Podcast #131 Show Notes: Rules for Business Vehicle Tax Deductions

Deducting your business vehicle sounds like a great way to lower your tax bill. Unfortunately, it is probably not going to be a significant deduction for most doctors.  For starters, W2 employees cannot deduct a car or business mileage. You don’t own a business so you cannot own a business vehicle. A business can buy a car if it is going to use it at least 50% for business purposes. Regardless of the percentage of time you use your car for business purposes, business owners can still deduct their business miles. Deducting business miles is worth $.58/mile in 2019. That is not insignificant and can really add up. I discuss the rules of business vehicle tax deductions in this episode to help you decide what you can deduct, along with answering listener questions about how business people making millions avoid paying taxes, being on Tricare and using an HSA, what to do with the TSP when you retire, what to do with the whole life insurance policy your parents bought you, and how the pro-rata rule affects the mega backdoor Roth IRA.

This episode was sponsored by Bob Bhayani at drdisabilityquotes.com. They are a truly independent provider of disability insurance planning solutions to the medical community nationwide. Bob specializes in working with residents and fellows early in their careers to set up sound financial and insurance strategies. Contact Bob today by email at [email protected], or by calling (973) 771-9100.

Quote of the Day

Our quote of the day comes from Charlie Munger, Warren Buffett’s partner, who said,

“If you have a $2,000 monthly mortgage payment, grandma can help. If you have a $20,000 monthly mortgage payment, no one can help.”

That is the truth and one of the biggest reasons why you have to watch that lifestyle inflation, especially if you are funding it with debt.

Rules for Business Vehicle Tax Deduction

The listener who asked the question that sparked this week’s episode said he was  “planning on doing the unforgivable for a WCI reader — buying a Tesla.” Thankfully he clarified that all his ducks were in a row and he has planned ahead for this purchase. But he wanted to know if he could buy the Tesla through his practice. Unfortunately for him, he is a W2 employee so the answer is no. A business can buy a car if it is going to use it at least 50% for business purposes. Business owners can write off our business miles, whether we use that car more than 50% for business purposes or not. But a W2 employee doesn’t own a business and thus can’t do either of those things.

If you are a contractor paid on a 1099 you have options to write off your vehicle and mileage. Let’s start with business miles.

Business Mileage Deduction

There is a bit of confusion about what miles are deductible. You can’t deduct commuting miles. What do I mean by that? I mean the drive between your house and your business and back, those miles are not deductible. Those are not business miles. Business miles are miles you drive for business purposes. So if you leave your office and you go meet with a client and you come back to your office, those miles are business miles. But coming home in the evening, those aren’t business miles. For most doctors, if they drive into clinic, do a little bit of work there and then they go over to the hospital and round, then they come back to clinic and then they drive home, the miles that are business miles are the ones between the clinic and the hospital, not the ones between home and the clinic or home and the hospital. The deduction is $.58/mile for 2019.

Business Vehicle Deductions

The vehicle deduction this Tesla driving doctor was talking about is a section 179 deduction. These are for vehicles that are used more than 50% of the time for business purposes. The deduction is limited to the amount of use. So if you’re only using it 60% of the time for business purposes, you only get to deduct 60% of those expenses.
The vehicle has to be purchased and put into service during the year in which you’re applying for the section 179 deduction. But this can be a huge deduction. If you claim 100% bonus depreciation, you can actually deduct up to $18,000 in the first year, another $16,000 in the second year and $9,600 in the third year, etc. It can really add up to be a lot of money. But there are also maximum limits on section 179 deductions, a total of $1 million for the year on a single property or up to $2.5 million for all property.

Obviously that’s much more than vehicles. One thing to keep in mind is the different amount you can deduct for a vehicle that weighs 6,000 pounds or more. If the vehicle is rated more than 6,000 pounds gross vehicle weight and less than 14,000 pounds gross vehicle weight, then you can deduct more than you could for a vehicle that weighs less than 6,000 pounds. The vehicle has to be either be new or new to you. So a used vehicle is okay, and it can’t be used for transporting persons or property for hire. You can’t expense more than the cost of the vehicle and you can’t deduct more than your business net income for the year. So if you’ve got this side gig and you made $2,000 here, you can’t then take a $15,000 deduction for the car. You can’t use it to generate a tax loss.

Keep in mind, of course, that if your vehicle doesn’t weigh 6,000 pounds, the available deduction is much smaller. How much does a Tesla weigh? Well, a Model S weighs 4,647 pounds, a Model 3 weighs 3,552 pounds, and even a Model X weighs 5,421 pounds. So none of them are 6,000-pound cars. A vehicle deduction isn’t going to work for this doctor and probably won’t for most doctors.

Reader and Listener Q&A

Making Millions and Avoid Paying Taxes

A listener feels like he is doing everything possible to lower his W2 taxable income and still paying a lot in taxes. What else can he do? And he wonders how these business people who are making millions of dollars avoid paying any taxes?

Without any 1099 income, he can’t open a solo 401(k) to invest more money there and lower his taxable income. He can talk to his employer about starting a defined benefit plan or cash balance plan. But he can’t open one on his own. People like him end up investing in a taxable account, which is perfectly fine. You can invest pretty tax-efficiently in a taxable account. If you stick to things like a total stock market index fund, the total international stock market index fund, muni bonds, equity real estate, those sorts of things, and I’m not talking about REITs, I’m talking about equity real estate because you get depreciation deductions that you can use to offset your income.

If you stick to those things, it’s pretty tax efficient. You can also donate appreciated shares to charity in lieu of cash and of course, you still get the whole deduction for what you donated, but neither you nor the charity has to pay the capital gains taxes on that. If you hold shares for at least a year, you get the longterm capital gains rates. In those sorts of investments, the dividends tend to be almost all qualified so they are taxed at the lower qualified dividend rate. You can also tax loss harvest and deduct up to $3,000 worth of losses each year against your ordinary income. So you can invest pretty tax-efficiently in a taxable account. I wouldn’t necessarily feel like you’re doomed if you’re out of retirement accounts and you want to save more. It’s not that big of a deal.

