New laws and proposed legislation could push the tax burden on some physicians to 50 percent or more. Time is running out to take advantage of today's relatively low tax rates by converting your retirement savings to a tax-free Roth IRA.
Believe it or not, even The Wall Street Journal can be guilty of offering advice that may be inappropriate for doctors. A June 2010 article detailed all the reasons why investors should not convert retirement account assets to Roth IRAs, when in fact the advantage of converting all retirement assets to Roth IRAs could give doctors a tax benefit that may never be offered again.
One theme in our book, "For Doctors Only: A Guide to Working Less and Building More," is: “Advice for the masses is often detrimental when followed by doctors.” The average Journal reader is not subject to the highest marginal income tax rate, while the average doctor is taxed at the highest rate. Taxes have always been the primary reason why traditional financial planning is inadequate for physicians. In light of the Obama administration’s goal to fund programs by aggressively taxing Americans who earn more than $250,000, the need to take advantage of short-term and long-term tax-saving opportunities can not be overstated.
Tax Brackets Are Going UpCurrently, the highest published federal income tax bracket is 35 percent. At the very least, most tax advisors anticipate that will increase to 39.6 percent (the highest marginal rate before the Bush tax cuts). This is just the beginning. Here are some additional tax increases that have been passed, or that are currently showing up in proposed legislation:
• The Medicare tax of 2.9 percent that currently applies only to salary will increase to 3.8 percent for those earning more than $200,000 ($250,000 if married).
• The Medicare tax of 3.8 percent may eventually apply to all income (salary and distributions) of service professionals currently taxed as S corporations and to all investment income of high-income taxpayers.
• All itemized deductions will be capped so as to only receive a benefit at 28 percent (even though a significant amount of income could be taxed at rates of up 39.6 percent).
• Capital-gains tax rates will increase from 15 percent to as high as 23.8 percent (including Medicare tax) in 2013, based on the Health Care Reform Act and the expiration of the Bush tax cuts
For the most successful doctors, taxes could be 39.6 percent plus 3.8 percent, for a total of 43.4 percent on much of their income. In addition, the cap on itemized deductions from 39.6 percent to 28 percent is a decline in write-offs of 11.6 percent. If you are in California, New York or other high tax-rate states, the state income tax could push your overall tax burden to 50 percent or more. With that in mind, income-tax planning is paramount to long-term financial success.
Take Advantage of the Roth Conversion
In 2010, you have an opportunity to convert retirement plan assets to a Roth IRA, pay all your income taxes in advance, and never pay taxes on these funds or their earnings ever again. This should be a no-brainer for most doctors who expect to need income of more than $100,000 per year in retirement and who have the after-tax funds available to pay the taxes.
For example, if you have $1 million of retirement-account assets and $350,000 of liquid non-retirement assets, you can convert your retirement plan assets to a Roth IRA, pay the taxes with your non-retirement funds, and never pay taxes on those funds as they grow or as you withdraw them in retirement (assuming you meet the requirements of the Roth IRA rules).
By paying the taxes on a Roth conversion now, you can lock in the tax liability at today’s relatively low tax rate. In addition, you can give yourself very valuable tax flexibility. By having access to some funds that will not be subject to taxes, you can choose to access taxable or tax-free funds in retirement. When tax rates are relatively low, you can choose to take taxable funds. When rates are high, your Roth IRA will offer you funds that have no tax liability attached to them.
How to Create Roth-Like Benefits
Although you can convert your retirement assets to a Roth IRA this year, you still cannot contribute directly to a Roth due to income restrictions. Since the benefit of contributing after-tax dollars to an investment that will never be taxed again is obvious, what else can high income doctors do? There is only one other investment that isn’t taxed as it grows in value, nor does it create a tax liability when the owner accesses the funds: Cash-value life insurance. Doctors have two options to mimic the value of a Roth IRA:
1. Purchase cash-value life insurance with after-tax dollars; or
2. Purchase cash-value life insurance as part of a tax-deductible contribution from your medical practice.
If you believe that the costs of future U.S. debt obligations and money spent on federal government programs will be significantly reduced and result in lower taxes, then you are in the minority. The need to manage tax liabilities should be a primary goal of your financial planning. By managing taxes at the corporate level and eliminating unnecessary taxes on retirement plans by converting to a Roth IRA now, you could give yourself very valuable financial flexibility as we enter a very volatile economic period.
Christopher Jarvis is a principal of the financial consulting firm of O’Dell Jarvis Mandell LLC, where Kim Renners is the Director of Wealth Management. For a free (plus $5 shipping and handling) copy of “For Doctors Only: A Guide to Working Less and Building More,” call (877) 656-4362.
Disclosure: This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized tax advice. There is no guarantee that the views and opinions expressed in this article will come to pass or that they will be appropriate for your particular circumstances. U.S tax law changes frequently, accordingly information presented herein is subject to change without notice. You should seek professional tax, financial planning and legal advice before implementing any strategy discussed herein. For additional information about the OJM Group, including fees and services, send for our disclosure statement as set forth on Form ADV using the contact information herein. Please read the disclosure statement carefully before you invest or send money.