By Dr. James M. Dahle, WCI Founder
Taxes are part of life and many good things are done with tax dollars. But as Judge Learned Hand said, “Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes.” I pay every dime I owe in taxes, but I'm not going to leave a tip. If you feel the same way, check out these tips to lower your tax bill.
How to Reduce Taxable Income
Remember one of the most important principles of financial planning–the goal is to have more money after paying taxes and living the way you would live anyway, not just to pay less in taxes. These tips can all reduce your tax bill, but will not necessarily leave you with more after tax if you would not have done these things anyway.
#1 401(k) Contributions
The biggest tax deduction available to most doctors and other high earners is to simply save for retirement. Tax-deferred retirement accounts like 401(k)s and 403(b)s allow you to save money at your currently high marginal tax rate, protect those investments from taxes and creditors as they grow, and use account withdrawals in retirement to fill the lower tax brackets. The lifetime tax savings is likely higher than the amount you contribute to the account.
#2 Cash Balance Plans
If being able to contribute $19,500 to $64,500 into a tax-deferred 401(k) is good, how would you feel about contributing another $10,000-200,000 into another tax-deferred account? Pretty attractive, right? Enter the cash balance plan, which is basically another defined contribution plan masquerading as a defined benefit (pension) plan. You can have a personal one as an independent contractor, your partnership can put one in place, or you can talk your employer into offering one as a benefit.
#3 HSA Contributions
Imagine a 401(k) where not only did you get the tax break up front and the tax-protected growth, but you also got to have tax-free withdrawals? That's how a Health Savings Account (HSA) works, at least when it is spent on health care. Even if you don't spend it on health care, there is no penalty to withdrawing the money after age 65, so it is at least as good as your 401(k).
#4 Self-Employed Health Insurance Deduction
One of the largest deductions for many partners, independent contractors, and other self-employed folks is the ability to deduct your health insurance premiums.
If you're paying anywhere near what I'm paying for health insurance, this is a huge deduction for you. Your employer deducts these premiums as a business expense, so if you are your employer, you can too!
#5 Deferred Compensation
Some employers offer plans that allow you to defer your compensations for years or even decades. Among doctors, these usually take the form of 457(b) plans. Like a 401(k), you get to choose and control the investments. Unlike the 401(k), it is still your employer's money and subject to your employer's creditors. A little caution is warranted, but most doctors use these plans if they are available to them, especially if offered by a governmental employer.
#6 The 199A Deduction
The 199A (pass-thru business) deduction is the largest deduction on our taxes. This is a deduction equivalent to 20% of ordinary business income and was put in place as part of the 2018 Tax Cuts and Jobs Act to equalize the playing field between C Corporations and the pass-thru business entities like sole proprietorships, partnerships, and S Corporations (and the LLCs taxed as any of the above.) For those above certain income threshholds (taxable income of $164,900-264,900 single, $329,800-$429,800 married), certain professionals (doctors, lawyers, financial advisors etc) are excluded from this deduction. Even if not excluded, it is limited to an amount equal to 50% of wages paid by the business. This is a big, complicated deduction, but if you can qualify for it, you will find it well worth your time and effort to maximize it and there are a fair number of techniques to doing so.
#7 The Home Office Deduction
If there is an area of your home that you use regularly and exclusively for a business, you can deduct it. Since calculating and using the deduction can be complicated, the IRS has made a simplified version available- $5 per square foot of up to 300 square feet and no recapture of the deduction when the home is sold. That $1500 deduction may be worth $500 or more off your taxes. Beats a kick in the teeth.
#8 Rent Out Your House to Your Business
You know what kicks the snot out of the home office deduction? Just renting your house to your business for up to 14 days per year. Keep careful records on this one, but basically you're allowed to rent your house out to anyone you like, including your own business, without paying taxes on that rental income. So if you rent it out to strangers, you could save some taxes there. But if you rent it to your business, the cost becomes a deduction to your business, but never shows up as taxable to anyone. Make sure you're charging a fair rate to your business. Not sure what that is? Hit the local AirBNB and VRBO listings, and don't forget to charge the cleaning fee. For many doctors, this deduction is likely 10-20 times the size of the home office deduction.
#9 Hire Your Children
If you have a non-incorporated business and you hire your minor children as employees, what you pay them is a deduction to the business. Neither the business nor your children have to pay payroll taxes like Social Security and Medicare on that income, and up to $12,200 in income can be earned before any federal income tax is due. Just be sure the work they are doing is reasonable for their age and their wage is reasonable for the work. Keep good records. My favorite child job? Modeling. But there are dozens of others.
#10 Contribute to Roth IRAs
Roth IRA contributions won't lower this year's tax bill, but they will lower the tax bill for every other year of your life. All the money earned in a Roth IRA, so long as it is withdrawn in retirement, is never taxed. This obviously goes for Roth 401(k)s, Roth 403(b)s, and Roth 457(b)s too. Didn't think you could still contribute to Roth IRAs due to your high income? Have I got a treat for you.