How are these businessmen that are making millions avoiding paying taxes? Well, first of all, there is a big media effect here. If all you read is the New York Times and all you watch on TV is MSNBC, you might think that there’s a lot of people with seven-figure incomes that aren’t paying any taxes, but, as one of those people with a seven-figure income, I assure you, I am paying a lot in taxes. I think last year, 34% of my income went to taxes. That’s just income and payroll taxes. So all these rich people are not getting out of paying their taxes. There are a few things that people can use to reduce their taxes in very impressive ways. For example, real estate depreciation. You can shelter a lot of income with real estate depreciation. So if you’re a real estate mogul and you have all these properties, you can probably shelter all or most of your income from that.  If you never sell those properties and recapture that depreciation, you really could go a long, long time without paying any significant amount of tax.

I’m pretty confident that’s why Donald Trump is not releasing his taxes, because it’s going to show he’s not paying very much at all if anything. And that’s perfectly allowed. You can do that, too, if you want to be a real estate mogul instead of a doctor. Another thing that happens a lot is what these hedge fund managers get. They get this carried interest deduction where basically their wages become taxed at longterm capital gains rate and, in fact, can be deferred for years. That substantially reduces their taxes, as well. That is one thing that you may hear about these gazillionaires who are aren’t paying much in taxes.

I saw in the New York Times an article this last week that said the top 400 people on Forbes list of most wealthy are paying less in taxes than some other subset of less wealthy people. That is because they don’t have income. We don’t have a tax on wealth. We have a tax on income. And so if you don’t have any income, you don’t pay any tax. Now obviously they still have some income and they pay tax on that just like the rest of us do. But if you were just spending money you’ve saved, if you’re just spending your wealth, you don’t have to pay tax on that. Likewise, if you borrow against your wealth, if you borrow against your car or against your house or against your life insurance policy or against your portfolio, you don’t have to pay tax on that. A borrowed money spends just as easily as earned money and just as easily as selling something that adds capital gains in it. So that’s one other way you can really reduce your taxes.

But I think, honestly, most of this is just the media effect or the media reporting that all these people that make more money than you aren’t paying that much in taxes, and you feel like you’re missing out on something, that if you just had someone different preparing your taxes, you would do a lot better. That is probably not the case.

That said, doctors are in that working category with a high income and that earned income is the highest taxed stuff. So if you want your tax a little bit lower, try to convert your earned income into passive income as quickly as possible.

 

TRICARE and an HSA

“I am an active duty military physician in Nevada, and my wife has a civilian job where she is covered by health insurance plan with an HSA option.  She also has TRICARE as her secondary insurance since she is my dependent. Does this mean that she is not allowed to contribute to an HSA, since she is not solely using a high deductible health plan due to her TRICARE coverage?”

If you are covered by anything but a high deductible healthcare plan, you cannot use an HSA. That’s the rule. And so, obviously, if someone else is buying your health insurance, don’t go buy your own just so you can use an HSA. The health insurance benefit is worth way more than the benefit of an HSA. Just invest your money in a taxable account. Take advantage of the other person buying your health insurance for you and move on.

 

Whole Life Insurance Policy from Your Parents

A listener was gifted a whole life insurance policy that his parents bought 20 years ago. Now he wants to know what to do with it.

This is actually a pretty common problem. There are a lot of parents out there who have been suckered into buying a whole life insurance policy on their children. A term life insurance policy is going to be all the insurance you ever need. The really crummy returns on a whole life policy are very front loaded. It’s not unusual at all to not break even for five to 15 years after you buy the policy, but after that time, the returns are often a little bit better, at least in a well designed policy that you bought for that purpose. That’s usually not the case with these policies that are sold to parents and put in force on kids. They’re usually not that great of policies. The insurance is not that cheap and the payments are tiny and so the fees of the policy tend to eat up a lot of the cash value. Most of the time you should tell your parents thank you very much, I appreciate you thinking of me and you take the money out and use it to pay off your student loans or use it to fund a Roth IRA.

Don’t tell your parents it would have been worth three times as much if they had put the money into a 529 for you instead. Even though that is probably true. It doesn’t make them feel very good because they really think they have been doing you this huge service by making premium payments every month for the last 20 years.

If you want to evaluate it check out these posts I wrote:

How to Evaluate Your Whole Life Insurance Policy

How to Dump Your Whole Life Policy

If you do decide to get rid of it, occasionally people want to exchange it into a variable annuity to preserve the basis, if they have a big loss on it, and let it grow back to basis before surrendering the variable annuity. But I discuss those tricks in those posts.  If you feel like you can’t evaluate it yourself,  I only know of one person that is offering the service, a guy by the name of James Hunt at evaluatelifeinsurance.org.  He will take a look at your policy and try to help you decide whether to keep it or not.

For the most part, these little tiny policies that your parents bought you are just complicating your financial life. Most people who have these have a cash value of $2,000 or $5,000, maybe $10,000 and a much better use for your money at this point in your life.

TSP Account After Retirement

 

“I’m a 53 year old practicing physician and my wife is about to retire after putting her 30 years into the VA. I max out my 401(k) at work. We both do backdoor Roth IRAs. The question I have is what to do with her TSP account when she retires. There’ll be approximately $700,000 in it. I know I have the option of leaving it in, which is not a bad option, the expense ratios are great but the investment options are somewhat limited. I could transfer it to an IRA. I know I can’t do a rollover because that would induce tax issues. The other option is we could do the annuity option. I’ve also had some people say transfer it to an IRA and buy a deferred annuity since we won’t need the money since I will continue to work for several years. We’d love to hear your advice.”

This is complicated by the fact that you’re not retiring, so, presumably, you’re both going to want to continue to do backdoor Roth IRAs going forward. So if you want to do that, you can’t just roll that TSP money into an IRA because it’s going to cause her backdoor Roth IRA to be complicated by the prorata calculation. So that money has to either stay in the TSP, go into another 401(k), which it doesn’t sound like she has, or all be converted. $700,000 is going to cause a heck of a tax bill if you convert the entire thing to Roth.

I would just leave it in the TSP. It is not like the TSP is a bad plan. The expense ratios in the thrift savings plan are two to three basis points. That is essentially free and the funds are good. The C fund is basically an S&P 500 index fund. The S fund is an extended market index fund. The I fund is now a total international stock market fund. It used to be a developed index stock market fund. Those are good funds. There is nothing wrong with using them. A large percentage of my portfolio is made up of those funds,  so I think it is perfectly fine to leave a substantial portion of your money in the TSP, especially now that the distribution options have gotten so much better in the last year or two.

