The longer I do this, the more I realize how important reiterating the basics of finance is. Interacting with regular readers on the forum and the comments section, it's easy to think that most of my readers are hyper-sophisticated financial gurus interested in relatively minor points of investing and finance. But when I go out and meet doctors who have never heard of WCI, it becomes obvious that just repeating the basics over and over again will do far more good. They don't want to know the intricacies of non-recognition vs recognition policies, they just need to hear “Whole Life Insurance…Bad.” Along that vein, I thought today would be a great opportunity to take a careful look at Schedule A.
A personal finance guru who hears the words “Schedule A” immediately knows we're talking about itemized deductions, but I bet there is plenty more for the rest of us to learn from a post like this. Tax literacy is particularly low among physicians. I often run into people, online and in real life, who think if they could just find the right “tax guy” that they would pay dramatically less in taxes. In reality, while a good accountant can be useful in a complicated business or real estate situation, they are likely to only make minor changes around the edges. Real reduction of your tax bill comes from living your life differently. The big changes come from getting married, having kids, maxing out retirement accounts, generating more income, changing your business structure, buying a house, moving to a different state, or giving money away to charity. We'll be talking about some of those items today, as they get reported on Schedule A.
All Tax Deductions Are Not All Equal
Before we get into the nitty-gritty, let's recognize an important point- all deductions are not equal. In fact, there are really three types. The first is a business expense, which comes off before you even enter your gross income on your 1040. Those are the best deductions, since you don't even have to pay payroll taxes on those. The second is an “above-the-line” deduction (the line is Line 38 of the 1040-your adjusted gross income,) such as retirement plan contributions, the self-employed health insurance deduction, and the student loan interest deduction. The third type, a “below-the-line” deduction, is what goes on Schedule A. While better than a kick in the teeth, Schedule A deductions are not nearly as good as the other types.
Itemized vs Standard Tax Deduction
Schedule A contains all of your “itemized” deductions, including medical expenses, charitable donations, taxes, and mortgage interest. Most people know that they need to add up their itemized deductions and then decide whether to take the standard deduction or, if your itemized deductions are larger, the itemized deduction.
The standard deductions in 2016 are:
- Single- $6,300
- Married Filing Jointly- $12,600
- Married Filing Single- $6,300
- Head of Household- $9,300
- Surviving Spouse- $12,600
In reality, that's an incredibly easy decision and your tax software will typically take care of that for you. But the point is, if your itemized deductions aren't going to be anywhere near the standard deduction, you don't have to bother with Schedule A at all. I don't do a Schedule A for my kids, for instance. But the subtleties come in when you realize that stuff that you thought was completely deductible, is really only partially deductible. For example, if you're married filing jointly, and the total of your itemized deductions is $15,000, then yes, you should itemize, but no, your mortgage interest really isn't fully deductible. Only the portion above $12,600 is. That affects many people at the lower income end, although a few people can get around it by “bunching” itemized deductions, taking the standard deduction every other year.
At the other end of the income spectrum is the Pease phaseouts. At an adjusted gross income (line 37) of $259,400 (single) or $311,300 (MFJ), your itemized deductions start getting phased out. Basically your itemized deductions are reduced by 3% of the amount of AGI above the threshhold. So if your AGI is $500K and you're MFJ and you have $50K in itemized deductions, then your actual deduction is $50,000-($500,000-$311,300)*3%= $44,342. You never lose more than 80% of your itemized deductions however. In reality, for most of us in this income range, this is just a disguise of a higher marginal tax rate. It basically increases your marginal tax rate by 1.18% but it shouldn't cause you to reduce your itemized deductions (unless you can change them to business deductions) since it is really more predicated on your AGI, not your deduction total.
Itemized, below-the-line deductions also have no effect on anything that is predicated on your AGI. This includes Roth IRA direct contribution eligibility and traditional IRA deduction eligibility. That's because the bottom line on Schedule A feeds directly into Line 40 on your 1040, below Line 37/38- your AGI.
Schedule A, Line by Line
Let's take a look at Schedule A.
