How To Avoid Common Physician Tax Errors
While it’s true that most doctors are relatively high-earners, physicians also face unique financial obligations (i.e. high loan repayment, disability insurance premiums, etc.) that make it essential to avoid any mistakes when it comes to taxes. By avoiding a few common tax errors, doctors can keep more of their earnings to put towards financial goals such as paying back loans, saving up for a house, and investing in retirement.
Mistake #1: Physicians don’t maximize contributions to their employer-sponsored retirement plan.
Utilizing your employer-sponsored retirement plan such as a 401(k), 403(b), 457, or 401(a) is one of the well-known tax strategies to reduce your taxable income. Still, it’s worth repeating: if you fail to maximize your contributions to employer-sponsored retirement programs, you are missing an opportunity to lower your taxable income. Plus, depending on your employer’s match, you may be missing out on free money!
How to avoid it:
Because physicians tend to earn relatively high incomes, most can afford the maximum permitted contribution toward their employer-sponsored retirement program each year. For a 401(k) account, that maximum is $19,000 each year or $25,000 for taxpayers over the age of 50. It’s advisable for most doctors to take full-advantage of their employer-sponsored retirement plan each year in order to reduce their effective tax rate.
Most physicians can adjust their employer-sponsored retirement account contribution amount by simply logging into their retirement account and changing the settings. By upping the amount of each paycheck put towards a 401(k), 403(b), or similar account, physicians can save on taxes and bolster their retirement savings.
Some employers have multiple retirement plans. Depending on your employer’s offerings, you may be able to maximize contributions to more than one plan. Talk with one of our advisors to determine if this strategy is right for you.
Mistake #2: Physicians save for medical expenses without using a Health Savings Account (HSA)
While setting aside money for unexpected medical expenses is always a smart move, physicians who don’t utilize a Health Savings Account (HSA) are losing out on multiple tax perks. HSAs are available to any physician with high-deductible health insurance plan.
How to avoid it:
First, determine if you qualify for an HSA by taking this brief quiz. If you are eligible, opening a HSA will allow you put aside money for healthcare costs while benefiting from three distinct tax advantages:
- Tax deductible contributions: Physicians make pre-tax HSA contributions through their employer’s payroll in order to reduce their taxable income. For 2019, annual HSA contributions are capped at $3,500 for an individual and $7,000 for a family.
- Tax-free withdrawals for qualifying medical expenses: When physicians take out money from an HSA to pay for deductibles, copays, coinsurance, and other medical expenses, the withdrawals are not subject to taxes.
- Tax-free interest: Funds within your HSA can grow and accrue interest free of taxes.
- Something else you may want to consider with these accounts is that any money that has accrued in the account at age 65 can be used for non-medical expense purposes just like an IRA. As such, it can function as a supplemental retirement plan.
In addition to triple-tax savings, HSA funds roll over at the end of the year, so you’ll never lose the money you’ve invested. Most banks and brokerages have HSA offerings, and you can determine the best fit for your needs by comparing various interest rates, fees, and eligibility requirements.
Don’t pay unnecessary taxes on money for healthcare expenses. For qualifying physicians, HSAs are both a savvy savings strategy and a highly effective tax-reduction tool.
Mistake #4: Doctors miss out on state deductions for 529 plans
A 529 plan is a specialized savings account with several tax benefits. Most people are familiar with 529 plans as college savings account, which allows for tax-free withdrawals for higher education costs. 529 plans also do not place limits on income, age, or yearly contributions.
However, some physicians mistakenly think that tax-free withdrawals for college expenses are the only way to save on taxes with a 529 plan. As a result, they may miss out on other 529 tax benefits.
How to avoid it:
While 529 contributions are not deductible from your federal taxes, they are eligible for state income tax advantages in the majority of U.S. states.
First, check and see what tax benefits your home state offers for 529 plans. More than 30 states offer state income tax deductions for contributions to a 529 plan. Three states (Indiana, Utah, and Vermont) currently offer a state income tax credit for 529 plan contributions. Refer to your state’s specific plan to make sure you are receiving the maximum tax benefit from any money you put towards a 529 plan.
Moreover, you can benefit from the option of tax-free withdrawals well before your children reach college-age. While 529s are often referred to a “college savings plan,” you can also withdraw up to $10,000 tax-free each year to pay for elementary or secondary school tuition.
For physicians who are paying or saving for their children’s education, putting that future tuition money into a 529 plan comes with substantial tax benefits.
Mistake #5: Doctors don’t properly record or file their charitable donations
Most physicians are aware that they can reduce their taxable income by making philanthropic donations. To employ this strategy for a tax write-off, it’s important to track your donations correctly and know how you plan to file your deductions.
How to Avoid It:
First, if you want to deduct a charitable donation from your taxable income, you have to itemize your deductions. If the total of your itemized deductions is less than the standard deduction, go with the standard deduction when you file your taxes.
If you do choose to itemize your deductions, it’s important to keep proper records of your charitable donations. To qualify for a deduction, your donation has to go an approved non-profit group with a mission that is charitable, religious, or educational. Donations to individuals cannot be deducted. To verify an organization’s qualifying status, you can search the IRS list of approved 501(c)(3) organizations.