They also have some unique funds. They have a total bond market fund. They call it the F fund. And then, of course, they have the G fund, which is the really special fund in there. The G fund is basically treasury returns at money market risk. They give you the average treasury yield despite the fact that it basically never loses principal. A lot of people keep their money in the TSP just to take advantage of that G fund. That is what I did when I left the military and I keep rolling money into the TSP, not taking it out. So I would just leave the money in the TSP, and if you feel like you need other asset classes that the TSP doesn’t offer, do that in your other accounts.

Should you annuitize it? Not yet. It doesn’t sound like you need the income. You might want to annuitize some of it down the road, but the nice thing about controlling the assets is you can always annuitize at any point later without having to do so now. But most people who have $700,000 in the TSP probably don’t need to buy an immediate annuity because they probably have lots of assets that they’re going to be able to live off of in retirement.

Roth Conversions in Medical School

“I’m a second year medical student and I have a question about Roth conversions. I have two kids and I receive a need-based grant. Before medical school, I was able to get about $150,000 in traditional contributions to my 401(k). I’m looking to convert that to a Roth, but I’m concerned about losing my grant money, which equates to about 25% of my tuition. I tried to speak with my financial aid office and they didn’t seem to know much about Roth conversions and seem to be really confused on how that would end up being reported on the FAFSA. I was hoping that you could give some insight on that and how that might impact financial aid in general if I do a Roth conversion.”

This is a fortunate medical student. Typically, medical school is a fantastic time to do Roth conversions. If you divided up that $150,000 and converted about a quarter of it every year during medical school, you may able to do the entire $150,000 Roth conversion pretty close to tax free, which would be pretty cool. The problem in this situation is with the need-based grants. Obviously, if you have income, you have less need and doing a Roth conversion produces income because that’s taxable income. Even if his tax is 0%, it’s taxable income, so it’s probably going to screw up the FAFSA. If you look at the FAFSA form, you’ll see that you have to report your adjusted gross income on it, and those Roth conversions do count toward your adjusted gross income. So what should you do?

You might have to wait until you’re finishing your third year and going into your fourth year to do the Roth conversion because, by the time you report that income, you are going to be done getting all your financial aid for medical school. You could then do a little bit more of the conversion the year you leave medical school and maybe even during residency you do a little bit more. But if it’s really going to screw up your FAFSA and keep you from getting grants, especially grants and scholarships, you’d be leaving money on the table by doing those Roth conversions. Probably not worth it in that situation, but I’d still try to get some converted in the last year or two of medical school and during residency.

Prorata Rule and Mega Backdoor Roth IRAs

“Does the prorata rule apply to a mega backdoor Roth IRA conversion period? Specifically, my question is if I have money within a traditional IRA, does that prevent me from doing a mega backdoor Roth IRA?”

It can, but probably not. This is really a great question. The pro-rata rule comes from IRS form 8606 and particularly lines six through eight. Line eight reads, “Enter the net amount you converted from traditional SEP and simple IRAs to Roth IRAs in 2018.”  When you do a mega backdoor Roth IRA, you are either doing an in-plan conversion where you’re going from your traditional 401(k) to a Roth 401(k) or you’re taking money out of the plan and put it in a traditional IRA and then converting that traditional IRA to a Roth IRA or you’re taking the money directly from the 401(k) into a Roth IRA. Now in two of those three situations, you didn’t convert any money from a traditional IRA to a Roth IRA, so you don’t have to report anything on line eight of form 8606 and the pro-rata rule does not apply.

But if you were taking money out of the plan and putting it into a traditional IRA and then moving it to a Roth IRA, well then you would have to report that on line eight of form 8606. So if you do this right, I think the answer is no, it doesn’t apply, but if you do it wrong, it’s certainly could.