Medical Expenses – Lines 1-4
The first section is all about your medical expenses. However, you can almost certainly skip right over this, and I'll tell you why. First, consider a typical physician income. Even if you're a good saver, you've probably got an AGI of $150-200K. So 10% of that is $15-20K. And the maximum out of pocket for most insurance plans is less than that. So the chances of you spending enough on health care in a single year to actually get a deduction here is pretty low. Even if you did get one, it probably wouldn't be very big, especially if you consider that anything spent out of your health savings account doesn't count.
Taxes – Lines 5-9
In this section, you get to deduct either your state and local income taxes or your sales taxes. As a physician, you're almost always going to be better off deducting your income taxes instead of sales taxes, unless you live in a state with no income tax (or are in the military.) If you do live in a no income tax state, then might as well take the sales tax deduction. There are two choices there, you can either add up all the sales tax you've paid or just take an IRS estimate of it. No way am I going to add up all my sales tax on my own, so when I've taken this deduction, I just took the IRS estimate. Maybe if you had some really big purchases in the year (like a wakeboat) it might make sense to try to add up all your sales tax, but man, I think it's a pain to keep track of mileage. I can't imagine trying to keep track of all the sales tax I paid in a year. Besides, the chances of me spending as much as the average guy with my income seems very low to me, so it would be strange for someone like me to not be better off with the IRS estimate/tables. At any rate, even in a year with some big purchases, you're still not going to get anywhere near what you're paying for state taxes. I mean, the Utah table pretty much maxes out at $2,454 and I'm paying 10 times that in state income taxes.
You also get to deduct any property taxes (Line 7) paid on your primary and any secondary homes and can deduct “other taxes” like foreign taxes paid. (generally don't, since you should take the foreign tax credit instead on line 8.)
Mortgage Interest- Lines 10-15
Here is where you get all that tax benefit from having a mortgage. It's pretty straightforward for most us. Take the amount in Box 1 on your 1098 from your lender, and put it on line 10. If you are paying PMI, it goes on Line 13 (and comes from Box 5 on your 1098.) Then ask yourself why you're paying PMI when you could have gotten a doctor mortgage without it. Remember only the interest on the first $100K of a home equity line of credit is deductible unless you spent it on improving the house.
If you take the Boy Scouts with you to Lake Powell, you can write off the mileage. Name this canyon for bonus points.
Charity- Lines 16-19
Pay tithing? Now's your chance to reap the rewards. Cash goes on line 16 (make sure you have documentation of anything over $250 in case of an audit. Stuff you gave to Goodwill goes on Line 17. So does any charitable miles. So if you've been driving Boy Scouts all over tarnation, keep a record and get a few bucks off your taxes. Don't expect much though, it's only 10 cents a mile, so maybe 3-4 cents off your taxes per mile. You're spending way more than that on gas. Which brings up a good point. Many doctors ask me, “What can I do to lower my taxes,” at which point I list off the various deductions such as taxes, mortgage interest, and charitable contributions. They reply, “But those cost me more than the tax benefit, don't they?” Of course they do. If your goal is to have more after-tax money available to you, then giving it to charity (or a lender, or the government) isn't going to help. You're paying a dollar to get 30 or 40 cents back. But if you're doing these things anyway, you might as well get the deductions.
The Other Stuff- Lines 20-28
For most of us, you really only have to pay attention to lines 5-19. But it's possible, even if unlikely, that you could get a deduction after line 19. It seems like there would be something there you could use, but in reality, like medical expenses, it almost never works out for a physician due to the 2% of AGI “floor.” That is to say, only the amount greater than 2% of your AGI (perhaps $4K for a physician) is actually deductible.
Line 20, casualty or theft losses, isn't actually subject to the 2% floor. So if you had something really expensive stolen or ruined by natural disaster, be sure to claim that. But here's the catch, you can't deduct the loss of anything worth less than $100 OR losses that total less than 10% of AGI. Anything worth more than 10% of your AGI probably ought to have insurance on it, so don't count on ever getting anything from this deduction.
Line 21 is all about the work expenses your employer didn't pay for, like white coats, CME, your license, scrubs, and stethoscopes. Unfortunately, it's all subject to the 2% floor, so you probably won't get much of a deduction if any. One good reason to have at least a little 1099 income!
Line 22 is where you put your accountant's fees or what you paid for Turbotax. Again, with the 2% floor, you're probably not going to get much of a deduction. Maybe if you have a really expensive tax return, bought some really nice scrubs and took a really expensive CME trip.
