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.
Sticker Shock
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 |
| 10% | < $17,400 |
| 15% | $17,400-70,700 |
| 25% | $70,700-142,700 |
| 28% | $142,700-$217,450 |
| 33% | $217,450-$388,350 |
| 35% | >$388,350 |
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 |
| $50,000 | 12900 | ($198) | -0.4% |
| $100,000 | 52900 | 5065 | 5% |
| $150,000 | 92900 | 13285 | 9% |
| $200,000 | 132900 | 25285 | 13% |
| $250,000 | 172900 | 36191 | 14% |
| $300,000 | 212900 | 47391 | 16% |
| $350,000 | 252900 | 60363.5 | 17% |
| $400,000 | 292900 | 73563.5 | 18% |
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.
Mr amt with marginal rates of 35% plus zero benefit from state income tax starting under $200,000 TI pops up and says what about me doc?
im pretty sure annuities grow tax deferred…. you wrote grow tax free.
The only thing worse than paying the taxes is NOT paying the taxes.
Meaning of course that you never made the money.
It’s wise to be conscious of taxes and reduce them with the given government accounts.. HSA, 401k, 403b, roth ira, 529, etc.
But I’m growing to fear them less as time goes on… although I do think it’s smart to be diversified amongst tax deferred and taxable accounts.
nothing worse than deferring a 35% tax bill today only to get served up with a 50% tax bill in 2040
Rex- They grow tax-free (no taxes each year as the investment grows), but you do pay taxes on all the earnings upon removing the money. Should that be called tax-free growth or tax-deferred growth? Dunno. Certainly it isn’t the same as an IRA (which we consider tax-deferred on both the principal and earnings) or a Roth IRA (which we consider tax-free on both the principal and the earnings.)
It’s properly termed deferred bc there is never free in the end. Death benefits are tax free.
Roth is tax free but it’s after tax money. While this is after tax money, the gains are still taxed.
You could say your house grows tax free then or anything that doesn’t occur taxes until the sale but it’s misleading at best. Should I call my non qualified apple stock has having tax free growth?
So correct me if Iam wrong.
For a hospital employe doctor, married
17 k in 401; 10k in roth; 6250 in hsa; 13 k each in 529 per kid.
any other significant tax breaks , that i am missing?
Dan
I wasn’t aware that you could contribute to a defined contribution plan and a defined benefit plan. Is this true? Can you get to 80K in tax deferred growth? If so, let me know how. We have a DCP where I can contribute up to 50K which is great. Can I also do a defined benefit plan too?
yeah.. I think dan is correct. We cannot contribute to defined benefit plan. That is a sort of pension plan that is solely goverened by employer. In my case it doesnt even have an account. We can contribute 49K to defined contribution plan. I think thats wht WCI meant.
529 plans are only Tax deferred for the amount your state allows, thats not even close to 13K as dan mentioned, so its really not a hude tax break. Ofcourse the benefit is “tax free” if used for education for kid in college.
Some physicians also have access to “Top Hat Plan” which is 457B plan in addition to your 401/403B plan. You can contribute another 17k to it.
So total for married doctor
17K -401/403
17K – 457 plan — if you have the access
upto 49K — DCP
Thats equal to 83K tax deferred. Plus you can contribute 5K in back door and 529 plans contribution are state tax deductible to certain amount. If both of you are physician or have working spouse you can multipl everything by 2. So technically its possible to defer taxes in close to 166K plus you can contribute 10K in backdoor IRA and enjoy tax free growth forever.
WCI correct me if I am wrong. I am slightly confused by IRC 415c limit rule. Does this include 403B elective deferral? I thought and assumed in my above post that elective deferral is seperate from 415c limit. ( 415c limit includes employer matching + your addtional contribution upyo 50K or 100% your salary whatever is less)
@kksom Can consider series I-bonds up to 10K/year per person. Grows tax deferred.
@GK 529s have tax FREE growth not deferred (provided withdrawn to pay higher educational expenses).
White Coat,
I think is a very good post overall. However, I think your advocating for defined benefit plan may border on taxophobia of your own. I personally would NOT want a defined benefit plan as an employee with roughly 30 years until retirement age. My concern is overrunning the retirement brackets just with the 50K/year of defined contributions. For example, if you invest 50K this year and get a 10% nominal compounded return, you will have 872,470 at 30 years. Next year you contribute 50K and at 30 years will have 793,154, then with following years contribution will have 721,050 at 30 years. The value of this is 9,047,171.25 (using the investopedia website for an annuity with 50K per year contributions at 10%). If you assume a more conservative 5% nominal return you still expect 3,488,039.49 at 30 years. Remember also that this money will likely continue to compound for another 15-35 years during retirement and will be taxed at ordinary income tax rates and not long term capital gains rates. (I am also excluding the increases in amount that can be contributed to defined contribution plans which will likely be more than 50K per year going forward.) You will also have social security distributions that will be taxed. Adding a defined benefit plan on top of this could be a future tax disaster even if rates don’t go up. It also reduces the amount you have available to invest in taxable accounts/Roths, reducing your tax diversification.
