By Dr. James M. Dahle, WCI Founder
Doctors are all worried that they are paying too much in taxes. Most of the time, they are right. But they usually think it is because they're not FILING their taxes correctly when, in reality, the reason their taxes are too high is that they're not LIVING their life in the way prescribed by the IRS. If you want to reduce your tax bill, you need to live your life differently. That often means getting married (or staying single if your partner is also a high earner), saving more for retirement, saving for college, saving for healthcare expenses, buying a home, starting a business, making less, buying health insurance, etc.
But not everything you do to reduce your taxes is a smart move.
15 Dumbest Ways to Lower Your Taxes
In the quest to lower your tax bill, I often hear a lot of stupid ideas. Today, I'm going to go over the 15 worst ones.
#1 Make Less Money
This is probably the best place to start because it is the underlying idea behind many of the other ones. The best way to lower your taxes is to make less money. Just stop working. The problem with this method is that it leaves you poorer than working, earning, and paying taxes on those earnings. Yes, your tax bill is lower, but the goal is to have the most money after-tax, not pay the least in tax. This might seem obvious, but I see variations of this all the time.
#2 Borrow Money
Guess what? You don't have to pay taxes on money you borrow. It doesn't matter if you borrow from your credit card, from a payday lender, from a bank, from your 401(k), against your whole life insurance policy, against your car, or against your house. You won't pay taxes. But what you will pay is interest. This money is tax-free but not interest-free. You borrow after-tax money and you pay back the loan with after-tax money. There is no free lunch here.
That doesn't mean it is always a stupid technique. Imagine a 90-year-old with a very low basis on some shares of stock or a property. Their heirs may be a lot better off if they just borrow against it and pay a little interest for a few years until they die. Then, the heirs get the step up in basis at death. But if the 90-year-old sells the asset, they have to pay the capital gains taxes—a scenario that could have been completely avoided if they had just owned the asset until they died. Most of the time, though, borrowing money and paying interest on it instead of selling it and paying taxes on it is a losing idea.
#3 Losing Money
You know another great way to lower your tax bill? Lose money. That's right. When you lose money, you don't have to pay taxes on it. It might even reduce taxes on your other income. You can subtract up to $3,000 per year in capital losses from your ordinary income. This is the underlying idea behind tax-loss harvesting, of course. But in tax-loss harvesting, the loss is typically temporary, while the tax break is permanent (OK, technically it's only permanent if you leave those shares to heirs or donate them to charity). You're not really selling the investment either; you're exchanging it for a very similar one.
But losing money is not a way to get richer, even if it does keep your tax bill very low. I had a huge deduction when I finally sold my accidental rental property. But I would much rather have not lost that money in the first place.
Another variation of this one is starting a business. Lots of people start a business and get all excited about all of the stuff they can deduct from it. Guess what? The reason you get those deductions is because the money was spent and is gone, leaving you poorer. If you start a blog, write off a few hundred dollars in expenses and make little income from it, you have a lower tax bill. But you don't have more money after-tax than if you had never started it. In fact, after a while, the IRS won't even let you deduct your losses. It will just reclassify your “business” as a hobby.
#4 Giving to Charity
I am a big fan of charitable giving. But it is a terrible tax reduction technique. Take my situation, for example. At the time I wrote this, my marginal tax rate was 42%. When I gave $100 to charity, my tax bill was lowered by $42. But I was $58 poorer. Yes, the tax incentives make it less financially painful to give (or alternatively, allow me to give more than I otherwise could), but I'm not coming out ahead. Giving to charity JUST to get a tax deduction is a dumb move. Obviously, if you want to give to charity, you should use that donation to lower your tax bill as much as you can.
Another place people get burned with this one is that they assume a donation is tax-deductible when it is not deductible to them. For example, if you are married and your total itemized deductions are $15,000 and you give $5,000 to charity, you're not going to get any deduction for it. It won't lower your tax bill by one dollar. That's because $15,000 + $5,000 = $20,000, which is still less than the 2022 standard deduction of $25,900 (for 2023, it'll increase even more to $27,700).
#5 Getting a Big Mortgage
Sometimes people buy a house “for the tax deductions.” This is even dumber than donating to charity for the deduction. Yes, property tax and mortgage interest (with certain limitations) are deductible as an itemized deduction, but again you're spending $100 to get $42. If you itemize. And the mortgage is less than $1 million if you bought it before December 15, 2017, and less than $750,000 if you bought it after December 15, 2017. And the total of property and income taxes is under $10,000.
Don't get me wrong, I would still claim those deductions, but don't pretend that you are coming out ahead by buying that house. The buy vs. rent decision is far more complex than just whether you get a tax deduction.
To make matters worse, buying a house often leads to other spending like furniture, insurance, and even fancier vacations and schools as you try to keep up with the Joneses. Buying that big house might be a great way to lower your taxes, but it is certainly not a great way to get richer.
#6 Cheating on Your Taxes
Here's another way to lower your taxes—cheat and lie. This is also ridiculously common. It reminds me of an email I once got from a reader. His wife's parents sent her a W-2, but she had never done any work for them, had never been paid by them, and certainly had not filled out any of the required paperwork. That's just cheating. I'm fairly aggressive on my taxes. I call the gray areas in my favor. I pay every dollar I owe, but I'm not going to leave a tip. I'm also going to pay my fair share. What's my fair share? What the tax code dictates I pay. I still report income that the IRS has no way to know I received. Just like when I used to work for tips—I reported those, too.
Why is this a bad way to lower your taxes? If you get caught, you will pay taxes and penalties (at a minimum). If it is particularly egregious, you may even do jail time. But most importantly, it is morally and ethically wrong. “But it's just a little white lie,” you say. My response: don't cheat on your taxes, even a little.
#7 Not Contributing to 401(k)s
Say what? Let me explain. I have long maintained that contributing to tax-deferred retirement accounts during your peak earnings years is the best tax deduction doctors can get. It's larger than almost anything else, especially if you have access to a 401(k)/profit-sharing plan and a defined benefit/cash balance plan. The best part about it is that you get a massive deduction, but, unlike charitable donations or mortgage interest, you still have the money. You get an upfront tax deduction, tax-protected growth for decades, and usually an arbitrage between the tax rate you saved upon contributing and the tax rate you pay upon withdrawal. But some people argue that you should not use a 401(k) for one of two reasons, both of which are technically true but applied incorrectly.
