I’ve noticed that many doctors suffer from a common malady I call Tax-O-Phobia. When combined with a closely-related, but also common illness, Liability-Phobia, it makes doctors make poor financial decisions. Tax-O-Phobia comes from three things: sticker shock, a misunderstanding of the value of various tax breaks, and a confusion between marginal tax rates and effective tax rates.
There’s nothing quite like that first 5-figure paycheck when you get out of residency. Of course, no one cares about “good” sticker shock. What you notice is what appears to be a very high tax bill accompanying that 5-figure paycheck. Whether you see it as a withholding on your monthly statements, as quarterly estimated tax payments, or as a big check in April (with associated penalties and interest), the shock of realizing your tax bill just went up by over 10 times is one that drives doctors to make dumb financial decisions, like running into the arms of a commissioned salesman offering a product that promises to lower your taxes.
Tax Breaks Are Not All Equal
There are dozens of tax breaks available in our ridiculously complex tax code. But they are not equal. Many docs simply don’t understand that some are extremely valuable, while others contribute minimally, or even not at all, to lowering your tax bill. This causes them to mistakenly skip the really useful ones, and focus instead on the ones that are much less valuable.
The biggest tax break I see attendings missing out on is maxing out their retirement plan contributions (or not starting an appropriate one in the first place.) Every dollar you put into your 401K is a dollar you don’t pay taxes on. And since that dollar is saved at your marginal rate, it may be worth up to 35 cents (plus another 3-9 cents in state taxes) in tax savings. The best part about this is that you don’t have to spend anything at all. All that money is still yours, you just don’t have to pay taxes on it. I’m continually amazed to see docs putting large chunks of money into cash value life insurance and annuities when they haven’t even maxed out their 401K. A related mistake is not having access to enough retirement plan “space.” If you are a business owner/independent contractor, you ought to have a 401K/profit-sharing plan/SEP-IRA/Solo 401K that allows you to shelter up to $50K. You can add on another $10-50K into a defined benefit plan each year and up to $6250 into an HSA (Stealth IRA). If you’re an employee, and these options aren’t available to you, it’s time to go to your employer and demand them. When interviewing for a new employee job, this is the most important benefit to ask about. The difference between being able to shelter $17K and being able to shelter $80K every year over your career will make a huge difference in taxes paid and the retirement stash available to you later.
Yes, you’ll have to pay taxes on that money eventually, but if done wisely, you’ll pay at far lower rates later. Most docs don’t realize that the first $12K ($6K single) of your 401K withdrawals are tax-free each year, the next $17K are taxed at only 10%, and the next $53K are only taxed at 15%. A retired married doc not yet getting social security can take out $82K and only owe $10K in taxes, an effective rate of 12%. Saving money at 35% and spending it at 12% is a winning formula. If you relocate for retirement to a state without income taxes, you may save up to 9% more on those withdrawals. And that doesn’t even include the wonderful benefit of tax-free growth between the time of contribution and the time of withdrawal.
The next step down in the tax-break pecking order after tax-deferred retirement plans are other savings plans, such as the backdoor Roth IRA and 529 plan contributions. Yes, these breaks are valuable, since you get the break, still have the money to spend, and get tax-free withdrawals. But the amount of money saved on taxes for an attending isn’t nearly as significant.
Even less significant are the tax breaks you get for spending money. This includes things like mortgage interest, property taxes, CME and other business expenses, alimony/child support, and charitable contributions. Yes, it’s nice to have Uncle Sam subsidizing your lifestyle, business, and preferred charitable organizations, but it doesn’t necessarily make sense to spend a dollar in order to save 33 cents. Better than a kick in the teeth, yes, but not the biggest bang for your buck.
Last on the pecking order are instances where you trade one tax break for another. For example, annuities grow tax-free. But when compared to a taxable investing account, you’re trading tax-free growth for a lower capital gains/dividends tax rate and a step-up in basis at death. The difference just isn’t very significant, and may very well be negative for your particular circumstances, especially after fees.
Marginal Rates Are Not Effective Rates
Most of us are familiar with the tax brackets. I’ll reproduce the 2012 tax brackets here for a married doc.
|Marginal Tax Bracket||Taxable Income|
For some reason doctors think that if they make $300,000 they pay 1/3 of that in federal income taxes. It just isn’t true. The marginal tax bracket just means that they pay 1/3 of their final dollar in taxes. This chart shows the effective tax rates for a married, single-earner, with two kids taking the standard deduction (most docs itemize so rates would be lower) and contributing 20% of his salary to retirement plans.
|Income||Taxable Income||Taxes Due||Effective Tax Rate|
Yes, this neglects Medicare/Social Security taxes, state/local income taxes, property taxes, and sales taxes. Rates would also be higher if you were single, had no kids, or chose not to save 20% of your income in tax-deferred accounts (which gets progressively harder to do as you get above $250K, usually requiring a defined benefit plan.) But the rates are certainly much lower than you’d be led to believe if you didn’t understand the difference between marginal rates and effective rates.
Liability Phobia Compounds The Problem
As physicians, we’re also paranoid about being sued- by our patients, our employees, or our neighbors. Physicians fail to appreciate how rare these suits are. They also fail to appreciate how rare it is that the cost of one of these suits, if successful, isn’t paid by a reasonable malpractice, business, or umbrella insurance policy. Beyond that, they fail to realize just what a small part of their assets is actually at risk by a successful suit that exceeds the insurance policy limits. Although laws are state-specific, most states provide significant protection for your retirement plans and home value. With simple asset protection plans (such as putting toxic assets such as businesses and rental property into an LLC), you can reduce that risk even further.
Tax-O-Phobia and Liability Phobia causes doctors to make dumb investments without consideration of the actual after-fee, after-tax return on the investment. The most common ones are annuities, cash-value life insurance, limited partnerships, and accounts in overseas tax havens. These are generally investments made to be sold, not bought, and are avoided by those who can get a grip on their Tax-O-Phobia. The complexity (with associated scams), fees, poor returns, and illiquidity general outweigh any possible tax benefits.