Line 23 is where you put your investment expenses. Finally! Something you may be able to deduct, at least if you pay a financial advisor big AUM fees to do your investment management. Most of us DIYers aren't going to get much of a deduction here though. [Update 8/26- This DOES NOT include mutual fund expense ratios since your returns/income/gains/losses are all net the ER already.] If you pay your taxes by credit card, include the fees here. (No, you don't have to reduce them by the amount you earned as credit card rewards.) By the way, if you are paying AUM fees, try to get your advisor to take them out of your tax-deferred accounts- then you can pay them with pre-tax dollars. Way better than a Line 23 deduction.
Line 28 is where you put your gambling losses. At least they're not subject to the 2% floor. There are a few other losses you probably don't have that can go on this line.
Dumping Your Whole Life Policy
Some people who dump their whole life policy exchange it to a VA if it has a loss in order to preserve that loss to help on their taxes. They can either wait until the investment in the VA grows back to their basis, then sell for no tax cost, or sell it immediately and claim the tax loss this year. Those in the know are saying this loss should go on Line 23, as an ordinary loss subject to the 2% floor. Keep in mind that unless you have a bunch of other losses subject to the 2% floor, that it needs to be a decently sized whole life policy to make all this worth it.
The Pease Phase-out-Lines 29 and 30
Here is where you reduce your itemized deductions if you make what the government apparently considers to be too much. Enter the amount on Line 29 on Line 40 of your 1040.
As tax schedules go, Schedule A is one of the easier ones and usually the first one a taxpayer has to start using when they grow out of using a 1040 EZ. It's no big deal, especially the second time you do it. But understanding how it works goes a long way toward understanding our tax code.
What do you think? Do you itemize? Why or why not? What is your largest deduction on Schedule A? What have you successfully deducted on lines 20-28? Comment below!
“Whole life policies…bad”….
But Time shares are still a great investment right?
Ok are mutual fund ERs really deductible? Personal capital lists these. I have never heard this. I need to amend some returns if this is true.
Negative, ghostrider. http://ibd.morningstar.com/article/article.asp?id=439368&CN=brf295,http://ibd.morningstar.com/archive/archive.asp?inputs=days=14;frmtId=12,%20brf295
Good short article Matt. Christine Benz is the head of personal finance at Morningstar. She basically says that AUM fees and fees paid to a fee only Cfp are deductible. Commissions and ERs are not.
What the heck was I thinking suggesting you could deduct your mutual fund ERs. Of course you can’t, because you don’t have any income to deduct it against since your returns/income and gains/losses are net the ER. Duh. My apologies and post updated.
So, can I deduct the AUM fees assessed on my 401k? They are taken out as a percentage of AUM on each individual’s account in the same way that ER are taken out.
That is a gray area. See http://bit.ly/2bGnHYK
I think the way it works is that you pay those with pre-tax dollars, so that’s in effect a deduction. In a taxable account, you’re paying with post-tax dollars, so you could then deduct those.
Should one not be able to find or request the amount in fees paid annually to one’s mutual fund holdings from the brokerage company? For the Vanguard and Fidelity veterans out there, can you find this online? Where? Seems incredible if the answer is no. Also, is there any tax case law or IRS comment on deductibility of MF fees. This certainly would be nice to know.
Personal Capital will list all the fees you are paying to mutual funds and it may shock you. I consider Christine Benz to be a very reliable personal finance writer and she says they are not deductible. I suspect that Johanna will comment on this topic today.
My ears have been burning…did someone mention my name?
I’m surprised that you did not mention the effect of state income taxes on the AMT calculation. Given that sales taxes are not included in the calculation and income taxes are, I don’t think it is a given that income taxes will be the better choice of the 2.
Those with raw land for investment need to be aware that capitalizing real estate taxes will sometimes be better than deducting, especially if you are in the AMT zone. See this article at PMD http://bit.ly/2bSWuDb .
As to the assertion that a “good accountant [is] likely to only make minor changes around the edges”, I must differ. In particular, I have reviewed a few doctor returns this year with significant issues (requiring amendment), in both directions, both self- and CPA-prepared. That’s not a blanket appeal for everyone to hire a CPA, but to say that those with at least a K1, schedule C, or schedule E should probably use a professional. (WCI is exempt because he is, for all practical purposes, an unlicensed professional).