The first is, “You will pay more in taxes in retirement because the account will be larger.” This is true. If you put in $50,000 and save 40% on it ($20,000 tax deduction) and then, 30 years later, pull out $400,000 and pay 20% on it ($80,0000 tax bill), you will have paid more absolute dollars in taxes. But you will have a lot more money than if you had never made the contribution. You are coming out ahead. In fact, this is still the case if you saved 40% ($20,000) on it and paid 40% ($160,000) on it.
The second is, “You are paying ordinary income tax rates on those earnings instead of the lower long-term capital gains rates.” This one is also technically true but irrelevant. The best way to think about a tax-deferred retirement account is that it is actually two accounts—one a Roth/tax-free account owned entirely by you and the other a tax account owned entirely by the government that it would like you to invest for a few decades before you hand it back over. If you withdraw at a lower rate than you contribute, some of the money in that government account is actually transferred to your account. But even if you withdraw at the same rate you contributed, the government account was simply never yours to start with. The earnings in your “tax-free” account come out tax-free. If you had not used the 401(k) and invested in taxable instead, the amount invested is the same size as the “tax-free” portion of the retirement account, but earnings now are taxable at ordinary, qualified dividend, and/or LTCG rates.
#8 Contributing to Roth 401(k)s During Peak Earnings Years
This one gets a bit complex but is somewhat similar to the situation above. Doctors contribute to their Roth 401(k) with lots of excitement about having tax-free income later. The problem is they would have been better off using a tax-deferred account, so while they save taxes, they end up with less money overall. There are some exceptions to this rule (it can actually be really complex), including people with large pensions, people with lots of rental income, and supersavers. But the general rule stands for most doctors—use tax-deferred accounts instead of Roth accounts whenever possible in your peak earnings years.
#9 Pulling Money Out of IRAs/401(k)s Early
This is a technique recommended by lots of people trying to sell you something. Imagine you are an unethical (or ill-informed) insurance salesperson and want to sell your wares to the American Middle Class. Where is their money? It's all in their home equity and their 401(k)s. They don't have much of a taxable account or much income. So, if you want to transfer their money to your pocket, you need to convince them to pull it out of either their home or their 401(k). One great way to do that is to scare them with the idea of having to pay “huge RMDs” or “large amounts of taxes” in retirement. Large Required Minimum Distributions (RMDs) are the ultimate first-world problem. I know LOTS of retirees who would love to have huge RMDs. Yes, you will lower your taxes by doing this. But you will also lower the amount of money you have after-tax. It's a bad idea.
#10 Whole Life Insurance
Speaking of insurance salespeople, whole life insurance is perhaps the classic method of lowering someone's taxes while leaving them poorer on an after-tax basis. The tax benefits of whole life insurance (and its cousins, variable life and universal life) are dramatically oversold. Just like a term life insurance policy, the death benefits are tax-free. The reinvested dividends are tax-free (because they are technically a return of premium—i.e. you paid too much for the insurance you got). You can do a partial surrender (lowering your death benefit) and take your basis out first. And you can borrow against it (like your house or car) tax-free. That's it.
In exchange for those “awesome tax benefits,” you get a crummy return due to high commissions, high fees, and high costs of insurance. Because of the crummy return, you end up with less money overall. To make matters worse, if you decide you want out, the tax consequences go from bad to worse. If you have a loss when you surrender the policy (the usual story), it isn't deductible, unlike a loss in real estate or in mutual funds. You can exchange it for a low-cost variable annuity (VA) and let the value grow back to basis, but that's going to cost you the VA fees at a minimum. If you have a gain, you have to pay taxes on it at your ordinary income tax rates rather than the lower long-term capital gains rates.
It gets even worse if the agent convinced you to buy whole life insurance INSTEAD of using a 401(k) or Roth IRA because you have now missed out on far superior tax benefits.
#11 Putting Insurance Products in a Retirement Plan
If you thought just buying whole life insurance for the tax benefits was a dumb idea, you haven't seen anything yet. Some people, including a prominent physician making the rounds on the internet, advocate for putting insurance products—like annuities or cash value life insurance—INSIDE your retirement accounts. The primary tax benefit of annuities and cash value life insurance is the tax-protected growth—it isn't taxed as it grows. You already have that in a retirement account. Annuities and cash value life insurance may also receive asset protection from creditors in your state, but you probably have that already from the retirement account. Now, you're paying all these extra commissions, fees, and insurance costs without even getting any additional benefit!
To make matters worse, putting life insurance into a defined benefit/cash balance plan actually eliminates one of the tax benefits of life insurance—the death benefit is now no longer completely tax-free. An amount equal to the cash value is now taxable to your heirs in the event of your death. The physician advocating for this technique thinks this is a great way to buy insurance with pre-tax dollars. While it is true that it is purchased initially with pre-tax dollars in the plan, when the defined benefit plan is closed in a few years and you purchase the policy from the plan, you must do so with after-tax dollars. In the end, assuming you didn't die in the first few years after you bought it, you're still buying it with after-tax dollars. If you did die in the first few years, your heirs would have been way better off if you had spent that money on a big huge term policy.
If you decide not to buy the policy when you close the plan and just surrender it, you ended up with a crummy investment in your defined benefit plan and, thus, less money than you would have had if you had just bought traditional stock and bond mutual funds in there. Since most defined benefit plans are closed every 5-10 years and most cash value life insurance policies don't break even for 5-10 years, you just bought an investment with an expected return of 0%. That's going to leave you poorer on an after-tax basis.
#12 Tax-Loss Harvesting in a 0% Bracket
Tax-loss harvesting is a great way to save on taxes, right? Well, not always. Up to a taxable income of $41,675 ($83,350 married) [2022]—a figure many children, students, residents, and retirees are under—the long-term capital gains rate is zero. The LAST thing you want to do is lower your basis in this situation. By lowering your basis, you may be increasing your future taxes if your income is higher in the future when you cash out of this investment. In fact, you might be better off TAX-GAIN HARVESTING up to those income limits. This raises your basis at no tax cost. Yes, you could still use $3,000 in losses against your ordinary income, but that isn't worth very much in those lower brackets, and that benefit could easily be eaten up by the increased capital gains taxes in the future caused by lowering your basis today.
