My June article in ACEP NOW was all about lowering the tax hit on your investments. As usual, the audience I'm writing for is not quite as sophisticated as many of the readers of this blog, so these sorts of articles sometimes function as a bit of a “back to basics” piece for you. Investing in a tax-efficient manner is important since it boosts your after-tax return, the only one that matters. Here's an excerpt:
Q. I like seeing the money my investments are making, but every time tax season rolls around, it seems like a big chunk is going to the IRS. How can I reduce my investment-related tax bill?
A. There are a number of ways to reduce your investment-related taxes. In fact, it is possible to completely eliminate taxes on your investments. However, prior to doing so, consider what your real goal is. Is it to reduce your tax bill or to maximize your after-tax returns? Of course, as you give it more thought, you’ll realize that your goal is to maximize the after-tax returns, and sometimes that involves paying more in taxes than you would pay using other investing techniques. This article will discuss six ways savvy investors reduce their tax bill while boosting their after-tax investment returns.
#1 Investing in Retirement Accounts
Hands down, there is no doubt that the single best way to decrease your investment-related taxes is to invest in tax-protected accounts such as 401(k)s and Roth IRAs. Too few physicians have gone to the trouble of actually reading the plan documents for their employer-provided retirement plans or, if self-employed, opening an appropriate retirement plan. They also may not be aware that despite their high income, they can still contribute to a personal and spousal Roth IRA—they simply have to do it “through the backdoor”. Health savings accounts may be the best investment account you have, a topic also discussed in a previous column. If you have more than one unrelated employer, for example, if you’re an emergency physician doing locums on the side, you may also have more than one 401(k).
Investing in retirement accounts has multiple tax-related benefits. With a tax-deferred account, you get an upfront tax break and often an “arbitrage” between your current high tax bracket and a future lower tax bracket. Very few emergency physicians are saving enough money to be in the same tax bracket in retirement as in their peak earnings years. With a tax-free (or Roth) account, all future gains are tax-free. Dividends and capital gains distributions also benefit from tax-deferred or even tax-free treatment, depending on the type of account.
#2 Buying and Holding Tax-Efficient Investments
Another important way to reduce the taxman’s take on your investment returns in a nonqualified (ie, taxable) account is to invest in a tax-efficient manner. That means choosing investments such as low-cost, low-turnover stock index mutual funds, where taxable distributions are minimized and those that you do get receive favored tax treatment at the lower-dividend and long-term capital gains tax rates. For example, if you wanted to invest in two mutual funds with similar expected returns but had to put one in your taxable account, look up their tax efficiency on a Website such as Morningstar.com and put the most tax-efficient one in the taxable account. Holding on to your investments for decades rather than frenetically churning them also reduces the tax bill.
Read the other four reasons here, then come back and let me know what you thought. Which of these steps have you implemented to reduce your investment taxes? Any other methods that make a big difference for you? Comment below!
Timely. I just read Phil Demuth’s Overtaxed Investor. This book had some actionable advice in it, which I rarely find these days in personal finance books. I like his writing style and it is a quick read. I convinced my library to buy it, so the price of admission was well tolerated. (Although, I suspect you could try to deduct the cost of the book….)
I’m reading it now. It’s good so far. Lots of great ideas.
Very succinct and useful information, and I have employed almost all of these. The death strategy will have to wait.
WCI,
When will you write your tax book? I desperately need it. I paid >257K in income tax last year. Crazy!
you should be happy you have an income like that, I am willing to take your tax load for your income
What a wonderful problem to have!
I hope to have it out by January, but that means I need to write it first. I’m just now cutting back on shifts to hopefully allow me to do so.
WealthyDoc
Are you self employed?
Are you maximizing all reasonable deductions? 410k, HSA, backdoor Roth?
Do you hire your spouse or your kids and maximize their retirement plans?
Did you take the opportunity to tax loss harvest some losing investments?
how old are you?
Is a defined benefit plan a reasonable option?
Just some thoughts that come to mind.
Thanks for the comments.
I am employed by a hospital network but I do consulting on the side and I have an an investment management LLC. I could pay all of my annual expenses based just on passive investment income (my definition of FI). I do get tax credits (e.g. state 529), and deductions (e.g. charity), schedule C work expenses off a 1099. I use a FSA instead of a HSA. I have a 401k, Pension, 403b, 457, 529, Roth 401K and Backdoor Roths every year. My family members have not been working or contributing to retirement plans but that is something to consider for sure. Also I’m sure I need to learn more about TLH. There haven’t been a lot of loses so far but I need the knowledge to take advantage of them when they inevitably will occur. I will dig up some of WCI posts on those topics. Thanks.