Mutual fund expense ratios are not deductible. Expenses you pay to have investment accounts managed are but are subject to the 2% floor. So, for example, if your AGI is $350,000, you can deduct expenses (including tax-prep and employee business expenses) that exceed $7,000.
Schedule e isn’t that tough… Just required reading and attention to detail just like the rest of the tax forms.
Not always, but (just off the top of my head) PAL carryovers, the 15-day personal rental rule, and ownership of multiple properties create planning opportunities and the chance of errors.
I do use an accountant.
I have always used turbo (other than a few foolish times I tried to do it by hand)… 2 times I talked with hr block and another one and I was unimpressed so I just read a lot and use turbo tax … At some point I may use a cpa but I would have to figure out when they would save me more than they cost … And do it in a way that I cannot easily do myself ( I don’t have a business so mine aren’t simple but they are not complex)
Just to be clear, there are many people who do just fine preparing their own tax returns. The problem for the ones who don’t is that they are not aware of what they are missing until the IRS catches something or they have their work reviewed by a qualified independent pro. “Qualified” is the kicker.
I’m certainly not exempt since I make plenty of errors too. But the point is things are so complicated, even CPAs are making errors. So if your errors aren’t costing you more than the CPA, you may be better off without them.
I agree. The problem is determining what those figures are – any suggestions? One simple error can cost you thousands of dollars.
No CPA, EA, or individual is going to be 100% error-free. We’ve had our share of calls to clients telling them we found a mistake on a prior year and need to amend. What I’m saying is that, with a good firm, the error rate is much lower.
I should hope so!
If your AGI is above the threshod where itemized deductions are reduced to up to 80% of the actual amount, if you are also subject to the AMT does that tax scheme result in you having itemized deductions potentially reduced more than 80% of the actual amount?
I was concerned about the information given about calculating investment expenses on mutual funds to use for misc. Sch. A deductions. I reviewed IRS Publ. 529 which suggests that one can’t further deduct investment expenses related to publicly traded mutual funds because they are already included as part of the net income amount reported on form 1099. Please review and amend as needed.
As noted above, I was wrong and the post has been amended.
Good article. Years ago I filed tax returns for a living but it’s nice to walk through the Schedule A.
I want to say Line 21 can be a pretty decent one for residents. Depending on the year, all of the testing, license fees, etc. for a new resident really adds up. For us personally we were hit with a pretty high floor, but with both of our expenses together it saved us a few bucks.
Also, technically, those credit card rewards are “income from whatever source derived.” 😉
I view credit card rewards as a discount on purchases, not income. Most agree with me.
http://www.investopedia.com/ask/answers/110614/are-credit-card-rewards-considered-taxable-income-irs.asp
While I agree with you, I got into a lengthy debate with my professor/dean about this during my tax policy & procedure seminar in law school. At the time there was no statute or revenue ruling that I could find that strongly supported my argument. But I felt like you do, I account for this when I make purchases, and that cash back or free airplane flight is something that I bargained for more or less when I went about spending money to earn the points.
If I recall, what ultimately swayed me and a few classmates to concede this to him was that taxpayers deduct the full purchase price of expenses and don’t account for the skymiles or whatnot they receive in return (e.g., you buy some office supplies for $100, you deduct $100, not $98.50 because of your 1.5% rewards card). In most tax court decisions regarding deductibility, includability, etc., any sort of double-dip like this for the taxpayer is usually a deciding factor. The other thing that swayed us were the facts that he was a former tax division trial attorney for the US DOJ, and more importantly, the one who decided our very subjective final grades. 😀
Of course this is all pretty meaningless since I couldn’t find a case where the service ever asserted this, either 🙂
Yes, technically you cannot deduct the whole thing as a business expense if you got 2% back. You can only deduct 98%. That doesn’t change the fact that it is a discount.
Now the $400 you got for signing up for that bank account….different story.
I have a dear friend who takes her family on trips using her work accrued skymiles. IN the Army we weren’t allowed to accrue them or something; I think she ought to be paying income and wage taxes on some value assigned to her miles or the company maybe ought to donate them to charity.