#13 Forming an LLC
Here's one I hear all the time—”I want to form an LLC to lower my taxes.” I'm not sure what people are thinking. Maybe they think LLCs are eligible for lower tax rates or something. Or maybe they think there is something that can be deducted from an LLC but not a sole proprietorship. Both are wrong. An LLC is a pass-thru entity. It is taxed as a sole proprietorship, a partnership, or a corporation. But it isn't taxed as an LLC. And of course, any business expense that could be deducted from an LLC can already be deducted from a sole proprietorship, partnership, or corporation. An LLC does limit your liability and usually provides some asset protection, and it can make a business look more official. It is also a lower-hassle way to have your business taxed as a corporation if you so desire. But it is not a way to lower your taxes.
#14 Having a Child
This one does work for most Americans but not for many readers of this blog. The child tax credit of up to $2,000 per child phases out pretty quickly starting at $200,000 ($400,000 married). Don't get me wrong, that's a lot better than it used to be, and children lower taxes for docs under that limit a lot more than they did before tax reform. But don't expect any tax break at all if you are a very high earner. Plus, who are we trying to kid? (See what I did there?) This is a lot like charitable deductions and mortgage interest; yes, there might be a deduction, but you're going to spend a whole lot more on that kid than you will ever get back as a tax benefit.
#15 Investing in Municipal Bonds in a Low Bracket
Sick of paying taxes on your money market fund, bond fund, or individual bonds? Just invest in a municipal money market, muni bond fund, or individual muni bonds. That interest is usually federal income tax-free and sometimes state tax-free. The problem is that if you are in a lower tax bracket, you would be better off investing in regular old taxable bonds and paying the taxes on the interest at ordinary income tax rates. In fact, you might even want to put those taxable bonds in a tax-protected account and put your stocks into a taxable account, which could potentially lower your overall tax bill even more. But either way, muni bonds are the wrong choice. They're even dumber if you buy them inside a retirement account where their growth is already tax-protected.
It is a good idea to make sure you aren't paying any more in taxes than you have to, but the 15 methods of tax reduction listed above are just plain dumb. Make sure you aren't using any of them.
If you need help with tax preparation or you’re looking for tips on the best tax strategies, hire a WCI-vetted professional to help you figure it out.
What do you think? Are there any dumb tax reduction techniques I have missed? Comment below!
[This updated post was originally published in 2019.]
Thanks for great post. I’m nearing the end of fellowship so lots of free dinners with “financial advisors.” With your help, I’m able to recognize many red flags. Regarding #9, one these salesman told me to take my 401k with me when I leave because institutions often change the way it manages the funds of non-employees. Both my residency and fellowship 401ks are in the target date options for now. What do you think? Do you still have your 401k from residency or fellowship? Or have you rolled those into your current job?
My residency didn’t offer a 401(k). When I leave a 401(k), I roll the money into the best 401(k) available to me. In my case, that’s my military TSP. Be careful rolling it into an IRA because that causes the pro-rata rule to apply to your Backdoor Roth IRA.
As far as “non-employee being treated differently.” Well, they can’t contribute any more and they don’t get a match, but other than that, it’s pretty much the same in my experience.
Hey L.R., congrats on nearing the end of training! It’s a monumental achievement.
When I graduated residency, I did roll my 401k into my new employer’s plan. But I mainly did this for reasons of convenience and control.
It’s nice to consolidate accounts when you can. As your assets grow, you’ll likely accumulate more investment accounts, so why not make life simpler, eh?
But for me, my new employer’s 401k offered better Vanguard index fund options than my residency’s plan at lower fees, and it was easier to monitor and make changes via the internet. I think the only way to make changes in residency was by faxing in paper!
When you cross over to the “other side,” just compare the investment options of your old and new employer. This will help you make this decision.
I am currently helping a woman roll over her 401k from her employer plan. She left a couple years ago and hadn’t done anything with it. Wells Fargo who was the custodian of the 401k had it rolled over into an IRA with Total IRA and then Total IRA transferred it to a third organization charging fees all along the way. We are still trying to get the necessary paperwork together to get them to transfer it to her Vanguard IRA. Which takes a lot more messing around than the ten minute phone call that would have been necessary if she had rolled it over right away. Apparently there is a law that allows them to do that after an employee leaves and doesn’t take their 401k with them. She did not have a very high balance (less than $2k) which may have been a factor in Wells Fargo rolling it over, but I would still avoid leaving a 401k with your past employer unless you are confident they will not move the money.
I still have mine from residency with the custodian of that hospital system, and I graduated in 2013. So far the only thing that I’ve noticed is that they took back the non-vested portion of their match sometime in the last 6 months (I was 80% vested in the matching funds). Their plan is managed through Fidelity, and so is my current employer, so I can actually see both plans when I log into my Fidelity account. As long as there are no fees to do so, one of my financial goals this year is to roll the old residency plan over into my current plan. From a logistical standpoint it will just make things slightly easier to manage since the funds available and low cost options are virtually identical.
I think in some cases an employer might pay for some of the typical 401k administrative fees (anything above an beyond an ER in an index fund). If that’s the case, the employer may force the then-ex-employee to start paying those added funds themselves. But on the whole if the funds are good and not better at your new place of work, best to just keep it with the ex-employer
My residency 401k accepts rollovers into it and offers fantastic products through Fidelity like institutional total market index funds with expense ratios of 0.015. I could not have beaten that deal with any other option and was glad to have it when I changed employers and needed to rollover funds from both a 401k and cash balance plan to avoid having an IRA that would then have prevented backdoor Roth option. As long as you have a good option, there’s no need to roll over the plan right away. Keep your options open while you’re early in your career. (this includes keeping state medical licenses but that’s a topic for a different post). Awesome job graduating training with a 401k!
I suspect this is a great article because it is similar to what my accountant told me over the years.
Only part I do not get is the bonds in the 401K and stocks in the taxable accounts.
My issue with stocks in taxable accounts is that every time I trade them I pay taxes.
In a 401K that is not an issue. This allows me to follow a newsletter for stocks (trading) and get (theoretically) a higher return than buying some stocks and sitting on them for long periods. Makes my stocks more agile, so to speak. Also simplifies my taxes. Regarding Muni bonds – in California these can be a good investment. Some day my income will drop (hopefully not too soon) and the Munis will be sold (without a tax loss BTW) but in the meantime they are sweet – unless the tax laws change.