#11 Tax Loss Harvest
Up to $3,000 in investment losses can be used to offset your earned income each year, savings perhaps $1,000-1,500 in taxes. Unused losses can be carried over year to year. But who wants to lose money on their investment? Nobody, of course, but you might as well let Uncle Sam share the pain. When tax loss harvesting similar (but not “substantially identical”) high-quality, long-term investments, you aren't even really losing money in the long run. You are just taking advantage of some price fluctuations to lower your tax bill.
#12 Tax Gain Harvesting
Many people don't realize this, but below a taxable income of $40,400 ($80,800 married) you don't pay taxes on long term capital gains (or qualified dividends for that matter). Taxable investing accounts can be very tax-efficient for these folks. Even if you expect more taxable income than this in retirement, there may be times during your life when you can raise the basis on your investments by tax gain harvesting (sell and buy the investment back), lowering future tax bills. It can be a great move for minors, students, and early retirees.
#13 Give to Charity
There are a plethora of ways to give money to charity and receive some of that money back in the form of a lower tax bill. If you itemize your deductions, anything you give to charity shows up on your Schedule A as a deduction. But there are plenty of other creative and unique ways to give to charity, such as charitable remainder or charitable lead trusts and donor advised funds. The best way for retirees is often Qualified Charitable Distributions from IRAs. My personal favorite way to give to charity is to donate appreciated mutual fund shares from a taxable account. The charity and I both get out of paying capital gains taxes, and I get a Schedule A deduction for the entire value of the donated shares. Combined with tax-loss harvesting, this can save charitable high earners a ton of money in taxes.
#14 Hire Someone to Care for Your Children
In a two-earner family with kids? I bet you're paying someone to care for your children at least occasionally. That qualifies you for a tax credit (even better than a deduction). The credit is up to 35% of $3,000 (one kid under 12) or $6,000 (two kids under 12) spent on childcare. That includes summer day camps too. Unlike the child tax credit, there's no phaseout on this one. (Although to be fair, with the child tax credit phaseout starting at a MAGI $200,000 [$400,000 married] many physician families will still qualify for it.)
#15 Buy a House with a Mortgage
Like giving to charity, spending money on a mortgage, property taxes, and Private Mortgage Insurance won't leave you with more money afterward, but if you're going to buy the house anyway, you might as well claim the deduction for it on Schedule A. Remember for new mortgages that only the interest on the first $750,000 in debt is deductible. This is still a massive deduction for some of my readers. Remember that property taxes are combined with income taxes and limited to $10,000 total as a Schedule A (itemized) deduction.
#16 Real Estate Depreciation
If you invest directly in equity real estate (or via syndications or private non-REIT funds), the depreciation of the property can eliminate the taxes on the income from the property for many years. You can also avoid the recapture of that depreciation by exchanging a property rather than selling it. If you can qualify for Real Estate Professional Status (work 750 hours in real estate in a year and not work in anything else more than that), you can even use that depreciation to offset your (or your spouse's) earned income.
#17 Send Your Kids to College
There are lots of college-related deductions, but don't expect to come out ahead after sending your kid to college! Earnings in college savings accounts like 529s and Coverdell ESAs are tax-free when used for college. Your state may offer a state tax deduction or credit for contributing too. The American Opportunity Tax Credit (four years of up to $2,500 for tuition or similar expenses) and the Lifetime Learning Credit (unlimited years, up to $2,000 per year for tuition and similar expenses) are also nice, but most doctor families are phased out of these credits. If you can get your AGI under $180,000 and have a kid in college, take a look at them as the tax savings are probably more than using a 529 account.
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#18 Don't Forget Business Expenses
There are a plethora of business expenses. Basically, if you need it to run your business, you can deduct. For self-employed docs, this can include computer, stethoscopes, scrubs, phones and phone plans, CME costs, license/DEA/board exam fees, travel costs, business (not commuting) miles, and lots of other things. If it is legit, deduct. If you're an employee, see if you can't get your employer to reimburse you for it.
#19 Get Another 401(k)
Many doctors don't realize they're eligible for a second 401(k). The rules can be a little complex, but basically you can have a separate 401(k) for every unrelated employer, all with a $58K total potential contribution. The usual set-up is a 401(k) where you're an employee and you put in your “employee” contribution and your employee includes a match, and an individual 401(k) for your moonlighting or side gig, where you can contribute 20% of your profits as an “employer” contribution.
#20 Sell Your House Properly
I mentioned earlier that rental property can be exchanged without the payment of capital gains taxes. That doesn't work for your primary residence, but you do get to exclude $250K ($500K married) in capital gains on your residence from your taxable income. That sort of a huge potential savings makes people start asking “How long do I have to live there in order for it to count?” and “How often can I do this?” The answers are 2 of the last 5 years and every 2 years. So if you have a rental property that has appreciated and you want to sell, move into it for 2 years before you sell. Many people move in and out of their rental properties to maximize this tax break. Note that any depreciation taken while it was a rental property would still have to be recaptured. Note also, that if you only live there for two out of five years before selling that you only get to exclude 40% (2/5) of the gain up to $250K/$500K.
There you go, the top 20 ways high earners can save on taxes. Understand them and profit.
What do you think? Was your favorite/largest tax break listed? Which one was it? Comment below!