Three Tax Opportunities for Doctors | Travis Chick
Often tax time can be very stressful. For many, it’s a “hurry up and wait” approach. You rush to get your tax professional all the documents they will need, just for him to tell you how much you will ultimately owe (or get back). If this sounds like your current approach, do not worry, you are not alone.
Today I am going to highlight some of the biggest tax opportunities we see missed with doctors, both throughout the year and at tax time. By no means is this a comprehensive list, but resolving these will have a huge impact on your tax situation both now and in the future. And at the income level doctors can achieve, these mistakes lead to tens of thousands of dollars in overpaid taxes as well as missed opportunities for tax efficient investments.
Tax Opportunities:
Individual (Solo) 401(k) Contribution
Back-Door Roth IRA Strategy
Using Asset Location for Tax Efficient Investing
Individual (Solo) 401(k) Contribution
Intuitively (or maybe experience has shown you) we know that not all money is treated equally. As employees, we have W2 wages, which is a classification of income that allows you to contribute to your tax advantaged company sponsored 401(k) plan, Defined Benefit and Cash Balance plans, as well as Individual Retirement Accounts (IRAs). Often, contributions to these types of plan reduce your current income in the tax year you make these contributions, lowering your tax bill.
But for many doctors, W2 wages are not their only income. Many doctors use their expertise in other ways to earn income. This can be done through speaking engagements, consultant work, medical writing, being an expert witness or many other “side-hustle” type jobs. This income is classified as self-employment income (1099 income) and comes with a unique opportunity to set up additional tax-advantaged retirement plans that offer further benefits.
So, what exactly is an individual 401(k)? Quite simply, this is a tool that allows the self-employed, or business owners with no full-time employees, many of the same benefits of a traditional 401(k) with a few important distinctions.
First, the important consideration of the Individual 401(k) is you get to potentially contribute as two different entities: you as the employee (of yourself) and you as the employer (of yourself). Just as with the traditional 401(k), the maximum contribution to the plan is $58,000 in 2021, subject to the following rules:
1. As the employee, you can defer up to $19,500 if you are under age 50. You can make an additional $6,500 contribution if you are over the age of 50, or 100% of compensation, whichever is less. Keep in mind, this 401(k)-contribution limit applies to each person, not each plan. If you are already maximizing the contribution to your company sponsored plan, this contribution will not apply.
2. As the employer, you can make an additional profit-sharing contribution up to 25% of your compensation or net self-employment income (net profit less half your self-employment tax and plan contributions you made for yourself). The limit on compensation that can be used for this calculation to factor your contribution is $285,000 in 2020 and $290,000 in 2021.
Considering these calculations, if your 1099 Self-Employment income is over $232,000, you are eligible for a full $58,000 Individual 401(k) contribution in 2021. Assuming a 40% tax rate, this translates to $23,200 in additional tax savings. This is real money! This is your money! This can happen every year! And this is how you consistently and efficiently grow your net worth.
Part of the mistake that you will hear stems from “traditional” advice. The reality is only about 5% of the United States population has a net worth of $1 million. Are you part of that 5%? If so, why are you taking advice from people who specialize in the 95%? Even more dramatic, did you know that only 0.5% of the United States population has a net worth of $5 million? Are you taking the same advice as the 99.5%? Or is your advice specialized? If you’re taking advice intended for the 99.5%, you may have been advised to contribute some of this 1099 income into a SEP IRA. While this is still an option, it is not a solution for you.
Here's why:
Due to your earnings/savings capacity as well as the likelihood of your participation in a Defined Benefit/Cash Balance plan, you are likely primed to have a large amount of money in retirement held in your IRA accounts. This is a great thing, except for when you go to pay taxes. Because you have likely deferred a significant amount of money, you will also likely be in a significantly higher tax bracket than you would like to be.