Stop trading stocks and following a newsletter and getting a lower return and then you can put stocks in taxable in a boring old index fund, save the newsletter fees, lower your tax bill, and get a higher return.
But yes, if you’re going to be trading investments all the time, it’s best to do that in a tax-protected account.
What i have been doing for the last 20 years (following a newsletter to invest in equities) has actually worked pretty well. It is entirely possible a different approach would have worked as well or better (or worse) but evaluating what is better is not a simple matter (for me anyway) as the taxes, risks, and returns are variable and affect investment choices. As a simple example, what is better – a 7 % return over 20 years with a relative risk of 1.1 or an 8 % return with a relative risk of 1.3? I honestly do not know! What about the tax laws effect? Yikes. You pick your advice and hope for the best IMHO. But so far so good.
Just bear in mind the data is pretty clear that very few people can pick stocks well enough to outperform an index fund in that asset class over the long run. So the obvious thing to do is compare your returns to the index fund. If they’re about the same or better, fine, no biggie. But what most people discover when they actually track things is that they are woefully underperforming, especially after-fee (gotta count in the cost of the newsletter at a minimum) and after-tax. Mark Hulbert has tracked newsletter returns for years and it’s pretty underwhelming. Maybe he tracks yours:
http://hulbertratings.com/30-year-scoreboard/
I picked my newsletters based on Hulbert’s eval of their previous 20 year (now 30 year) performance. I use two newsletters. One newsletter i use suggests different Fidelity mutual funds not individual stocks. I also use a different newsletter that suggest various Vanguard bond funds. I am mostly invested in Fidelity “select portfolios” for stocks. I use Fidelity because that was TPMG’s choice for our 401Ks. The reason i subscribe is mostly to know when to sell, buying things is EZ for me. It is entirely possible an index fund would have been better but who knows? when relative risk and taxes are factored in things get very messy, i am pretty nihilistic on knowing which is better. As i mentioned, I have done fine so far…
What do you mean who knows? That data is available. Might as well see what it is. If you found out you underperformed by 3% a year, would you change strategy? Of course you would. But how do you know if you don’t look?
// If you found out you underperformed by 3% a year, would you change strategy? Of course you would.// Not necessarily. What if there was far less risk in my under performing investments> But anyway…here you go…
Annual Returns (%)
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
+23.4 +31.3 +35.3 +20.4 +25.9 -0.9 +39.0 +5.2 +29.3 +21.7
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
+44.9 -14.9 -7.3 -14.7 +38.4 +7.4 +15.0 +13.6 +15.6 -39.3
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
+35.4 +11.6 +1.2 +19.2 +37.5 +14.6 -2.1 +12.5 +24.0 -7.2
Fine, change my phrase to underperformed on a risk adjusted basis. But the point is the same. Anytime you’re using active management you should honestly track how you’re doing to make sure it is working and stop if it isn’t.
Or have Hulbert do it?
It doesn’t sound to me like you’re following any one newsletter exactly are you? In which case Hulbert’s data isn’t very useful to you.
//It doesn’t sound to me like you’re following any one newsletter exactly are you? In which case Hulbert’s data isn’t very useful to you.// I have no idea how you arrived at that conclusion. You make it sound so complicated! I follow a Vanguard oriented newsletter for bond funds, and a Fidelity oriented newsletter for stock funds, and follow both exactly. All my bond mutual funds are with Vanguard and all my stock mutual funds are with Fidelity. It requires almost no thinking on my part, i just buy and sell whatever they suggest. I am sure a S/P 500 index fund would be even easier however, and maybe “better”.
Then you should be able to use Hulbert’s data. I just remembered you were mixing two of them. Doesn’t the newsletter/Hulbert tell you if the 500 index fund is better? That’s the usual benchmark.
S&P 500 Annual Total Return Historical Data
View and export this data going back to 1988. Start your Free Trial
Data for this Date Range
Dec. 31, 2019 11.48%
Dec. 31, 2018 -4.38%
Dec. 31, 2017 21.83%
Dec. 31, 2016 11.96%
Dec. 31, 2015 1.38%
Dec. 31, 2014 13.69%
Dec. 31, 2013 32.39%
Dec. 31, 2012 16.00%
Dec. 31, 2011 2.11%
Dec. 31, 2010 15.06%
Dec. 31, 2009 26.46%
Dec. 31, 2008 -37.00%
Dec. 31, 2007 5.49%
Dec. 31, 2006 15.79%
Dec. 31, 2005 4.91%
Dec. 31, 2004 10.88%
Dec. 31, 2003 28.68%
Dec. 31, 2002 -22.10%
Dec. 31, 2001 -11.89%
Dec. 31, 2000 -9.10%
Dec. 31, 1999 21.04%
Dec. 31, 1998 28.58%
Dec. 31, 1997 33.36%
Dec. 31, 1996 22.96%
Dec. 31, 1995 37.58%
Dec. 31, 1994 1.32%
Dec. 31, 1993 10.08%
Dec. 31, 1992 7.62%
Dec. 31, 1991 30.47%
Dec. 31, 1990 -3.10%
Dec. 31, 1989 31.69%
Dec. 31, 1988 16.61%
You don’t need to show it to me or prove anything to me. I suggest you track your own returns after fees, taxes, newsletter subscriptions etc and see how it goes.
I appreciate when people follow a newsletter exactly. It means that whatever possible alpha some quant mines out of past data gets completely diluted or reversed once thousands of people apply the advice and bid up the prices of whatever is being recommended. Makes my passive index that much more fruitful.
Sarcasm aside, if I have a really good idea on stock picking or market timing, I’m certainly not philanthropic enough to share it with thousand of people. Odds are, this person isn’t either, but they can sell a newsletter.
Another idea on which to ruminate, if you follow different newsletters for stocks and bonds separately, what happens if they both go long risk and you go broke or short risk at the same time and you miss the big run up? It would be like telling two contractors what you wanted your house to roughly look like but don’t tell each what the other is doing.
Cheers,
DS
L.R.