You could be talking about me lol but there is a lot of work in the mix.
You might consider running for Congress and changing the law.
“Anything worth more than 10% of your AGI probably ought to have insurance on it, so don’t count on ever getting anything from this deduction.”
Unless you live in Louisiana or South Carolina and didn’t have flood insurance because you don’t live in a flood plane. One of my partners lost his house in the October 2015 floods in South Carolina and didn’t qualify for FEMA assistance due to his high income. He did get to deduct his loss on Schedule A. I imagine there will be some Louisiana docs who lost some expensive homes this month, and line 20 may be their only way to recover anything.
You can get flood insurance even if you aren’t in the flood plain. Your mortgage company won’t require it in that instance, but still possible to have in most circumstances and probably a good idea since FEMA claims most flood damage happens outside of areas that are designated to be in the flood plain. (https://www.floodsmart.gov/floodsmart/pages/flood_facts.jsp)
+1
Still many people didn’t have it. Even people I personally know and considered relatively sophisticated. Some even moved from New Orleans after Katrina thinking they were leaving flood risk behind for good.
As a New Orleanian I don’t think I could ever justify not paying for flood insurance, even if I’m out of the floodplain. After watching El Paso flood a number of years ago at 3,000′ elevation, no place is safe from floods. It only costs me about $700/year, and if you’re in a lower risk zone it’s much, much cheaper.
I agree. I always have flood insurance. I use insurance to avoid catastrophic loss…not for a policy on breaking my cell phone or similar ridiculous insurance policy.
Good point, but hopefully one that is rarely used.
You mentioned the fees of paying your 1040-Es via credit card is deductible. When I look at the rules it says that it is, but there is a floor there as well. According to
https://www.irs.gov/uac/pay-taxes-by-credit-or-debit-card
On the bottom they state there is a 2% floor 🙁
Right. That whole section has a 2% floor.
One deduction that I only recently became aware of is that regarding investment interest. If you take out a private loan in order to buy into a practice, and the buy-in comes in the form of shares of that practice’s stock (does not have to be publicly traded), you can deduct the interest on that loan as investment interest. Not subject to the 2% floor. I realize this is pretty narrow in applicability but anyone that becomes a partner at groups like Kaiser Permanente would be able to do this. And it can add up.
So if you buy stock on margin the interest on the loan is tax deductible?
Yes I believe it is
Absolutely. Margin interest is what often yields enough to get over the 2% floor. (Think about it.)
Investment interest can only be used to offset investment income. Which means that if you take out a loan to buy into a partnership, the partnership income is ordinary and taxable and the interest on the loan is suspended unless you have investment income to offset it (such as short-term dividends and interest income but not LTCGs).
Unused interest is carried forward until the activity is sold – which may never happen in the case of a partnership buyin. It is lost at death.
Absolutely! As long as you use that money to buy securities and not something else like muni bonds. Though whether anyone should buy stock on margin is a topic of discussion in and of itself (for the record, I lean toward no). But that’s a common deduction people take. What I didn’t know is that this deduction can also be taken for buying private (non-traded) shares like those for a medical practice partnership. Seeing as how buy-ins can sometimes run into the 6 figures, loans usually become necessary. So if the partnership operates within a stock ownership structure, and you’re doing the loan anyway out of necessity, why not have the government give you something back?
How does the govt verify if loan was taken? Assume buy in is 100k and I have a 100k readily available without a need for a loan, can I still write off the interest I would have had to pay if I got a loan?
No, you cannot write off an expense you did not have.
Your interest deduction is determined by the use of the money. For example, if you used the $ you have saved to buy into the practice and take out a business loan, the interest is deductible. If you take out a mortgage on your house, the interest is deductible on schedule A, etc.
Can I loan money to myself in this situation? Don’t think so as it just sounds a little out there but can’t hurt to verify.
I would strongly discourage trying that. In the event of an audit, you would be in pretty hot water when you couldn’t produce statements outlining the interest you paid to a financial institution/lender.
Why would you loan yourself money? Even if you could, you would have interest income in one pocket and interest expense in the other. Think about it.
This was a very good post. Since I do not do my own taxes I felt like I learned something.