Which brings me to the next mistake/opportunity:
Back-Door Roth IRA Strategy
I would assume that the majority of those reading this have heard of this strategy. I would also assume that many of you are already taking advantage of it in some way. But did you know you could get more into it than traditional advice offers? Let me explain.
With your earnings, you are likely earning too much to simply contribute to your Roth, meaning you are choosing to make your annual non-deductible $6,000 IRA contribution and converting to Roth each subsequent year. This is a great strategy both now and in the future. But when you retire, all these IRAs that you have accumulated will be subject to a part of the tax code called the IRA Aggregation Rule. This rule was created to limit the ability of taxpayers to take advantage of “abusive” tax strategies, requiring all IRAs to be aggregated together to determine the tax consequences of a distribution from any of them. The primary impact here determines how much of your IRA’s non-deductible contributions are treated as an after-tax return of principal when taxable distributions occur, whether they are treated as a withdrawal or a Roth Conversion.
However, any EMPLOYER retirement plans, in this case the Individual 401(k), are not included in the aggregation rule. But, if you had taken the advice meant for the 99.5% and made that SEP IRA contribution, it would be considered part of the IRA aggregation.
The fact that the employer retirement plans are separated out from the IRA Aggregation rule means that if those assets stay in the 401(k), they can avoid confounding the Back-Door Roth Strategy.
Considering this, you should be questioning the expertise of the advisor who is suggesting you roll your assets from your 401(k) into an IRA so they can manage the money “better.”
Who is it better for? You and your tax situation? Or the advisor to charge the fee?
And this leads me into the last topic for today:
Using Asset Location for Tax Efficient Investing
Going back to the percentage of the population that has a net worth of $5 million, there is a reason the highest effective tax is reserved for the top 1% of the population, or those earning over $518,400 in 2021. If you find yourself in this earnings category, HOW your investments are managed matters. Or, more specifically, WHERE your investments are managed matters.
If you have any experience at all investing, you have certainly heard the term “diversification.” We fundamentally think of this as the allocation between stocks and bonds. Now, as we recall from above, if you have done this correctly, you have begun to create for yourself three buckets of money, all with different tax treatment: Taxable, Tax-Deferred, and Tax-Free. My guess is most of you reading this are already invested in all three with your brokerage accounts, your Roth IRAs, and your company sponsored 401(k)s and IRAs. But my experience tells me that those accounts are likely being managed independent of each other and in a very diversified way. The industry tells you this is a good thing, but remember, the industry tailors its advice to the 99.5%. You are unique, and the tax treatment of your investments are also.
Different types of asset classes have different tax treatment that impacts your NET returns. If your income drives you into the highest income tax brackets, on top of understanding what diversification is, you should also have a fundamental understanding of the tax efficiency of the types of investments you own. Assets like High Yield Bond Funds or Private Real Estate deals should ideally be held in your tax-deferred or Roth accounts for two reasons; you do not want to pay 40% tax on that return, and you ideally want that return to compound on itself for years tax-deferred (or tax free).
Your tax efficient investments, like S&P 500 Index Funds, and other growth-oriented stocks are great to hold in your taxable brokerage type accounts. This allows for a strategy called tax-loss harvesting (which only generates more tax opportunity) and is a very effective way to control capital gains and potentially reduce current income.
But the only way to effectively utilize the asset location strategy is to ensure that ALL your assets are being managed as if they are one household, not a fragmented set of individually diversified portfolios.
If done correctly, numerous academic studies show that this strategy can boost after tax returns by as much as 0.25% annually. Now this is about as close to a “free lunch” as you can get in the investment world.
At AWM, we always try to stress to our clients the four uses of money:
Taxes
Spending
Savings/Growing
Giving
My guess is you probably already have a plan for how to spend, save/invest and give your money. The reality is that for most of the country, tax planning does not exist and there is no opportunity to utilize the strategies above. You are unique, your advice should be, too. I encourage you to OWN YOUR WEALTH, make an impact, and invest like a pro.