I suppose you have a defined benefit plan. This is probably the best way to substantially reduce your tax burden. TLH will probably not generate much benefits for you. Another idea is to create a donor advised fund for yourself and donate appreciated assets to your fund and get the tax deduction now that you have high incomes.
Yes I do have a charitable fund. I put 25k in and through investing it now has over 50k despite multiple donations from it.
Must be a dermatologist.
Wealthy Doc,
What state do you live in? tax credits may help. Trying to get business to do that now to limit tax liability, 275k is a lot.
This may not be the correct article to report on but I was curious if this idea would work out:
Based on holdings in a tax deferred account at the point you are required to start taking RMD (and thus having to start paying taxes on it), what do you think if several years before this occurs, you switch the majority of your holdings into a tax free vehicle such as a municipal bond? Then you can use the tax free dividends gained to get distributed satisfying the RMD and yet still does not incur any taxable event.
Your RMD’s from tax deferred accounts, e.g. 401k, traditional IRA, are taxable regardless of what they are invested in. Though pending RMD’s can affect your choice of investments in your taxable account.
Depreciation is great, but accelerated depreciation is much better, especially if you’re in the midst of your high earning years.
tax credits are better than accelerated depreciation, especially if you can get both
Do any of you use certain kinds of international funds because of lower nonqualified dividend distributions? I didn’t know that emerging markets was a big culprit for this until recently
WCI,
can you write one day about the different political parties in america as it relates to us Docs and investment?…I hear that Republicans lean more towards business and money, but is this true?..How about Obamacare affecting our bottom line, is this one true too?…
I guess Id love to read a non biased opinion based on facts from a healthcare professional standpoint…
I’m not happy with either of the two major political parties right now given who they’ve put forward as their nominees.
I can tell you this about PPACA- the whole point was to reduce the percentage of uninsured patients. I saw 17% uninsured before PPACA and I see 17% uninsured now. So that’s a failure from my perspective. I thought emergency docs would see a bit of a boom from that, but no dice.
Republicans are less likely to raise tax rates, so I generally favor them based on that alone as it is the most important federal issue to me. Politically, I would be best classified as a fiscal conservative and a social moderate. At least the Democrats did something about the major issues we have in health care, but I think it would have been a lot better if PPACA had real bipartisan backing.
Docs are funny bunch when it comes to financial know how. We hate paying taxes. We bitch and complain, moan and groan.
Do you folks realize that we are one of the biggest benifecery of tax laws. Most of us would make less than half as much if not for government back plans / incentives that force individuals and corporations to fund health care.
This party will come to an end in our life time. In the mean while enyoy it while it lasts.
“Do you folks realize that we are one of the biggest benifecery of tax laws.”
Do you care to elaborate?
Thanks
I will let sam elaborate, if he chooses too. However, his statement hit me like a ton of bricks. He is damn right. Government promotes policies to encourage companies to fund / subsidize health care cosst, tax incentives, and not to mention medicare and Medicaid. Do you believe most American can afford to pay for healthcare cost without government intervention.
Yes, we benefit tremendously from government intervention. Before government intervention physicians were mostly lower middle class, and rich ones either came from old money or married into it. It wasn’t uncommon prior to WW II for many physicians to barter.
Now golden yrs of financial well being for physicians ended in 1980’s, we still do OK. However, at current rate we maybe back to bartering in not too distant future, but this time under the guise of “sharing economy”.
So, to WCI, do all you can to avoid taxes, and hope the “others” keep paying their “fair share” and the government keeps forcing individuals / corporations to ear mark certain amount of money for health care. I love it. We have the best debt collector wiring for us, the US government.
There would certainly be less health care consumed. How much would come out of physician salaries is less clear. Probably some.
But somehow connecting that to a decision to buy whole life insurance is a long reach.
I read the post at ACEP website, it’s well done! I just like to add one point that Dr Dahle did not mention, that is the concept of asset location (as opposed to asset allocation.)
The purpose of asset allocation is to reduce risk, the purpose of asset location is to reduce taxes. For instance, if you asset allocation includes a REIT fund, a muni bond fund and a corporate bond fund. You must decide where to hold these funds. A tax efficient way to do it is to hold the REIT fund and the corporate bond fund in a retirement account since these funds have higher interest/dividend incomes and buy holding them in a retirement account, you don’t have to pay taxes now. The muni bond on the other hand, can be held in a regular brokerage account since it’s interest incomes are already tax-exempt. By doing asset location well, you can add 1% to 2% to your after tax return each year.