Ending

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Full Transcription

Intro: This is the The White Coat Investor podcast, where we help those who wear the white coat get a fair shake on Wall Street. We’ve been helping doctors and other high income professionals stop doing dumb things with their money since 2011. Here’s your host, Dr. Jim Dahle.
Dr. Jim Dahle: Welcome to White Coat Investor podcast number 131, deducting your car. This episode is sponsored by Bob Bhayani, at DrDisabilityQuotes.com. They’re a truly independent provider of disability insurance planning solutions to the medical community nationwide. Bob specializes in working with residents and fellows earlier in their careers to set up sound financial and insurance strategies. Contact Bob today by email at [email protected] or by calling (973) 771-9100. I’m sure you’ll have a great experience there as hundreds of other white coat investors have.
Dr. Jim Dahle: All right, our quote of the day today, this comes from Charlie Munger, you know, Warren Buffett’s partner who said, “If you have a $2,000 monthly mortgage payment, grandma can help. If you have a $20,000 monthly mortgage payment, no one can help.”, and that is the truth and one of the biggest reasons why you got to watch that lifestyle inflation, especially if you were funding it with debt. Thanks so much for what you do.
Dr. Jim Dahle: As most of you know or recall, I am also a practicing physician. I’m only half time now. I’ve been half time now for a little bit over a year. Before that, I was three quarter time for two years. And prior to that was working full time, even while I did all this White Coat Investor stuff. And so I’m in the trenches with you seeing patients. Yesterday, I had a shift. The day before I had a shift. Today, I have a shift. I’m doing all this kind of on the side a little bit. Although the truth is, you know the medicine has probably become the side gig at this point just because I’m pouring so much time and effort into the White Coat Investor. But my point is I still know what you’re going through and I want to say thanks for what you’re doing. This is not easy stuff.
Dr. Jim Dahle: You’re getting calls at all hours of the night. You’ve got people making you do all kinds of crazy stuff and jump through crazy hoops. I think yesterday, the one that was driving me nuts is they’ve decided they have to lock our suture cart in the ER because heaven forbid, some patient get in there and find out that we have antibiotic ointment packets or whatever it is they feel like they need to lock up now. But with our joint commission inspection coming up or whoever it is, whoever our accrediting body is, they’ve decided they’re going to lock everything up from us. So every time I need something out of that cart, I got to go hunt down someone with a key to get it open and what a pain, you know, to feel like you’re not in control of your work environment sometimes, but thanks for putting up with all that and taking care of all of us as patients.
Dr. Jim Dahle: If you are not familiar with our Fire Your Financial Advisor online course, this is a great value for a certain subset of our listeners and readers. Okay, some people have figured this investing stuff out. They know how to manage their own portfolio. They can rebalance. They know how to design it, and they have no trouble whatsoever, putting in the orders to buy and sell things and figuring out what a reasonable portfolio is. If that’s you, this is not a course for you. You’ll look at it and go, “I’m not going to spend $499 on that. I’m just going to go borrow some books from the library, figure it out, participate in some online forums and listen to White Coat Investor podcast and figure it out myself.” That’s perfectly fine, but there’s some people that need a little bit more help. And if that’s you, the Fire Your Financial Advisor course is perfect.
Dr. Jim Dahle: It rests right in between the total do it yourself track and the go find a financial advisor to teach this stuff to you track. $499 is a heck of a deal, way cheaper than hiring a financial advisor that’s probably going to cost you 10 times that much to put together a similar financial plan. It is an online course of videos of me talking just like this, and screencast that will walk you through every part of creating your own financial plan. And the best part about creating your own financial plan is you are then intimately familiar with it. And so you can adjust it as you need to, to fit your own life and changes in your life and it’s completely personalized to you because you wrote it. If needed even more help, we have a recommended financial advisor page on the whitecoatinvestor.com, you can go to that.
Dr. Jim Dahle: These are people that offer you good advice at a fair price, but a fair price is much more than you will pay for our online course. So if you have not taken that and you think you would benefit from it, go check it out. It’s about eight hours of coursework. You can take it with your spouse or partner, and you can’t go show it to your residency program, but you can take it with your spouse or partner and you’ll be able to take the quizzes as you go along. There’s even a pretest and a post test that lets you know that you’re actually learning this stuff. And here’s the best part, there is no risk here. We give a 100% money back guarantee for a full week after you buy it, no questions asked. Okay, go check it out. And if for whatever reason you don’t think it’s worth the value that I’m charging for it, ask for your money back and we’ll give you your money back.
Dr. Jim Dahle: No questions asked. But the truth is, very few people return this course because it is so useful and it is so helpful and people go, “Wow, why didn’t somebody teach me this in medical school?” Well, here you go. This is the course you should have gotten in medical school. All right, let’s get to your questions. This podcast isn’t supposed to be about me. It’s supposed to be about you. So let’s take our first question off the SpeakPipe. If you are interested by the way in getting your questions answered on this show, you can go to www.speakpipe.com/whitecoatinvestor, and record up to a minute and a half of questions there and we’ll get you on the podcast and answer your question right here on air. You can be as anonymous or unanonymous as you want to be. Most people seem to just leave their first name, but you can leave your name and your specialty and where you’re from. You can do whatever you like and we’ll get you on the podcast. Our first question today, however, is the one I named this podcast after. It comes from Alex. Let’s listen to his question.
Alex: Hi, Jim. Thanks for all that you do. I’ve been a longtime fan and I’m planning on doing the unforgivable for WCI reader, buying a Tesla. Don’t worry, all my ducks are in a row and I planned ahead for this. My question is about buying a car through my practice. Is this an option to most doctors? Am I correct in assuming that I can use pretax dollars for this expense? Does it matter that I am a W2 employee as opposed to 1099? Any help and some light on this topic would be appreciated. Thanks again.
Dr. Jim Dahle: All right, so basically Alex is asking, can I deduct a Tesla from my practice as a W2 employee? Well, no, Alex, you can’t. I mean here’s the deal, right, a business can buy a car if it is going to use it at least 50% for business purposes. All of us can write off our business miles, whether we use that car more than 50% for business purposes or not. For example, for the White Coat Investor, I probably put on 200 miles a year maybe on my car. Obviously I’m driving a lot more than that, going to Southern Utah to go play in the slot canyons. And so it’s way less than 50% of my mileage. And so the White Coat Investor does not own a car as a business, but we still deduct our mileage. I think it’s about 56 cents a mile, you get to deduct.