For optimal tax diversification, I would much rather pay the taxes up front and invest in I-bonds and equity funds in taxable in lieu of a DB plan. Over a 30 year period the higher returns will likely more than make up for the up front tax savings which may be largely offset by high DB fees and low returns. You maintain control and flexibility and are not reliant on some outsider to choose your investments for the next 30 years. For example, you can stop contributing to the I-bond portfolio (or perhaps one day EE bonds if/when rates go up) if your projected marginal tax rate in retirement gets too high.
I grant that a DB plan may make sense for older physicians.
For me and my wife (both physicians):
We are contributing the max to our 401K’s (17K a year each)
backdoor Roth IRA’s (5K a year each)
529 for daughter (12K a year)
After we make K1 partner we can contribute 33K a year each to a tax-deferred Keogh plan
We also have pension plans from our employers (2% per year of our base salary for first 20 years with 1% per year after to a max of 50%, vested at 10 years)
HSA/Stealth IRA won’t work for us (I think) as we have a employer provided zero deductible health insurance
Anything else we should be doing in terms of good tax breaks? Also, is the 529 contribution limited to 13K a year (and should we increase our contributions to 13K a year)?
Thanks for any advice/comments..
@Andy. I am not a tax expert but understand that you and your wife can each gift 13K to each child without filing a gift tax form per year. For 529s, you can actually front load up to 5 years contributions as well. So between the two of you, you could theoretically put 130K into 529 accounts this year if you don’t contribute the next 5 years or make other gifts.
http://www.physiciansmoneydigest.com/blogs/physicians-wealth-manager/12-2011/Gifting-Strategies
With regard to whether you should contribute more, I would go to the Bogleheads forum and read some of the discussions on pros and cons of 529s vs other investments. I will personally probably limit it to the amount of the state tax deduction for now until I pay down some higher interest rate loans and start building up a reasonable retirement portfolio.
@Rex- All right, I’ll call it tax-deferred rather than “tax-free growth.” I think it’s all semantics though.
@KKS- There are also I-bonds, Coverdell ESAs, and if your employer offers them, defined benefit plans, 457s, 401As etc. Then there are the less attractive insurance based products like annuities.
@Dan and GK- You absolutely can have both a defined contribution plan up to $50K plus a defined benefit plan. You can have this set up for you if you’re self-employed, or lobby your employer for it if you’re not. The current limit on ours is only $15K a year, but there are plenty of docs putting in even more than $50K a year into a DBP. These can be set up in a lot of different ways. Also, I agree with Mark that the 529 is never tax-deferred as long as used for education. You get tax-free growth (both state and federal) plus you might get a state tax credit for all or part of your contribution, depending on the state. You’re correct that the 415c limit ($50K for those under 50) includes both employee and employer contributions.
Andy- I think Mark addressed your question well about 529s. I do the same as him and am currently limiting my 529 contributions to the amount of the state deduction, which is about $10K total for my 3 kids due to other savings priorities.
Mark- Good comment about the DBP. I think there are a few flaws in your argument.
First, I think using a 10% nominal return for your entire portfolio is unrealistic. Is it possible? Sure, but probably not likely, especially after taxes and expenses. There are many people who think that even risky assets won’t make 5% nominal going forward, much less the safer assets in the portfolio. There is a huge difference in how much money you end up with making 10% instead of 5%. For example, $50K per year for 30 years at 5% is $3.3 Million, or enough to provide an income of $130K per year (in today’s dollars.) At 10% that comes out to $8.2 Million, well more than twice as much.
Second, nominal is a bad way to make long term calculations. Inflation will have an even bigger effect on the final amount than taxes and expenses. My nominal return over the last 8 years is between 7 and 8%, just over 4% after inflation.
Third, this is all quite dependent on actually working and contributing for 30 years, no early retirement and no cutting back. It turns out that docs who save a lot and invest well tend to want to at least cut back before 65, if not retire completely.
Fourth, if you find your stash is getting so big that you need to worry about overrunning tax brackets, having huge estate tax burdens and basically having too much money, you can always spend more, give more away, and save less. I don’t know about you, but I don’t find it particularly difficult to spend a lot of money. You can just buy a nicer place, drive nicer cars, take nicer vacations, give more money to your favorite charities etc. That’s just not a significant issue to me. Money saved earlier is better than money saved later anyway, due to the benefits of compound interest.
Fifth, your suggestion to use a taxable account now to avoid high taxes later doesn’t take into the account that you’re paying high taxes now. Worst case scenario is you pay about the same in taxes later as you save now. Hardly a bad outcome. Should you defer more money now instead of using a Roth IRA? Well, that’s a good question but luckily you can now do both with the backdoor Roth. But if you have to choose between them while making your attending salary, I think you’re almost always better off getting the tax break now.
Sixth, you’re assuming a lot of things about a defined benefit plan that I don’t think are necessarily true. These things can be designed to be pretty flexible. For example, when I separate from my partnership, I can roll mine into an IRA or another 401K. Voila- lots more freedom and control over investments and fees. There are additional costs, of course, but they’re not so high that they outweigh the benefits of the additional tax break.
