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These strategies are easily implemented but commonly overlooked ways to manage and reduce your tax liability.
Physicians who are further along in their careers can probably remember the “tax shelters” of the 1980s, which were investment structures designed to create current tax deductions and defer taxable gains well into the future.
While many of these specific tax-leveraging vehicles are a thing of the past, there are still many opportunities to reduce taxable income. A list of “tax tips” could go on for pages, and many tips show up in articles regularly. Here are seven tips physicians can use to improve their tax situation:
Of course, it is important to maximize contributions to your health savings account (HSA).
For 2014, if you have high-deductible family coverage, you can contribute up to $6,550, and if you are over age 55, an additional $1,000. Often overlooked, however, is the opportunity for your spouse to contribute $1,000 to his or her own HSA if he or she is age 55 or older and covered under your high-deductible health insurance plan.
Instead of cash, consider making contributions of securities with a low basis that you have held for more than one year. You receive a deduction for the full market value of the securities donated at the time of the contribution, while avoiding capital gains.
Making an “in-kind” donation directly to charity can be somewhat cumbersome to coordinate, and is especially time-consuming if you make multiple in-kind donations. Instead, work with your investment advisor to establish a donor-advised fund into which you can contribute the appreciated securities, liquidate them tax-free, and then make cash donations from the fund.
Contributing to a donor-advised fund provides a current year deduction even if the funds are not sent to the intended charity until a subsequent year. This provides flexibility to apply the deduction in a year when it is most beneficial.
If you have income that you do not receive through your employer-for example, medical director fees or research stipends-and you report the outside income on your personal tax return (or through an entity you own), you can establish a retirement plan for the separate activity.
If you are covered under another retirement plan, you only need to make sure that the two activities/businesses are not considered “controlled or affiliated service groups” (both defined under the Employee Retirement Income Security Act).
A retirement plan for a sole proprietorship can allow for significant funding, deductible against your income, without significant administrative costs.
Next: Strategy No. 4
We advise our clients to contribute as much as possible to retirement plans and individual retirement accounts (IRAs), even if contributions are nondeductible.
In addition to the benefits of tax-deferred growth, income withdrawn from retirement plan accounts is exempt from the 3.8% surtax on net investment income. Also, carefully consider directing retirement plan savings to Roth IRA accounts and/or converting pretax retirement savings to Roth IRAs.
Even though marginal income tax rates increased a few years ago for high-income earners, we believe that allocating a portion of savings to Roth accounts is helpful. A Roth “bucket” can provide a hedge against high tax rates in retirement, because it allows for some control over taxable income by having the flexibility to pull retirement income from both pre- and post-tax accounts.
In addition to having different types of retirement plan accounts, you can achieve even more flexibility by having a pool of after-tax investments. As a means of building a Roth bucket, many retirement plans now allow for the conversion of traditional deferrals into Roth deferrals.
Remember too that if you are unable to fund a Roth account because your income exceeds the allowable threshold, you can make traditional (non-deductible) IRA contributions and immediately convert those to a Roth account, regardless of income.
Retirement plan funding and personal savings for retirement should be your first planning priority. But if funding children’s higher education is also an objective, then you can avoid taxes on investment earnings and gains by saving for a child’s higher education using a “Section 529” plan.
If you have children not expecting to enter college for several years, you can expect to spend $200,000 or more per child on college expenses. Saving for college within a tax-deferred environment will result in a significant tax savings because accrued interest, dividends, and capital gains are not taxed.
Many investment managers focus primarily focused on investment performance and give little, if any, consideration to the tax aspects of specific investment decisions.
Generally speaking, this is beneficial because disregarding investment considerations in favor of taxes may result in the tail wagging the dog. Nevertheless, for doctors in the higher income tax brackets, a “tax managed” approach to investing is important. “Tax managed” mutual funds, using exchange traded funds and other tax-efficient options should be considered.
One of the primary objectives of managers of tax-managed accounts is to keep the investors’ tax consequences to a minimum.
Those fortunate enough to be in this position, often with a net worth of more than $10 million, need to evaluate tax considerations both in terms of income and estate tax, and coordinate planning to address both types of tax.
At this level, some important strategies to consider include a gifting plan, possibly insurance to cover part or all of the estate tax liability, leveraging wealth transfer to the next generation through structures such as trusts and family limited partnerships, and charitable planning opportunities that use a variety of structures to make charitable contributions in a tax efficient manner, while in certain situations also generating annuity income for retirement.
If you have a significant net worth, the best tax strategy is to spend some money with capable legal and financial advisors to make sure that appropriate strategies and techniques are used to avoid the 40% estate tax on a net worth in excess of $5.34 million per individual.