Dr. Jim Dahle: It’s not insignificant. It really adds up in a hurry. But people who are looking to buy it for their business, they actually need to use it 50% or more for the business. And so that’s great if you own a business. If you’re a W2 employee, you don’t own a business. You cannot deduct a car for a business that you don’t even own, right. That doesn’t make any sense whatsoever. The other thing people get a little bit confused about is that you can’t deduct commuting miles. What do I mean by that? I mean the drive between your house and your business and back, those miles are not deductible. Those are not business miles. What are business miles are miles you drive for business purposes. So if you leave your office and you go meet with a client and you come back to your office, those miles are business miles.
Dr. Jim Dahle: But coming home in the evening, those aren’t business miles. So what are business miles for most docs? Well, for example, if they drive into clinic, right, and do a little bit of work there and then they go over to the hospital and around, then they come back to clinic and then they drive home, the miles that are business miles are the ones between the clinic and the hospital, not the ones between home and the clinic or home in the hospital. I hope that’s clear there, but the deduction we’re talking about here is the section 179 deduction, and these are for vehicles that are used more than 50% of the time for business purposes. And of course, the deduction is limited to the amount of use. So if you’re only using it 60% of the time for business purposes, you only get to deduct 60% of those expenses.
Dr. Jim Dahle: Although there are apparently some vehicles that are considered only as business vehicles, you know, taxis, airport, shuttle vans and limousines, whatever. So if you’re doing Uber on the side, I guess you can deduct all those miles, right? Also, the vehicle has to be purchased and put into service during the year in which you’re applying for the section 179 deduction. But this can be a huge deduction. If you claim what’s allowed now as bonus depreciation, if you claim 100% bonus depreciation, you can actually deduct up to $18,000 in the first year, another $16,000 in the second year and $9,600 in the third year, et cetera. And so it can really add up to be a lot of money. But there are also maximum limits on section 179 deductions, a total of $1 million for the year on a single property or up to $2.5 million for all property.
Dr. Jim Dahle: Obviously that’s much more than vehicles. One thing to keep in mind is something people have figured out that there is a different amount you can deduct for a vehicle that weighs 6,000 pounds or more, you know, SUVs or other larger vehicles. So if it’s rated more than 6,000 pounds gross vehicle weight and actually less than 14,000 pounds gross vehicle weight, then you can deduct more than you could for a vehicle that weighs less than 6,000 pounds. The vehicle has to be either be new or new to you. So a used vehicle is okay and it can’t be used for transporting persons or property for hire. You can’t expense more than the cost of the vehicle and you can’t deduct more than your business net income for the year. So if you’ve got this side gig and you made $2,000 here, you can’t then take a $15,000 deduction for the car.
Dr. Jim Dahle: You can’t use it to generate a tax loss. Keep in mind of course, that if your vehicle doesn’t weigh 6,000 pounds, the available deduction is much smaller. As a general, the deduction’s $25,000 for a more expensive vehicle and it’s like $11,000 something for a smaller vehicle. So it’s significantly less, that’s not including the bonus depreciation as well. And you can look up more on that or talk to your accountant more about that if this is really going to be a significant deduction for you, which it probably shouldn’t be for most docs quite honestly. So how much does a Tesla weigh? Well, a Model S weighs 4,647 pounds, a Model 3 weighs 3,552 pounds, and even a Model X weighs 5,421 pounds. So none of them are a 6,000 pound car. So bear that in mind. This is probably not going to work for you at all as a deduction. I’m very sorry about that, Alex. All right, let’s move on to the next question. This one comes from Sam. Let’s take a listen.
Sam: Hi, Jim. I had a two part question, both of them related to each other. My first question is to make sure I’m doing everything possible to lower my W2 taxable income. I am maxing out my 401(k). I’m maxing out my HSA, doing a backdoor Roth IRA. My employer does not allow a mega backdoor Roth. I’m aware of a 529, I don’t have a 457 plan, so I just want to see if there’s anything I’m missing because even after I do all of that, I still have a very large tax burden. I mean doing all those things only lowers my W2 taxable income by $20,000, $30,000 or so. My wife is doing everything she can to max out her plans. But that’s my question. What am I missing here? Because I’m still paying a lot in taxes.
Sam: The next part of the question is just how do these businessmen who are making millions of dollars avoid paying any taxes? Is it all just real estate depreciation? I mean how are they getting away with that? How are they paying no taxes, yet me with my $250,000, $300,000 income, I’m paying a ton in taxes. Thanks so much for your help.
Dr. Jim Dahle: Okay, Sam, is there anything you’re missing? Well you’ve got a lot of accounts there, which is good. You’ve clearly been reading the White Coat Investor and learned a lot from it. If you have any 1099 income, you can use an individual 401(k) or a solo 401(k) for that. If you’ve already maxed out your employee contribution at your main gig, then you can only put in 20% of your self employed income into that individual 401(k). You can also talk to your employer and to start in a defined benefit plan or cash balance plan. But you can’t open one on your own, if you don’t have any self-employed income. And so what the most people end up doing, they end up investing in a taxable account, which is perfectly fine. You can invest pretty tax efficiently in a taxable account. If you stick to things like a total stock market index fund, the total international stock market index fund, muni bonds, equity real estate, those sorts of things, and I’m not talking about REITs, I’m talking about equity real estate because you get depreciation deductions that you can use to offset your income.
Dr. Jim Dahle: If you stick to those things, it’s pretty tax efficient. You can also donate appreciated shares to charity in lieu of cash and of course you still get the whole deduction for what you donated, but neither you nor the charity has to pay the capital gains taxes on that. If you hold shares for at least a year, you get the longterm capital gains rates. In those sorts of investments, the dividends tend to be almost all qualified so they are taxed at the lower qualified dividend rate. You can also tax loss harvest and deduct up to $3,000 of worth of losses each year against your ordinary income. So you can invest pretty tax efficiently in a taxable account. I wouldn’t necessarily feel like you’re doomed if you’re out of retirement accounts and you want to save more, it’s not that big of a deal. You know, I didn’t have a taxable account for a long time.
Dr. Jim Dahle: Now our income’s gone up a lot. Thanks to all of you supporting the White Coat Investor. Thank you very much for that, by the way. But now we have a pretty sizable taxable account and so we’re having to invest it very tax efficiently. And it’s really not that hard to do. It’s not a Roth IRA, granted. You don’t get the arbitrage you get with the 401(k) for sure, but it’s not that bad. You shouldn’t feel like you can’t do it. So really, Sam’s also asking, well, how are these businessmen that are making millions avoiding paying taxes? Well, first of all, there’s a big media effect here, right. If all you read is the New York Times and all you watch on TV is MSNBC, you might think that there’s a lot of people with seven figure incomes that aren’t paying any taxes, but as one of those people with a seven figure income, I assure you, I am paying a lot of taxes.
