Whether you are a physician who is still in residency or have enjoyed a mature career and are nearing retirement, strategic tax planning is critical at any stage of a high-income earner’s journey. Smart planning throughout your career not only helps to alleviate tax burdens on a year to year basis, but works to maximize your income in retirement, as well.
Unfortunately, even though the average physician spends roughly a decade in graduate school and training, there is little to no education provided on personal finance or tax planning. With this in mind, we’ve compiled a list of the top 5 tax planning strategies that can specifically benefit hard-working physicians looking to reduce their taxable income and improve their lifetime income stream.
1. Choose a Retirement Plan that Allows for Maximum Retirement Contributions
One of the simplest and most popular ways to reduce your taxable income is by contributing the maximum annual amount to pre-tax retirement accounts such as 401(k)s and Profit Sharing Plans (PSPs). Contributions made to these plans are made pre-tax, which means they are tax deductible for the year in which the contribution is made. The funds placed in pre-tax accounts will grow tax-deferred until funds are distributed in retirement. In the meantime, these funds may be exempt from legal claims as long as they remain invested in qualified plans.
Maximum annual contributions to pre-tax accounts are dictated by the Internal Revenue Service and increase periodically to account for inflation and reflect Cost-of-Living Adjustments (COLA). In 2019, individuals under age 50 can contribute $19,000 into their 401(k) plan and another $37,000 into their PSP for a total of $56,000. Individuals over age 50 are afforded an additional “catch-up” amount of $6,000, bringing their totals to $25,000 and $62,000 respectively. In 2020, for individuals under 50, those amounts increase to $19,500 and $57,000; for individuals over age 50, the amounts increase to $26,000 and $63, 500.
Learn about our process, MDFIT™, designed precisely for the unique wealth management needs of physicians.
2. Capitalize on Tax-Advantaged Savings Vehicles
Luckily, retirement accounts aren’t the only savings vehicles that can help alleviate your tax obligations. Additional tax-advantaged accounts, such as 529 College Savings Plans, can be utilized, albeit in a different manner.
While contributions to 529 plans are generally not tax-deductible, like those of your 401(k) and PSP, the funds in a 529 do grow tax-deferred and are distributed tax-free when the funds are used for the intended educational purposes. Recently, tax laws have even expanded their definition of “acceptable use” to be more inclusive. Whereas distributions were previously only tax-exempt for college and graduate school expenses, the parameters of the law have widened to also include K-12 expenses up to $10,000 a year.
An added bonus is that individuals can contribute up to five years of gifts into a 529 plan at the outset without gift tax ramifications. Not only does this provide a great outlet for gifting, but allows more time for the gifted funds to grow tax-deferred, increasing the likelihood they will cover a young beneficiary’s future college tuition in full. In 2019, the gift tax limit is $15,000, which means it would be possible to fund $75,000 into a new 529 account for a child this year. These contributions can also be utilized as an estate planning tool since 529 funds are considered to be outside of the estate of the grantor.
3. Consider the Tax-Efficiency of Your Investment Vehicles
Many times, maximizing the after-tax return on investments will correspond with how tax-efficient our investment vehicles of choice happen to be. As a rule of thumb, the after-tax return of investments should always be considered for those in the top tax bracket.
On the fixed income side, municipal bonds are often the best choice for minimizing taxes and maximizing returns, but not always. After all, at any given time, the after-tax yield on a taxable bond may actually be higher than the tax-free yield on a municipal bond. A fluctuating yield curve and tax rates may cause these numbers to change.
While you may want to avoid “letting the tax tail completely wag the dog,” you’ll always want to be aware that some investment vehicles are more tax-efficient than others and maximizing your after-tax return should be an integral part of your overall tax planning strategy both in retirement and in your accumulation phase.
4. Stay Abreast of Tax Law Changes
Tax laws are constantly evolving and this past year was no exception. One of the most notable changes in 2018 was the dramatic reduction of itemized deductions and the increase in the standard deduction, which means many physicians may want to take the standard deduction moving forward. Given these new limits, individuals may choose to take advantage of “bunching deductions” in order to surpass the higher threshold. Bunching deductions is a technique that allows taxpayers to delay claiming deductible expenses, such as charitable contributions, from one year to the next, resulting in a larger total deduction amount later down the road. While charitable contributions are still fully deductible if the tax payer is itemizing, making larger donations in a single year, rather than smaller ones year after year, may help push a physician over the standard deduction limit which can reduce taxable income.
Donor-advised Funds (DAF) are also a great way to increase deductions in a single year as these accounts allow an individual to donate a large sum all at once and subsequently direct smaller contributions to charities over a number of years. Individuals over age 59 ½ can consider making contributions directly out of their IRA account. Not only will the distributions made from an IRA not be considered taxable income if they are directed straight to the charity, but they could ultimately reduce the donor’s Required Minimum Distribution amount at age 70 ½ due to the reduced account balance remaining after contributing funds from the IRA account for many years.
5. Consider the Timing of Your Social Security Benefits
Legally, individuals are eligible to begin claiming social security benefits as early as age 62, but it will cost them in both a decreased benefit amount for life and heavy taxation if the individual is still working. After Full Retirement Age (FRA), the benefits will no longer be taxed as harshly, but will incur some tax if the individual is still receiving a paycheck, in which case waiting until age 70 may be most beneficial. Each year an individual defers claiming benefits past their FRA, their benefit amount increases by about 8% a year until age 70—a compelling reason to consider delaying benefits, especially if you are still a practicing physician at the peak of your income-earning years.
Taking the Next Step
If you are a physician who is unsure whether you are capitalizing on the most tax-efficient planning strategies, we’d be happy to review your current plan or help you begin devising a new one. At Atlanta Financial, we have designed MDFIT™, a process designed to assist physicians and their families manage their financial resources in order to meet their long-term life goals. Our advisors are here to help you navigate the unique financial and tax-planning challenges you may encounter at any stage of your medical career.
For more information on making sound financial decisions as a physician, download our free report on the Top 3 Financial Mistakes Physicians Tend to Make.
Atlanta Financial has specialized in working with physicians to enhance and protect their wealth for more than three decades. Our experienced team has a deep understanding of the strategies necessary today to combat the uncertainties that physicians face today. Atlanta Financial currently serves the financial needs of physicians and their families across the spectrum of medical specialties through our MDFIT™ process, designed precisely for your unique wealth management needs.