In short, I think encountering a “future tax disaster,” while possible, is pretty rare and shouldn’t keep most docs from deferring taxes now.
Those are some fair points in your rebuttal. I agree that real is much better than nominal and almost used real in my analysis. I used nominal analysis because 1) I have found that relatively few people, especially physicians think in real terms and 2) DB plans tend to pay a nominally fixed amount (see below)
To update my prior post in real terms:
9M in 30 years at 3% inflation would be worth 3.7M today which if divided equally over 25 years of retirement with (unrealistically low) zero real growth (say ages 66-90 or 71-95) would be 148,315 a year in today’s dollars. With social security added to that you could be earning more in real terms than many physicians are today. Even using a 5% nominal return, which I think would be low for a diversified portfolio (only about 2% over historical inflation rate and less than your portfolio in a bad investing environment), you will have $54,382 real income over a 25 year period plus social security plus liquidation of taxable investments. If you will have been investing 20% of your income in taxable/IRAs on top of the 50K/year in 401ks/403bs all along and have paid off your mortgage, you should be able to have a very comfortable retirement.
Regarding your 3rd point, if you do plan to retire very early, then probably a DB plan could make a lot of sense.
Your readers should be aware of the potential drawbacks and risks of DB plans before demanding one. 9 out of 10 DB plans provide a fixed nominal benefit over time. (http://personalfinance.byu.edu/?q=node/906) I would recommend looking at the other potentially significant drawbacks listed at this site. Does yours provide a COLA? Also, if you are right about low returns in the stock and bond market going forward, what are the chances that your DB will meet the actuarial projections and remain fully funded? What is your risk exposure if the plan does becomes underfunded? What happens to the plan if a large number of physicians retire in a down market? How easy is it to actually convert your plan to a 401k or an IRA when you leave/retire and do you take a haircut if you do (I don’t know the answer)?
On your 5th point, I actually am taking into account the high tax bracket now, I am just concerned that either I will be in an even higher bracket in retirement and/or that the DB plan would have negative real returns. Additionally I believe I can invest very efficiently within taxable accounts and Roths. So, I have to challenge that “worst case scenario is you pay about the same in taxes later as you save now.” A worse scenario is that you have a negative real return on the DB investments chosen by the investment company over the 30 years prior to retirement because of the high administrative costs and/or poor investments AND end up in the same or higher marginal tax rate because tax rates go up across the board AND don’t have a COLA AND have fewer taxable investments than you would otherwise have because you used a DB in the first place.
BTW, the risk goes down a lot as you get closer to retirement (especially if you are designing the plan). I personally won’t be demanding a DB plan any time soon. However, I am certainly willing to have an open mind going forward.
With a db plan, an actuary determines if you are on track and the following year, you adjust your contribution/deduction.
From a physician standpoint, if you are the owner then db plans are better if you have few to no employees. The main drawbacks are the required contributions as opposed to optional contributions and the higher cost to maintain vs a dc plan. Costs have gotten more reasonable over time. While you can have both, the deductible contributions of one affect the amount you can put in the other. In my plans, maxing out my db plan to give the highest benefit reduces my dc plan to around 31k per year.
Once vested, it’s as easy to move your cash to an Ira if necessary/appropriate as from a 401k meaning usually no big deal.
Kind of the way I think about things is I expect there to be a higher tax in the future, so I feel taxes now will be cheaper than taxes later, so I pay the 33% tax now on my salary to do the backdoor roth and roth the 401k. Do you guys agree? Everyone thinks they will be in a lower tax bracket when retiring, but I feel I will be in a higher tax bracket as I have a lot of time to accumulate funds. At least by paying the taxes now, if you need a lump sum for something in 40 years, you at least avoid a taxable event by having everything rothed now.
Nobody knows. Historically most people are in a lower tax bracket and rate in retirement. Bc of this uncertainty for future situations some do things similar to you but nobody can be certain of taxes that far in advance. This is just another reason why you shouldn’t over focus on the tax angle. As can be seen from the above discussion the exact line between appropriate and over focus can be blurry. With that said using insurance vehicles bc of tax reasons is likely always a mistake.
Joe-
Tax diversification is a good thing. I think it’s appropriate to hedge your bets a bit by doing backdoor Roths, maybe some Roth conversions, and perhaps even doing of your 401K as a Roth 401K. But doing everything Roth in the 33% tax bracket? That’s almost surely a mistake. Calculate out how high your retirement income would have to be for you to have an effective tax rate that is 33% or higher using today’s brackets. Increase the brackets a bit (in case taxes go up) and do the calculation again. If you run the numbers you’ll see going “all Roth for an attending isn’t smart.
On a sidenote what HSA do people invest in ? is there any that comes out ahead in terms of the various fees involved?
I like HSA Administrators. I keep meaning to try to get them to advertise on the blog. http://www.hsaadministrators.info/ Alliant Credit Union also has one that pays 1.5%. http://www.alliantcreditunion.org/depositsinvestments/healthsavings/