their assets, and one declared bankruptcy. That left the physicians." The bank went after the deep pockets for the whole $100,000, and got it.

How did the doctors, successful both in their practices and in money management, stumble into this mess? "The doctors were acquainted with the other partners," says Brownstein. "They were people well-established in the community, seemingly as financially secure as the doctors were. The doctors assumed these people had assets—reachable assets. But when the call went out to pay the loan, all but the doctors were suddenly impoverished."

It's not uncommon for physician investors to fall into such a snare. They'll follow an acquaintance into an investment deal simply because he pays his club dues promptly and drives a luxury car. That's not enough for a business marriage—especially for physicians. "If a deal falls apart and creditors descend, doctor investors are sitting ducks. Even if they're not wealthy, they have earning power and a reputation to preserve. They're not going anywhere."

What should those two doctors have done to protect themselves? "In theory, you can learn about fellow investors' finances by exchanging balance sheets—or, better yet, tax returns, which are usually more reliable," says Brownstein. "Realistically, though, most people won't supply those." So you might see whether Dun & Bradstreet has rated another backer's business, or ask fellow investors' permission to get personal credit reports.

But your surest protection is a simple one: Maintain the shield of limited partnership.

Make sure all your advisers are playing the same music

"If several specialists provide medical care with no coordination, that can lead to disaster. The same applies to financial experts," says Gregory W. Kasten of Lexington, KY. As an MD, MBA, and full-time financial planner, he's well-qualified to draw the analogy. Yet doctors often neglect such coordination, says Kasten. He cites this example.

"In the late '80s, a surgeon retained me to advise him on investments. With some help from tax shelter writeoffs, he'd accumulated a $2 million net worth. He mentioned casually that the IRS had inquired about those writeoffs, but he said he had a tax attorney 'taking care of all that.'

"He later mentioned that another attorney was wrapping up his divorce settlement. What divorce? He'd never mentioned it to me. Was his tax attorney aware of the settlement? I asked. The doctor pondered a while, and said, 'No, I guess not.'"

The wife's share of that settlement included substantial assets, and the doctor's half included his $750,000 retirement plan. In itself, that was an equitable division. With the IRS waiting in the wings, though, it provided the setting for disaster.

"If either of the lawyers had known the full story, they would have considered the threat of that tax liability in the divorce settlement," Kasten says. "Now it was too late. The IRS went after the surgeon, since his assets were all liquid. They hit him with an $800,000 tax bill. At the age of 55, he had to cash in his plan to start paying it. Withdrawing plan money early incurred a penalty, too. Now, at 58, the doctor has nothing left."

It's not difficult to avoid being hurt by a communications breakdown, says Kasten. "Choose one generalist among your advisers, and have him or her review your overall situation every six months, say, or even quarterly. Mention all your major financial concerns, and use a checklist: pension, estate planning, income taxes, investments. If any questions arise, consult in more detail with specialists. That way, you'll catch problems before they become unmanageable."

Don't be overconfident about your own ability

"You like doing it yourself? Then tile the patio or re-grout the bathroom—but don't be a do-it-yourselfer in financial matters," says Ted Tesser.

Tesser tells about a doctor who nearly lost $140,000 in taxes by playing gifted amateur. "At a party I attended, a surgeon was discussing his retirement," Tesser recalls. "He mentioned that he was about to sell his longtime Connecticut home and move into a Florida residence that he'd bought a couple of years earlier. That phrase—'a couple of years'—got my attention."

As an accountant, Tesser knew that according to then-current law, you could defer the gain on a house sale, but only if you put the money into another house within 24 months before or after selling the old one. "I asked a few questions. Then I had to risk spoiling his evening," Tesser says. "'You're a month and a half over the deadline,' I told him. 'So the gain on that sale will be fully taxable.' It turned out that the gain was about $500,000, which meant a tax of $140,000."

How had the surgeon gotten into this fix? "His wife was his bookkeeper and knew a little about taxes. They'd been proud of doing their own returns on their home computer, using tax-preparation software." Either the software or the users had neglected to check out the time limits on home transactions.

There was a way out, however.

Tesser proposed giving the old house to a charitable trust. "Then the charity could sell the house and replace it with an income-producing investment. And the surgeon and his wife could get the income for life, just as if they'd invested the sale proceeds themselves. Yet this way they'd pay no gains tax." Moreover, they could buy life insurance with some of that income to replace the house's value in their estate.

That idea resolved the surgeon's dilemma, but his story illustrates the engineer's adage: Computers let us make our mistakes even faster. Major tax software has sometimes created headlines because of glitches that could cause substantial errors, and users themselves often misapply perfectly good software.

"You can't blindly trust canned knowledge, whether it's in an 'all-you-need-to-know' book or on a computer disc," Tesser says. "All that packaged advice may be good—in general. But people with complicated legal, financial, or tax problems often need the sort of customized advice that you get only from personal advisers. They may point out what you've missed, or—who knows?—they may even out-think a computer program."

A common theme runs through these experiences: It's your money; pay attention. Then seek the best wisdom you can find to help you steer straight. Otherwise, you increase the chances of running into your own financial blunders—and you may not have to look farther than the mirror to see who's to blame.

The author is a former Senior Editor of Medical Economics.

 

Brad Burg. Avoid these financial missteps. Medical Economics 2001;19:64.