Dr. Jim Dahle: I think last year, 34% of my income went to taxes. That’s just income and payroll taxes. Obviously there’s still property taxes and gas taxes and sales taxes and all those kinds of things, but just a payroll taxes, that’s what I paid. So all these rich people are not getting out of paying their taxes. There are a few things that people can use to reduce their taxes in very impressive ways. For example, real estate depreciation that you mentioned. You know what? You can shelter a lot of income with real estate depreciation. So if you’re a real estate mogul and you have all these properties, ala Donald Trump, you can probably shelter all or most of your income from that. And if you never sell those properties and recapture that depreciation, you really could go a long, long time without paying any significant amount of tax.
Dr. Jim Dahle: I’m pretty confident, that’s why Donald Trump is not releasing his taxes because it’s going to show he’s not paying very much at all, if anything. And that’s perfectly allowed, you can do that too if you want to be a real estate mogul instead of a doctor. Another thing that happens a lot is what these hedge fund managers get, right. They get this carried interest deduction where basically their wages become taxed at longterm capital gains rate and in fact can be deferred for years. And so that substantially reduces their taxes as well. So that’s one thing that you may hear about these gazillionaires who are aren’t paying much in taxes. That’s another thing they often use. But you know what, one thing a lot of the very wealthiest people do, like for instance, I saw in the New York Times an article this last week, they said the top 400 people on Forbes list of most wealthy are paying less in taxes than some other subset of less wealthy people.
Dr. Jim Dahle: Well, that’s because they don’t have income. We don’t have a tax on wealth. We have a tax on income. And so if you don’t have any income, you don’t pay any tax. Now obviously they still have some income and they pay tax on that just like the rest of us do. But if you were just spending money you’ve saved, if you’re just spending your wealth, you don’t have to pay tax on that. Likewise, if you borrow against your wealth, if you borrow against your car or against your house or against your life insurance policy or against your portfolio, you don’t have to pay tax on that. A borrowed money spends just as easily as earned money and just as easily as selling something that add capital gains in it. So that’s one other way you can really reduce your taxes.
Dr. Jim Dahle: But I think honestly, most of this is just the media effect or the media reporting that all these people that make more money than you aren’t paying that much in taxes and you feel like you’re missing out on something, that if you just had somebody different preparing your taxes, you would do a lot better. But that’s probably not the case. That said, doctors are in that working category with a high income, you know that earned income is the highest tax stuff. So if you want some of this tax a little bit lower, try to convert your earned income into passive income as quickly as possible. Oh, I didn’t even mention municipal bonds, right. Municipal bond interest is also tax free, so you can put a whole bunch of money in municipal bonds and not pay taxes on that income as well. Of course, they pay less than regular bonds to make up for that effect, but in the highest tax brackets, you usually come out ahead. All right, Sam’s got another question. Let’s listen to this one.
Sam: Hi, Jim. I recently went from doing 1099 work to becoming a W2 employee and I don’t qualify for a 401(k) until after a year. So I want to see what I could do to help my tax situation for this year. Should I be opening up a solo 401(k) and putting my 1099 income in that? I also have a traditional IRA, would I be able to roll over that traditional IRA to the solo 401(k), and then do a backdoor Roth IRA to avoid the prorata rule? And then once eligible for my employer’s 401(k), transfer my solo 401(k) now with the traditional IRA in it into my employer’s 401(k). If that’s possible, if you have any suggestions on how to do that or where to go, I’d really appreciate it. And I also want to max it out as much as possible. So in addition to the $19,000 employee contribution part, how I would calculate and do the employer contribution part for my 1099? Thanks so much.
Dr. Jim Dahle: Okay. So I’m not entirely clear what’s going on here because Sam’s bouncing around so much. But I think what he’s saying is that he’s going from a 1099, meaning he’s an independent contractor or self-employed to now becoming an employee. And then asking if he should do an individual 401(k). No, if you’re an employee, you can’t do an individual 401(k). That’s for the self-employed. So if you’re going from W2 to 1099, yes, open an individual 401(k). If you’re going from 1099 to W2, you’re stuck with what your employer offers. So what do you do with your IRA? Well, if you want to keep doing backdoor Roth IRAs, you can’t have money in a traditional SEP or simple IRA on December 31st of the year, you do your conversion. And so you got to do something with the IRA. The easiest thing to do is just roll it over into your employer’s 401(k).
Dr. Jim Dahle: If you have an individual 401(k), you can roll it in there so long as, unlike Vanguards, the individual 401(k) allows rollovers into it. The other thing you can do is just pay the taxes and convert that outstanding traditional IRA, that tax deferred traditional IRA to a Roth IRA. Yes, you’re low taxes, but that’s not a big deal if this is a tiny little IRA. If you only got $3,000 or $10,000 in it, well, go ahead and convert it, not a big deal. But if it’s a $400,000 traditional IRA, you’re probably going to want to do a rollover rather than cough up the tax money on that. But yeah, basically, you can’t make employer contributions, right. Your employer has to do that. The only time you can make employer contributions is if you’re self employed. If you’re the employer and the employee, and obviously you cannot do a solo 401(k) at all if you don’t have some self employment income.
Dr. Jim Dahle: Okay. This question comes in by email. I am an active duty military physician in Nevada, and my wife has a civilian job where she is covered by health insurance plan with an HSA option. Well, thank you very much for your service. She also has TRICARE as her secondary insurance since she is my dependent. Does this mean that she is not allowed to contribute to an HSA, since she is not solely using a high deductible health plan due to her TRICARE coverage. Well, yes. If you are covered by anything but a high deductible healthcare plan, you cannot use an HSA. That’s the rule. And so obviously, if somebody else is buying your health insurance, don’t go buy your own just so you can use an HSA. The health insurance benefit is worth way more than the benefit of an HSA. Just invest your money in a taxable account. Take advantage of the other person buying your health insurance for you and move on.
Dr. Jim Dahle: All right. Our next SpeakPipe recording comes from Sean in Chicago. You guys were a member a few episodes ago, somebody had asked about these authorized participants, the folks, the breakdown and form ETF units. And there was a question about that that I answered and Sean is calling in to clarify it. Let’s listen to his recording here.
Sean: Hi, Dr. Dahle. This is Sean from Chicago. I’m a professional options trader and a high income professional who’s picked up your podcast a couple of years ago and recommended it to many since. I wanted to help you out with your questions from Tim from San Francisco. First, I wanted to say about all those questions that they’re pretty advanced finance questions as far as even professional traders go. I would like in especially the question about authorized participants in a heartbeat trade to be master plumbing level even for professional traders, but as an answer to his question, you have to understand that professional training groups don’t really pay capital gains taxes in the same form that investors do.
Sean: Pretty much all of their trading gains and losses are going to be netted out and then taxed as ordinary income. Additionally, in the example that he proposed where a trading group would get a low basis ETF from a mutual fund, they would just use the creation redemption process to redeem it back into shares at the same basis and they would just be making a tiny little margin on the trade. I hope this helps and thanks. Bye.