For now, keep them where they are. Sometimes your new employer plan will allow a “roll in.” Sometimes they do not. If they do not, then it is easy enough to ask the plan administrator to change the 401k to allow a “roll in.” Complicating matters is the fact that your new employer may have a less than optimal 401k plan. Hence, you may not want to roll it in. If you were to roll it over to a traditional IRA, it will cause you to pay more tax when you do the backdoor Roth IRA every year. This is called the pro-rata rule. Since half the year you have a fellow’s salary, and half the year you have an attending’s salary, it might make sense to roll it to a traditional IRA, and then convert it to a Roth. Part of it depends on how much money you have in it. If it is a large sum, you give up the opportunity cost of investing that money that now went to the government. Feel free to start a thread on the forum and I will chime in if I have time. List the specifics.
Physicians Capital Management, LLC
So many good points here!
It is somewhat funny how very smart people can be duped because of fear of taxes.
I hope no one has a kid just for the tax break. I am in a position to get the tax credit but I would absolutely rather if I could double my salary and not qualify. Also kids are VERY expensive. 2K a kid is nothing compared to what they cost. It does not even cover 2 months of daycare.
Another classic post!
We pay almost 3k a month and half of the time she stays home because she picked up a bug
Right now (and most likely for the next 4 years) I’m in the highest tax bracket. I have about half of my bond holdings in a Vanguard bond fund in my IRA and about half in a Vanguard tax-free bond fund in my taxable account. The tax-free bond fund in taxable makes sense right now because of my current tax bracket and the fact that I’ll be living off my taxable account when I retire in 4 years at age 50. My question is, what do I do with my tax-free bond fund after I retire and I’m no longer in the top bracket? The tax-equivalent yield won’t technically make sense to keep that fund anymore but I would still like to have some of my bond holdings in my taxable account until I’m taking withdrawals from my IRA at age 59. Do I just keep the tax-free fund?
Then exchange it for a taxable fund either in your taxable account or in a tax protected account (selling stocks there and buying them in taxable.)
Only reason to keep the tax free fund at that point is if it for some bizarre reason has huge capital gains.
I have made the mistake of investing (a percentage) of my contributions to a 401K Roth at my work enamored with the potential for never having to pay taxes on it again. Then I realized that I am likely to come out ahead later on with a traditional 401k because I’m at the highest tax margin now. Of course who knows where tax rates will go in future but I still think the odds are on my side that traditional is way to go.
For those who are worried about losing their mortgage interest deduction and use it as an excuse to pay off their mortgage fully, I have offered in the past a service where they send me how much interest in the past they would have paid to a bank and I would return 39.6% of it back to them if it made them feel better. So far have not had any takers.
A lot of the deductions get phased out at my income level so I am thrilled that the standard deductions have gone up as I never even went over the previous much lower standard deductions after I had paid off my home.
With the SALT deduction limitation, those who pay off their mortgages and don’t give much to charity are finding that there is no point in itemizing.
I ‘bunched’ my charitable giving in my last year of full time work to exceed the standard deduction. Sadly the several charities won’t believe they won’t get so large a donation for another 10 years or perhaps never. But they already had my address anyway. A smoother way many here do it is to ‘bunch’ several years donation to a charitable trust you run (eg Vanguard Charitable) then do your donations as usual over several years but only itemize the ‘bunch’ year. Supposedly you can hide your home address from the charities that way! Does Vanguard then get all that junk mail?
I doubt it but neither do I care if Vanguard’s mailbox is full of charity porn.
No “supposedly” about it: donor advised funds, allow you to withhold your address. In fact, they allow you to make completely anonymous donations. I often do this, when I am donating to help in the aftermath of a natural disaster that occurred someplace where I do not live. That way I am not subject to charity porn from charities.I have no plans to donate to in the future.
If you decide you want to set up a donor advised fund, I recommend that you do not include your name in the name of your fund. That way you have multiple choices about how much information to reveal. If you want to develop a long-term relationship with a charity, you can let the charity know your name (and possibly your address) in addition to your fund name. If you would like the charity to know that it has a regular donor but do not want the charity to be sending you information, if your fund has a generic name (such as “The Happy Donor Fund”) the charity will be able to see that they have a regular donor, but will not know who it is. And of course, if you donate anonymously, they will have no idea where the money came from or how frequently the anonymous donor will be contributing. It gives you a lot of control!
I like it! Interesting slant on an old topic.
I’m guilty of #1. Make less. I think it was a good change for me. Cutting taxes wasn’t my only motivation, but cutting back reduced my income and taxes. It also reduced my workload, liability, and stress level. There is a diminishing return on added dollars at the top marginal rates. As PoF has described those last work hours each week are paid at your lowest hourly rate since the taxes are highest.
#8. I do that too. I contribute to a Roth 401K. I don’t think the marginal tax rates are that high currently (on a historical basis). What will future rates be? I don’t really know. Playing the odds, I think they will be higher. I might be in one or more of those “exceptions” groups though. Plus I do contribute to a 457b also so I guess I am hedging my bets.
#14 cracks me up. My 14 yo said she heard we will “earn” $2,000 from a tax credit because of her. She “knows” we will make money because of her. She wanted to know what her portion is – since that would be fair. Or I could increase her allowance now. OMG. I explained the phase in income limits. She said if your income is that high then you could really afford to spend more so, either way, a higher allowance should work. Can you believe it? I think my kids will be running negotiation workshops soon. And I will be the first to sign up. I have a lot to learn.
Your 14 sounds like a business consultant. Get her some books on negotiations now and set her up for success lol
Yes, Wealthy Doc, part of my plan is making less, so I’m not certain its the number one stupid way to reduce taxes. It can be a step towards retirement.
Example:
At present, I make high wages for Psychiatry by having a full-time primary job that pays a market wage for my 25 years of knowledge and experience as Chief Medical Officer (really a fancy name for Medical Director with ~ 20% Admin time). I have a side hustle that pays half again my regular wage but requires me to work >20 weekends and several holidays a year (to leverage the hourly wage to the highest possible by taking work no one else wants). I put the max in the company 401 (with 5% match) and the max in the 457, max out the HSA, and then max out a SEP IRA on the side business to reduce my current taxes to the minimum. They take so much off the top of my check I need the side hustle to pay my bills…
Anyway, I will eventually sell the “big” house (4000 sq ft), move to a smaller house (still 2800 sq ft) with much lower maintenance electric, and lower property taxes. I will drop to 1-2 days a week (my idea of retired allows a few days a month of work) and my wages will drop by $300,000. Of that $300,000 fully $100,000 goes to TAXES. With the one or two days a week, I’m making a lot less money, but my federal tax bill drops to $20,000 a year.