The exact records required for charitable donation vary based on the amount and type of donation. For example, cash donations under $250 require a receipt, a cancelled check, or a credit card/bank statement, while larger cash donations require written acknowledgement of the donation from the recipient organization. If you donate items or property, you may have to have their value professionally appraised to claim the proper deduction. Follow the IRS guidelines for recording charitable donations to take full advantage of your available deduction from charitable gifts.
Mistake #6: Physicians Neglect Future Tax-Free Income Investments
Different tax-reduction strategies yield savings at different times. In order to reduce their high taxable income, most physicians rely heavily on tactics that allow for relatively immediate tax savings such as deductions and pre-tax investments. Conversely, many doctors do not put enough money into investments that yield future tax savings to help fund their retirement.
Many physicians prefer to opt for current tax savings because they expect to qualify for a lower tax bracket in retirement, and thus anticipate that retirement withdrawals from accounts such as 401(k)s will be taxed a lower rate. However, this is a risky calculation that often underestimates physicians’ retirement tax burdens.
The first flaw in this plan is that income parameters for different tax brackets are subject to change over time, so there is no guarantee of tax savings regardless of your retirement income. Moreover, few doctors actually want to drastically change their lifestyle and the associated costs during retirement. As a result, most doctors maintain similar tax burdens as they transition into retirement.
How to Avoid It:
To help counter the uncertainty surrounding future tax rates, it’s important for physicians to put money towards investments that allow for tax-free withdrawals during retirement. Health Savings Accounts and 529 plans do allow for tax-free withdrawals, however only for approved expenses (medical costs and education costs, respectively). To bolster retirement savings with other accounts that offer tax-free withdrawals, physicians should consider taking advantage of Backdoor Roth IRAs and Non-qualified Executive Benefit Plans.
Backdoor Roth IRA
A backdoor Roth IRA refers to an administrative technique to get around the income limits for contributing to a Roth IRA. Roth IRAs offer tax-free growth and, once the account holder is over the age of 59½ , tax-free withdrawals. However, in 2019 only individuals with less than $137,000 single adjusted gross income or less than $203,000 for those married filing jointly, are permitted to contribute directly to a Roth IRA.
The backdoor Roth IRA is a work-around, wherein the taxpayer puts their money into a traditional IRA, and then converts this money into a Roth IRA. The tax-payer will pay income tax on the converted amount, and if they received tax-deductions for the initial traditional IRA contributions, they will have to pay those deductions back.
You can contribute (and then convert) up to $6,000 per year to a traditional IRA, or $7,000 if you are aged 50 or older. Once you have paid the necessary taxes on the converted money, your investment will accrue tax-free interest and can serve as a source of tax-free income in your retirement.
This strategy does come with a caveat: while it is perfectly legal, the backdoor Roth IRA is technically a tax loophole. It is entirely possible that the rules will change to close the loophole in the future. Thus, while the backdoor Roth IRA can be a useful addition to your future tax savings, it’s inadvisable to hinge your entire long-term investment strategy on a loophole that could be closed at any time.
Non-qualified Executive Benefit Plans
Most of the Fortune 1000 companies offer a special retirement package called a non-qualified executive benefit plan. It is provided for their key executives as a retention tool that accumulates tax-free and can provide tax-free income. The financial structure used is backed by an insurance company. Just like 403bs are tax-sheltered annuities offered by insurance companies, in the same way, an insurance contract is used for this executive benefit plan. More specifically, it is an insurance contract known for paying money to beneficiaries upon the death of an insured that is used as the primary vehicle. For physicians who accumulate a substantial amount of their earnings inside of an employer retirement plan which will be fully taxable upon the time a distribution, this type of executive benefit plan can serve as a very effective hedge by providing tax-free income during retirement to help policyholders maintain their lifestyle.
Most permanent life insurance contracts can accrue “cash value.” When you pay the cost of a life insurance premium, a small portion of the premium covers the cost of the policy itself, while the remaining money is used to be added to the policy’s cash value. This cash-value can grow over time and you can make withdrawals to supplement your income during retirement. Provided that the policy stays in force until you pass away, the amount taken out of the policy is not federally taxed.
Using an insurance contract for retirement savings has become a controversial method among wealth management professionals because many insurance agents have structured them to be more favorable for the insurance company rather than the account owner. Therefore, they are not appropriate for everyone. However, physicians are often especially suited to reap the benefits of this tax savings vehicle. Because doctors tend to be high-earners, they often have remaining income to invest even after maxing out contributions to employer-sponsored retirement accounts, 529 plans, and other tax-advantaged accounts. Putting this money towards an executive benefit plan can help physicians establish a substantial source of tax-free income during their retirement.
Between long hours, stressful work, and pressing financial obligations, the last thing physicians should worry about is losing out on their earnings from over-taxation. From simple deductions to long-term investment tactics, there are numerous ways that you can take steps to protect your income from common tax missteps. Our team of financial professionals can help you every step of the way with proactive tax savings insights and tax filing services to help you reach your financial goals. Talk with one of our trusted advisors to learn more about avoiding common physician tax errors and creating a long-term tax savings strategy.