Dr. Jim Dahle: All right, Tim. There you go. There’s your answer. It turns out these guys are all paying ordinary income taxes anyway, so they don’t really care about the fact that they’re not getting a longterm capital gains rates on those sales. All right. Our next question comes from Jose. Let’s take a listen.
Jose: Hi, Dr. Dahle. My name is Jose Polito, and I’m a first year attending urologist in the Northeast. I recently learned from my parents, that’s when I was about 10 or 12, they got me a whole life insurance policy, which they had been paying into and now are transferring to me. I was wondering how to value these whole life insurance policies. I know that initially their returns are essentially negative for many years, but as this has been 20 years now, I was wondering if you knew any resources to properly value whole life policies so I can find out if I should keep this or liquidate the assets. Thank you.
Dr. Jim Dahle: Okay. This is actually a pretty common problem. There are a lot of parents out there who have kind of been suckered into buying a whole life insurance policy on their children. Here’s a tip for you. If you are buying insurance from the same people that sell you baby food, you’re probably doing something wrong, all right. You know, Gerber’s out there selling all these policies to people who are, you know, want to do the right thing for their kid, wanting to get them started on the right foot, et cetera. Northwestern Mutual also, their agents tend to try to sell these policies on your kids as well. This is generally not a good idea. You shouldn’t be buying policies on someone that has no need for insurance, and generally the policies that are bought aren’t exactly doing them anything to preserve insurance later.
Dr. Jim Dahle: You know, I look at these things, they’re $10,000, $50,000, maybe $100,000 policies, I don’t see kids running around with half a million and million dollar policies, some amount that’s actually going to make a difference to their family down the road, especially after inflation in 30 years from now. It’s usually some tiny little policy and the parents were so proud of themselves because they’d been feeding this thing every day for 18 or 25 years or every month for decades. And then they turn it over to you. You know, occasionally they turn it over to you with a loan on it. You know, they borrowed against it to pay for your school or to buy a car or whatever. And they feel like they did you this big service. They give you this whole life insurance policy with terrible returns and a loan on it. But mostly, what they’re doing is giving you this dilemma. You’ve got to figure out what you want to do with it because chances are, if you’re like most people, including most docs, you don’t actually want a whole life policy.
Dr. Jim Dahle: Term life policy is going to be all the insurance you ever need. And so you’re stuck with this and trying to figure out what to do with it. Now in general, the really crummy returns on a whole life policy are very front loaded. It’s not unusual at all to not break even for five to 15 years after you buy the policy, but after that time, the returns are often a little bit better, at least in a well designed policy that you bought for that purpose. That’s usually not the case with these policies that are sold to parents and put in force on kids. They’re usually not that great of policies. The insurance is not that cheap and the payments are tiny and so the fees of the policy tend to eat up a lot of the cash value. And so they tend to not be very good policies at all and most of the time, you ought to tell your parents, thank you very much, I appreciate you thinking of me and you take the money out and use it to pay off your student loans or use to fund a Roth IRA or whatever.
Dr. Jim Dahle: You know, that’s honestly what you should do most of the time because most of these policies are not very good. Don’t tell your parents it would have been worth three times as much if you put the money into a 529 for me instead. Well, that’s probably true. It doesn’t make them feel very good because they really think they’d been doing you this huge service by making premium payments every month for the last 25 years. But if you really want to evaluate it, I’ve got a couple of blog posts about it that you ought to take a look at. One’s called Evaluate Your Own Whole Life Insurance Policy. And so if you Google that or search that on the White Coat Investor site, that’ll pop right up and it’ll walk you through how to get an in force illustration and calculate out what your expected return is going forward. And then you can look at that and go, is this worth it to me or not. And with these little tiny child policies, it’s probably not worth it to you.
Dr. Jim Dahle: There’s another post there called Dump Your Whole Life Policy or How to Dump Your Whole Life Policy. You ought to read that one as well. If you do decide to get rid of it, occasionally, people want to exchange it into a variable annuity to kind of preserve the basis if they have a big loss on it and let it grow back to basis before surrendering the variable annuity. But that discusses those tricks in that post. If you feel like you can’t do that yourself, you can’t evaluate it yourself. I only know of one person that’s offering the service, a guy by the name of James Hunt, he does it in evaluatelifeinsurance.org. And you can look that up, pay him $100. He’ll take a look at your policy and try to help you decide whether to keep it or not.
Dr. Jim Dahle: So you can check that out as well. But for the most part, these little tiny policies that your parents bought you, I mean these are just complicating your financial life. Most people who have these, they’ve got cash value of $2,000 or $5,000, maybe $10,000 you know, and a much better use for your money at this point in your life in your 20s when you have the greatest need for cash of your whole life. All right, our next question comes from anonymous listener. Let’s take a listen.
Anonymous: Hey, Dr. Dahle, thank you for all you do. I wish you’d been around 20 years ago. In that vein, I’ve got a question outside your normal age range. I’m a 53 year old practicing physician and my wife is about to retire after putting her 30 years into the VA. I max out my 401(k) at work. We both do backdoor Roth IRAs. The question I have is what to do with her TSP account when she retires. There’ll be approximately $700,000 in it. I know I have the option of leaving it in, which is not a bad option but the expense ratios are great but the investment options are somewhat limited. I could transfer it to an IRA. I know I can’t do a rollover because that would induce tax issues. The other option is we could do the annuity option. I’ve also had some people say transfer it to an IRA and buy a deferred annuity since we won’t need the money since I will continue to work for several years. We’d love to hear your advice. Thank you very much.
Dr. Jim Dahle: Okay. Congratulations on your upcoming retirement. Thanks for your federal service obviously. So what should you do with your wife’s $700,000 TSP account when she retires? Well, this is complicated by the fact that you’re not retiring, so presumably, you’re both going to want to continue to do backdoor Roth IRAs going forward. So if you want to do that, you can’t just roll that TSP money into an IRA because it’s going to cause her backdoor Roth IRA to be complicated by the prorata calculation. So that money’s either got to stay in the TSP, it’s got to go into another 401(k), which it doesn’t sound like she has, either an individual one or another employer one or it’s got to all be converted and $700,000 is going to cause a heck of a tax bill if you Roth convert the entire thing.
Dr. Jim Dahle: So what I would do is I just leave it in the TSPs. It’s not like the TSP’s a bad plan. I mean the expense ratios in the thrift savings plan are two to three basis points. That’s essentially free and the funds are good, right? The C fund’s basically an S&P 500 index fund. The S fund is an extended market index fund. The I fund is now a total international stock market fund. It used to be a developed index stock market fund. Those are good funds. There’s nothing wrong with using them. A large percentage of my portfolio is made up of those funds and so I think it’s perfectly fine to leave a substantial portion of your money in the TSP, especially now the distribution options have got so much better in the last year or two. They also have some unique funds. They’ve got a total bond market fund. They call it the F fund.