I don’t need “things” anymore, and I will have funded a four year education for four children. All I need is time and less stress. At some point, the many taxes (federal, state, SS, Medicare, self-employment, etc.) make marginal dollars barely worth earning. Now if you are able to build up significant passive income, its less of an issue, but for me, all my marginal dollars require me to trade time (life) for that money and the government takes a lot of it.
I get the point, making less money isn’t the best way to reduce taxes, but in some ways I can’t wait to dump the “big house life” and start the “cabin in the mountains” life.
I disagree with #6. Cheating on your taxes is easily the best way to save money on your taxes. As long as you don’t get caught. You know, it’s just like speeding. Perfectly legal as long as you don’t get caught.
(All of this is said in jest, in case someone can’t read the sarcasm). 😉
Do you think WCI speeds? Or occasionally samples a grape at the supermarket?
Uh oh, they’re on to me.
Ha. My point was that if you do, the Winston Churchill ethics argument that you use isn’t very convincing.
(Yes, you could argue that ethical and legal aren’t the same thing, but millions of taxpayers have ethical issues with the tax code that are bona fide to them. I’m not even sure I can verbalize any ethical issues with speed limits, although I speed all the time.)
I’ll admit to speeding (rarely and by accident if some LEO is reading this), but sampling a grape? Unless they have a box to put a dime in if you do I’m not certain that is forgivable.
The comment about LLCs isn’t quite right, though the situations where LLCs can in fact result in tax savings are highly complex and need the advice of a tax professional. Suffice to say, LLCs taxed as S-corporations can have certain benefits that a sole proprietorship does not.
(None of this is legal advice.)
So….what exactly is wrong with the comment?
Any thoughts on this for those of us who have a larger mortgage above $750k?
https://www.svb.com/blogs/mary-toomey/maximizing-deductible-interest-expense
Seems a little squirrelly to call it investment interest expense but I suppose money is fungible.
Personally, I wouldn’t be very comfortable owing $2.5M for anything.
It’s interesting because the interest on the mortgage above $750k becomes “deductible” (again), so it doesn’t need to be a huge mortgage like in that example, just anything over $750k.
So for those in HCOL areas that want to keep their mortgage (to take advantage of low rates) and have enough investments in the stock market can use this strategy: pay off their mortgage, then do a cash-out refinance for the same amount as their previous mortgage, and invest that. Then the interest expense is deductible.
Another article on it: https://cressetcapital.com/post/borrow-more-invest-more-deduct-more-cash-out-refinances-present-unique-tax-and-investment-opportunities-for-homeowners/
#13 on forming an LLC isn’t precisely correct. There are many nuances, but the tax code favors corporations over individuals. There are some tax advantages to choosing to be a professional corporation (LLC or PC) taxed as an S Corp vs being a sole proprietor.
The most significant point is that with a doctor’s high income, you will pay far more in taxes if you receive your earnings as W-2 income than if you receive it as 1099 income through your single-member professional micro-corporation first (self-employed). Traditional employment for doctors is the equivalent of buying a high-commission financial asset–doctors are easily convinced it is best for them, but later discover that it wasn’t a great deal. Choosing an employment lite contract through your single-member professional micro-corporation (LLC or PC) rather than traditional employment is a far better option for doctors due to the tax savings, preserved professional autonomy (you are a long-term independent contractor), and the larger retirement savings available to you through a 401 (K)/cash balance plan (traditionally employed doctors have ERISA caps on their retirement plans).
In the end, for a number of reasons including tax savings, I believe every doctor would benefit from forming a single-member professional corporation that becomes a virtual cover surrounding their professional services.
This would shift them from the least tax-advantaged way to earn their high income, which is an individual to business contractual relationship ( traditional employment). Sadly this is the route that most graduates are being told is best for them.
By forming a single-member professional micro-corporation, with its associated tax advantages, doctors can now shift into contractual relationships that look like this:
Business-to-Business Contracts
-Employment Lite
-Side Professional Work
-Locums Tenens
Business to Individual Contractual Relationships
-Direct primary care and direct specialty care models
-Cash only medical practices
-Direct-to-consumer medical care of any type, for example, “Hims” or “Roman”
-Concierge/Lifestyle Medicine
-Integrated Medicine
-Precision Medicine
You’re making an argument for 1099 compensation vs. W-2 compensation. I don’t see where you’ve laid out something that you can do through an LLC or S-Corp that you couldn’t do with a sole proprietorship and 1099 compensation.
Hank,
I didn’t want to get too granular in my initial response, but here is a general response to your question.
First, you are right that I am making the point that from a tax perspective, it is best for doctors to receive their earnings as 1099 contractors rather than W-2 individuals. In my opinion, almost every employed doctor truly is a long-term independent contractor rather than an employer due to the built-in “without fault” 90-day terminations in most employment contracts. Thus employment lite contracts are much better for doctors than traditional employment contracts
Second, to answer your question about the tax advantages of LLC/S-corp over a sole proprietor–here are a few key differences:
Self-employment tax: As a sole proprietor, you are responsible for paying self-employment taxes on all of your income. This tax is currently set at 15.3% and is made up of both the Social Security and Medicare taxes. In contrast, S-Corp owners can receive both a salary and distributions from the business, and only the salary is subject to self-employment tax. Most professional micro-corporation owners will set their IRS-compliant “reasonable salary” at a rate lower than their 1099 earnings and thus lower their tax rate. It is the combination of salary and distributions that will create the most tax-advantaged blend to land in your household bank account.
Income taxes: Sole proprietors report their business income and expenses on their personal tax returns, while S-Corp owners file a separate tax return for the business. The advantage of this is that S-Corps can pass through business income and losses to their owners, who report this on their personal tax returns. This means that the business’s profits are only taxed once, at the owner’s personal tax rate. Tax-advantaged household income and expenses that flow through your single-member corporation ultimately create a blend that can benefit your household tax-free and reduce your business’s taxable corporate profits. A good example of this is the August Rule which you cannot take advantage of if you’re a sole proprietor. You need to have an LLC or Corporation that is taxed as an S-corp, C-corp, or Partnership and set up with a separate EIN.
