Putting a tax strategy in place is essential for physicians given the massive federal deficits and an administration determined to repeal the Bush era tax cuts. Three specific tax strategies pertinent to doctors include redeeming stock in a medical practice, Roth IRA conversions, and charitable remainder trusts.
Putting a tax strategy in place is essential for physicians given the massive federal deficits and an administration motivated to repeal the Bush era tax cuts. Three specific tax strategies pertinent to doctors include redeeming stock in a medical practice, Roth IRA conversions, and charitable remainder trusts.
Redeeming Stock in a Medical PracticeOne tax strategy that few physicians seem to be aware of involves redeeming stock in their practices. Typically, if a participant continues to contribute to an employer-sponsored retirement plan, there are no required monthly distributions (RMDs) on assets within that plan -- even after the individual reaches age 70 ½.
If, however, the participant owns 5 percent or more of the entity sponsoring the retirement plan -- common for MDs in private practice -- that individual will be required to take out RMDs after turning age 70 ½, even if he or she continues to work.
In other words, if a physician plans to remain on the payroll beyond age 70, one strategy would be to sell his shares in the practice before retirement to avoid being forced to take RMDs. Then, he or she can continue to maximize the compounding potential of the employer-sponsored retirement plan.
Time Running Out on Roth IRA ConversionThis year, regardless of modified adjusted gross income or filing status, taxpayers may convert their retirement accounts to Roth IRAs. The long-term wealth creation potential of the Roth IRA is tremendous, assuming that certain requirements are met. Meeting those requirements means that Roth IRA assets will never be taxed again.
The advantages of executing a Roth conversion include:
• No mandatory withdrawals after age 70 ½: Compare this to traditional IRAs and qualified retirement accounts, such as 401(k)s, where required minimum distributions must be taken out of the account by April 1 the year following the account holder reaching age 70 ½.
• There are significant estate-planning benefits: The next generation may continue to compound these tax-free assets after the owner’s death, via inherited Roth IRAs, provided the heirs take the required minimum distributions.
• Contributions are permitted after age 70 ½, provided the IRA’s owner has earned income; and
• Qualified withdrawals are tax-free.
Of course, there are costs and rules to executing a Roth conversion, as well. Taxes must be paid on the funds converted (though the IRA owner does have the option of spreading this income over tax years 2011 and 2012). Also, converted funds must remain in the Roth IRA for 5 or more years from the first day of the tax year of the conversion. Remove the funds before then and withdrawals will get hit with a 10% penalty.
A Roth conversion is particularly attractive to doctors who expect to be in a higher tax bracket in the future -- a likely event based on recent legislation -- or if one of the priorities is leaving money to the next generation.
New taxes take effect in 2013, and affect single individuals with wages over $200,000, married filing joint exceeding $250,000, or married filing separate over $125,000. Legislative changes are as follows:
First, the impact on wages and earned income:
• Today: Medicare tax = 1.45 percent (2.9 percent if self-employed because an employer is not paying 50% of the tax)
• 2013 and beyond: Medicare tax = 2.35 percent (or 5.70 percent if self-employed) on wages above the thresholds listed previously (wages below the thresholds are still at 1.45 percent/2.9 percent).
Second, the impact on unearned income (rental income, capital gains, annuities distributions, interest, etc.):
• Today = No impact.
• 2013 and beyond: A new 3.8 percent Medicare contribution tax imposed on unearned income.
An important note: Roth conversions are not considered investment income or earned income, so they are not impacted by the above tax changes. However, if the Obama administration’s proposed 2011 budget passes, and marginal brackets move to 39.6 percent from 35 percent for those in the highest bracket, Roth conversions will be taxed at a higher rate in 2011 than those executed in 2010 for physicians in these brackets.
Charitable Remainder TrustsA tax strategy often utilized by doctors with highly appreciated assets (such as real estate or stock purchased or received decades ago) is called a charitable remainder trust (CRT). This trust allows the donor to unleash income, avoid capital gains taxes, receive an income tax deduction, and diversify his net worth by selling a concentrated asset. CRTs can also leave money to charitable causes at the death of the donor.
It is crucial to note that CRTs are irrevocable; once they are funded, the donor will not able to pull the money back out. The amount of the donor’s income tax deduction is the present value of the remainder interest to the charity, that is, it equals the Internal Revenue Service’s estimated value that will pass to the charity upon the donor’s death or upon their spouse’s death.
Deductions typically fall in the range of 20 percent to 50 percent against adjusted gross income (AGI), and they may be carried forward for the next five years. The IRS does require that the donor receive an income stream of at least 5 percent of the trust’s value each year. (Note: the larger the payout percentage, the less the deduction.)
To avoid issues in the family when a large chunk of the donor’s estate goes to charity, the donor also may take a portion of the income stream to fund life insurance trusts or legacy trusts to leave to the family.
Redeeming shares in a medical practice before age 70, executing a Roth IRA conversion, and funding a charitable remainder trust are three tax strategies that may help doctors minimize taxes, defer or avoid required minimum distributions, and achieve their overall financial planning objectives this year.
Evan P. Welch, CFP, works with individuals, families and physicians to help them achieve their financial objectives through a long-term relationship based on knowledgeable advice. His firm is located in Boxborough, Mass. Welch can be reached at (978) 263-3336 x206.