Dr. Jim Dahle: They’ve got a bunch of lifecycle funds, although it sounds like your situation is complicated enough, you’re probably not going to use that. And then of course they have the G fund, which is the really special fund in there. The G fund is basically treasury returns at money market risk. They give you the average treasury yield despite the fact that it basically never loses principal. And so a lot of people keep their money in the TSP just to take advantage of that G fund. That’s what I did when I left the military and I keep rolling money into the TSP, not taking it out. And so despite the fact that I was only in the military four years, I probably only contributed something like $50,000 or $60,000 in there. I’ve got $300,000 in there now because I keep rolling money in to take advantage of that G fund.
Dr. Jim Dahle: So I would just leave the money in the TSP and if you feel like you need other asset classes that the TSP doesn’t offer, you want some real estate investment trust or you want some tips or you want to do some other types of real estate or something, do that in your other accounts. You’ve got back to Roth IRAs, you presumably got a 401(k), you’ve got some taxable accounts, diversify there. Should you annuitize it? Well, not yet. It doesn’t sound like you need the income, you’re still working. You might want to annuitize some of it down the road, but the nice thing about controlling the assets is you can always annuitize at any point later without having to do so. But most people who have $700,000 in the TSP probably don’t need to buy an immediate annuity because they probably got lots of assets that they’re going to be able to live off of in retirement. All right, let’s go on to our next question. This one comes from Nick.
Nick: Hi Dr. Dahle. My name’s Nick and I’m a second year medical student and I have a question about Roth conversions. I have two kids and I receive a need-based grant and before medical school, I was able to get about $150,000 in traditional contributions to my 401(k). I’m looking to convert that to a Roth, but I’m concerned about losing my grant money, equates to about 25% of my tuition. I tried to speak with my financial aid office and they didn’t seem to know much about Roth conversions and seem to be really confused on how that would end up being reported on the FASFA. So I was hoping that you could give some insight on that and how that might impact financial aid in general if I do a Roth conversion. Thank you.
Dr. Jim Dahle: Okay. Nick is a medical student in a very fortunate situation. He’s already got $150,000 traditional IRA. That’s great. And in fact, medical school is a fantastic time to do Roth conversions. If you divided up that $150,000 and converted about a quarter of it every year during medical school, you may able to do the entire $150,000 Roth conversion pretty close to tax free, which would be pretty cool. The problem it sounds like in this situation is that Nick is on some need-based grants and obviously if you have income, you have less need and doing a Roth conversion produces income because that’s taxable income. Even if his tax is 0%, it’s taxable income, so it’s probably going to screw up the FAFSA there. If you look at the FAFSA form, you’ll see that you have to report your adjusted gross income on it and those Roth conversions do count toward your adjusted gross income and so what should you do?
Dr. Jim Dahle: Well, you may not be able to do the whole conversion. It may screw things up. You might have to wait until that year in which you’re finishing your third year and going into your fourth year to do the Roth conversion because by the time you report that income, you’re going to be done getting all your financial aid for medical school. You could then do a little bit more of the conversion the year you leave medical school and maybe even during residency you do a little bit more. But if it’s really going to screw up your FAFSA and keep you from getting grants, especially grants and scholarships, I’m a little less concerned about loans, but grants or scholarships, you’d be leaving money on the table by doing those Roth conversions. So probably not worth it in that situation, but I’d still try to get some converted in the last year or two of medical school and during residency. All right. Our next question comes from an anonymous listener,
Anonymous: Dr. Dahle, I recently listened to your podcast on a mega backdoor Roth IRA conversion. The question that I have is, does the prorata rule apply to a mega backdoor Roth IRA conversion period? Specifically, my question is if I have money within a traditional IRA, does that prevent me from doing a mega backdoor Roth IRA?
Dr. Jim Dahle: Thank you very much. Okay, does the prorata rule affect the mega backdoor Roth IRA? Well, it can, but probably not. It’s really a great question. The prorata rule comes from IRS form 8606 and particularly lines six through eight. Line eight reads, “Enter the net amount you converted from traditional SEP and simple IRAs to Roth IRAs in 2018 with. When you do a mega backdoor Roth IRA, you either doing an in-plan conversion where you’re going from your traditional 401(k) to a Roth 401(k) or you’re taking money out of the plan and put it in a traditional IRA and then converting that traditional IRA to a Roth IRA or you’re taking the money directly from the plan from the 401(k) into a Roth IRA. Now in two of those three situations, you didn’t convert any money from a traditional IRA to a Roth IRA, so you don’t have to report anything on line eight of form 8606 and the prorata rule does not apply.
Dr. Jim Dahle: But if you were taking money out of the plan and putting it into a traditional IRA and then moving it to a Roth IRA, well then you would have to report that on line eight of form 8606. So if you do this right, I think the answer is no, it doesn’t apply, but if you do it wrong, it’s certainly could. I hope that is helpful. All right. As I mentioned at the beginning of the hour, if you have not checked out Fire your Financial Advisor, our online course, please do so. It’s not that it’s anti financial advisor, it’s a little bit provocatively named for sure, but in fact, the whole first section of it discusses how you can work better with a financial advisor and make sure you’re getting good advice at a fair price. And so even if you use an advisor, it’s a pretty useful course.
Dr. Jim Dahle: But if you want to learn to do it without your advisor, this is a great place to start. You can pick that up at whitecoatinvestor.com. If you go up there at the top of the page, you will see courses. It says across the top and if you look under there, the first one there is fire your financial advisor and you can even go to it directly at this URL, whitecoatinvestor.teachable.com/fire-your-financial-advisor and that will take you directly to the course. You can learn more about it and of course it comes with a 100% money back guarantee. This episode was sponsored by Bob Bhayani at DR disability quotes.com. They’re a truly independent provider of disability insurance planning solutions to the medical community nationwide. Bob specializes in working with residents and fellows, especially White Coat Investors who are early in their careers to set up sound financial insurance strategies. Contact Bob today by email [email protected] or by calling (973) 771-9100. thanks for leaving us a great rating of those five star ratings really do help us spread the word to other white coat investors. Head up, shoulders back. You’ve got this and we can help. We’ll see you next time on the White Coat Investor podcast.
Disclaimer: My dad, your host, Dr. Dahle, is a practicing emergency physician, blogger, author, and podcaster. He’s not a licensed accountant, attorney or financial advisor. So this podcast is for your entertainment and information only and should not be considered official personalized financial advice.