Deductions: S-Corp owners may be able to take advantage of certain tax deductions that are not available to sole proprietors, such as health insurance premiums and certain retirement plan contributions.
Limited liability: While not a direct tax advantage, it’s worth noting that S-Corps offer limited liability protection to their owners, which means that the personal assets of the owners are generally protected from business liabilities and debts. For high-net-worth individuals like doctors, this is a significant advantage over sole proprietors.
Hope that answers your questions.
There is also a tax downside to being paid on a 1099–you’re paying both halves of the payroll taxes.
You are correct, and that is especially true for sole proprietors. There is no one to share this payroll tax expense with. That is the exact reason that a doctor’s high income is less tax-advantaged for them. Beyond deducting the business expenses, there is no way to lower the income tax drag that they must pay (but due to the business deductions is it is still better than W-2 income).
The professional micro-corporation pays half of its owner’s W-2 payroll taxes just like a traditional employee. Thus unlike the sole proprietor, individually you are only responsible for half of the payroll taxes and your corporation covers the other half.
How the corporation actually reduces the owner’s taxes and the business taxes are all part of the secret sauce. Experienced agencies and tax professionals know how to do this with high-income professionals like doctors.
Ultimately professional micro-corporations can take that same 1099 income and repackage it as a lower salary for the owner which lowers the tax liability ( taxed as W-2 income). Most professional micro-corporation owners will set their IRS-compliant “reasonable salary” at a rate lower than their 1099 earnings and thus lower their tax burden. The bottom line is that to the IRS it will appear that you are taking a pay cut because your taxable income will go down. The IRS monitors this and expects your reportable income to be reasonable for your profession. The reality is that “reasonable” salaries are a wide range for medical professionals and choosing the lower end of that range has tax advantages to you. Sole proprietors don’t have the ability to do this.
When I first made the transition to a professional micro-corporation within an employment lite contract it was counter-intuitive to me that by getting paid LESS my household would benefit MORE. I was skeptical and thus ran a case study to compare my W-2 to this new business structure. Once I did that, the skepticism was removed because the net benefit to my household was nearly $70,000. Not chump change!
However, I was used to getting a weekly W-2 paycheck, thus getting a smaller regular paycheck still created a bit of angst. That’s because all I really knew from my past was the life of an employee–you work and you get a paycheck.
But what small business people know is that the flow of cash into their household is due to the four-fold combination of Self-employment (W-2) salary + Business Distributions + Tax-advantaged household income & expenses + Tax-deferred retirement plan(s).
All of the money does not flow predictably into your bank account every 2 weeks, rather it lands in your household in a more asynchronous manner. The rhythm is different with a combination of synchronous cash flow (salary) and asynchronous cash flow over 12 months. For doctors used to employment cash flow, this does take a bit of getting used to.
Honestly, it took me a full 12-18 month cycle to fully understand how this was better and different than the W-2 life.
The real affirmation that erased any angst and skepticism was when I did my taxes during the first 12-month cycle. The reduction in my effective tax rate was stunning.
That whole experience serves as my motivation for wanting to share this message of informing and inspiring doctors everywhere that they can do the same, and it’s why I formed a blog called Dr. Inc. to do this.
The article doesn’t say there are no benefits to incorporating. It says there is no tax advantage to forming an LLC. That is true.
I respectfully disagree, as I stated to Hank, there are self-employment tax and income tax benefits to LLC/S-Corps versus sole proprietors. That has been confirmed in my personal experience as well.
The first step is receiving the income as 1099 compensation rather than W-2. Just getting doctors to see this advantage is a huge step in the right direction.
The next phase involves sorting out the cost-benefit ratio of deciding whether it is best for you to report the income as a sole proprietor, single-member LLC, or as a business. A professional micro-corporation taxed as an S-corp opens up tax-advantaged options not possible for sole proprietors when it comes to space between what you earn and how it financially benefits your household. The overall return on investment associated with owning and operating a professional micro-corporation easily out-performs the W-2 worker but also out-performs the sole proprietor due to taxes and other elements.
Due to all of the advantages (including taxes) comparing apples to apples with income earned, a doctor’s net worth will grow faster annually as a professional micro-corporation (due to retained earnings). In other words for every dollar one earns for their professional services, the net benefit of those dollars to their net worth follows this forced rank order: professional micro-corporation/S-corp > sole proprietor>>W-2 employee.
Todd, an LLC is a legal entity. It can be taxed in multiple fashions. Many people assume there’s a tax benefit to *just* forming an LLC, but because it’s a legal entity, it doesn’t have bearing on taxation. That’s Jim’s point. You’re taking the comment several steps down the road to independent employment (1099) and how to structure tax status there and are, as a result, sort of missing the point.
S Corps yes, LLCs no. There is no tax benefit to an LLC except insofar as it files taxes as an S Corp.
Look, I understand your point about being an owner versus being an employee. I’m a big fan of ownership. But filing as an S Corp is not always advantageous compared to being a sole proprietor/partner. One of my businesses (WCI) files as an S Corp. Another (clinical work) files as a partner. In that case, the costs and hassle of having the S Corp be the partner are not worth any additional tax advantages.
I do agree with you and understand the spirit of what you are communicating about “LLC’s” and taxes versus sole proprietors.
In today’s physician labor market, too many physicians see W-2 employment as their only viable option. And this is a mistake. It is a mistake because high-income individuals pay more in taxes in comparison to their self-employed peers, and it’s also a mistake because traditional employment is not their only option.
Ownership is an option for doctors, and ownership does not necessarily mean “private practice”, nor does it mean that you can’t use your professional micro-corporation as a “1099 employee” to a large corporation.
Ownership first involves forming a professional micro-corporation that is conjoined to you as an individual. When a doctor does this, now they have empowered themselves to have tax classification options for every job situation–that range from individual to business classifications. Service professionals like doctors, lawyers, and accountants are given this superpower. Many doctors have forgotten they have it.
That dual individual and business classification opens the door to all job options that include:
Individual to Business Relationships:
-traditional employment
-joining a medical group/partnership
Business-to-Business Relationships:
-Employment Lite
-Side Professional Work
-Locums Tenens
-Telemedicine jobs
-Membership in professional medical group corporation—most doctors are unaware that they can join a group or partnership as a micro-corporation rather than as an individual.
Business to Individual Relationships:
-Direct primary care and direct specialty care models
-Cash only medical practices
-Direct to consumer medical care of any type, for example, “Hims” or “Roman”
-Concierge/Lifestyle Medicine
-Integrated Medicine
-Precision Medicine
Choosing which business classification is best for you is individualized to your job, life architecture, and income channels.
As you know the tax classification options for non-employment income are primarily:
-Individual/sole proprietor/ or single member LLC
-C Corporation
-S Corporation
-Partnership
-LLC
Of these options, most doctors find choosing to be a sole proprietor or professional micro-corporation (designated as an S Corp) will be best for them. As you know the big issue with sole proprietors is the lack of asset protection–which for high net-worth individuals like doctors is a big deal.
The empowerment to have options is where I believe many physicians miss the benefits of having a professional micro-corporation–not just for tax strategies but for a host of other reasons that range from higher income to greater well-being and professional satisfaction.
The 2022 Medscape physician survey provides some evidence of this as self-employed doctors make 20% more than their employed peers. That’s only a reference to the income side of the equation, not the tax savings side of the equation. In my personal experience with channeling my professional income through my micro-corporation(PC) my effective tax rate was nearly cut in half in comparison to when I received the same income as a W-2 worker.
As an example, let’s look at the majority work model for doctors today: Traditional Employment
I think W-2 employment to large corporations for doctors is here to stay and likely will always be the dominant model. But, I believe employment lite(1099) through a doctor’s micro-corporation is a better option than traditional employment due to the tax, fringe benefits, and enhanced retirement fund options. It’s the apples-to-apples alternative to traditional employment, but still within the safe harbor of big corporations.
Employment lite through a micro-corporation is a hidden option for doctors in the employment space. It’s hidden because doctor don’t know about their power to have a professional micro-corporation and because employers prefer having greater control over doctors as employees–and thus don’t offer this on their contractual menu. It’s like going to the Dairy Queen and believing you can only order off their visible menu–cause it’s all that you see–then you miss out on their hidden menu that includes my personal favorite the peanut buster parfait with peanut sauce rather than fudge. Much like this story, a doctor can’t ask for a contract that’s not on the large corporation’s menu unless they know there is a hidden menu that includes employment lite. (by the way employment lite is a type of professional service agreement that virtually every employer uses in some fashion–so it’s on their legal department’s menu).
Doctors working for large corporations should be able to choose their preferred path as either”1099 employees” or as “traditional employees”. Fundamental to the choice is taking the step to incorporate themselves.
As another common example, there is the proliferation of professional side jobs and part-time work for doctors–which is often contracted labor, or 1099 income. Recent Medscape data indicates that nearly 40% of doctors do this. Having options to determine which is the best tax classification for this non-employment income is ideal, and having a professional micro-corporation provides expanded options to choose from for a doctor. I think it is wise to speak to a tax professional who understands each doctor’s global financial picture at this point, as they can help guide their choice. So doctors should do this BEFORE they fill out that form W-9 as part of their tax plan.
As you stated generically “Having an LLC is not a way to lower your taxes”. I agree generically,
but I think we also agree that having BOTH business and individual tax classification options for a doctor’s income channels is a good tax strategy–with S Corp especially fitting that bill for doctors. Even more specifically I like professional micro-corporations (PCs or similar) designated as an S-corp a great fit for most doctors.
Many years ago before I knew about WCI, I transferred a 401k from a previous employer to an IRA. I also have a SEP-IRA. Now I have a pro-rata problem if I want to proceed with a backdoor Roth IRA. Is there a way to fix this?
You can roll that rollover IRA and SEP-IRA into a 401(k). Or you can convert it all to a Roth IRA. Or you can just do the contribution step and not the conversion step at this time. Or you can not do Backdoor Roth IRAs at all. Your choice.
I realize this blog post was from a few years ago originally, but reason #5 about taking out a big mortgage really isn’t as dumb, especially if you consider this at the time the article was posted which I am assuming is around 2019 based on the comments. Of course, if you do exactly what the paragraph states and take out a mortgage purely for the tax deduction, that is really dumb. But if you consider things from a different angle, does the tax deduction incentive help with the decision on taking out a larger mortgage? It helps. For some high earners, they don’t have any other deductions available. I count my blessings for the two low rate mortgages I have on two homes. but as I write this in 2023, the game has changed, and rates have tripled. Reason #5 is valid as written, but any tax deduction offered such as the mortgage rate deduction is a worthwhile consideration.
If you read carefully, the article doesn’t say taking out a mortgage is dumb. It says taking out a mortgage or keeping a mortgage just for the tax deduction is dumb.
Yes. That is true for pretty much every tax deduction you listed. There are legitimate reasons for doing nearly all of them, but lowering taxes is just a nice side effect. My taxes are definitely lowered because of all the charitable donations I make, but I make those donations, because I feel charitable. Financially I would be better off if I just kept the money to myself and paid the taxes on it.
The take away is to make sure you are not allowing the tax tail to wag the financial dog!
Yes. I read the article. And as I stated, I agree with item #5 as written. But if I had to remake my decision in 2020 to take out a larger mortgage than I needed based on current cash holdings, tax benefits would still have been a consideration albeit small in the scope of things. Not even mentioning the low interest rate. Would do it again in a heartbeat.
Hello
I had a quick question I locum and also earn 1099 income for a side home business when I am in my resident state
I live in an income tax free state. If I locum in a state with income taxes can I use the money from that state to fund my 401k instead of the 1099 income from my side home business in the state with no income taxes. In terms of tax implications it would not matter for federal taxes but in terms of state income taxes can I show that I only deducted the money I made for that state and put it into my 401k. Please let me know.
Thank you
I don’t know for sure but I don’t see why not. I don’t know of a rule that requires it to be pro-rated. When you file your taxes for that other state you would just decrease the amount of income attributable to that state by the amount that went into the 401(k). It would obviously save you a lot of money if you live in Texas and do locums in California.
Main benefit of physicians filing as an S Corp is avoiding 2.9% medicare tax on distribution income beyond base wage reasonable compensation. This can save 10s of thousands a year in taxes potentially. No other direct tax benefit that I am aware of.
https://www.fortenberrylaw.com/self-employment-taxes/