If deducting unreimbursed mileage as an employee, that should go under Line 21, correct?
I realize there is a 2% floor but theoretically, if you are using actual expenses and leasing an expensive enough car…..
It’s possible to get a deduction. Yes, that’s where you would put it.
Yes. If using mileage, you would be allowed whatever rate was in effect at the time of business use (54 cents this year). You also get a prorated amount of other expenses not included in the mileage calculation. If you are using actual expenses – see the final point in this post: http://bit.ly/2brswsV
If you are driving a very expensive car, actual expenses are generally the most beneficial.
Have you done the calculations for how much car you have to buy/lease to decide actual vs. mileage?
If you assume 50% of miles or more are driven for business; min. mileage per year is 12,000.
Assume independent contractor status, AGI >350k, combined AGI >500k. High tax state.
My gestalt says any car worth more than $35-40k either business lease or take actual cost vs. taking mileage deduction.
Corollary to this, if your car costs more than $40,000k, business lease > actual cost > mileage.
Obv buying a used beater is the frugal way to go, but if you are going to spend, lease > buy for high cost car and ability to use for business.
It depends on the lease.
There are some companies (BMW) that offer great terms on leasing. If you can couple that with a deduction, it makes sense.
There are other companies (particularly if you are targeting a newer rarer model car where no one has accurate residuals to calculate a fair lease price) where you end up paying a ridiculous amount for leasing as compared to just purchasing the vehicle. I think to lease in that instance would be letting the tax tail wag the dog.
Hmm. What about for a Tesla? Model S or 3?
Interesting question. So if you have a tesla you can deduct electricity as an actual expense instead of mileage? What documentation would you need for that (travel log, electrical bills)? Can you deduct super charger installation?
I think the IRS is a bit behind on including electricity in either the actual or mileage method. I wouldn’t hesitate to take the actual electric costs if they could be documented, however. Prorata on super charger installation acceptable for business use to total use for year but probably a depreciable item, not direct expense.
Can someone comment on how AMT effects these deductions? If it does, is there a way to avoid AMT or to know if you are effected?
The usual suspect with regard to schedule A that typically affects doctors is state and local income tax deductions. Other areas that go into the calculation but probably won’t be an issue are miscellaneous itemized deductions, interest on 2nd mortgages, and medical expenses. If you don’t itemize but instead claim the standard deduction, you will lose that. For a HIP, this could come into play if you live in a no-tax state, your mortgage is paid off, and you don’t give much to charity.
Other possible areas of concern not related to schedule A are: large families (many exemptions), nontaxable interest, and tax shelters.
The easiest way is to use tax software. Reading up on the AMT may help as well:
https://www.whitecoatinvestor.com/understanding-the-alternative-minimum-tax/
https://www.whitecoatinvestor.com/avoiding-the-alternative-minimum-tax-a-guest-post/
https://www.whitecoatinvestor.com/tips-to-avoid-paying-alternative-minimum-tax/
I think it is important to comment on the mortgage interest deduction limit. You can deduct mortgage interest on up to a $1 million dollar mortgage AND an additional $100K of either mortgage or home equity debt. In other words, your total deduction can be for up to but not over a $1.1 million dollar mortgage OR a $1 million dollar mortgage and $100K home equity debt. The fact that the final $100K of mortgage debt can be added to the $1 million dollar mortgage debt to bring the total up to $1.1 million of mortgage debt is extremely important and a fairly recent ruling by the Tax Court (2010).
Reference: Consider interest paid on acquisition indebtedness (note that CCA 200940030 defines acquisition indebtedness to include the home equity indebtedness and allows interest on $1.1 million of acquisition / equity indebtedness to be deducted here. Rev. Ruling 2010-25 reinforces this CCA designating $1 million as acquisition indebtedness and $100,000 as home equity loan that can be considered mortgage debt as well).
One other hugely important point about mortgage interest. The Tax Court (2015) recently ruled that if you are UNMARRIED with a partner and you each file separate returns, you are entitled to deduct $2.2 million in mortgage debt ($1.1 million for each UNMARRIED partner.) The key is you have to be UNMARRIED even if you have been living together for ages. Just another example of the screwed up tax system and a SERIOUS addition to the marriage penlty.
I guess it’s important to some people, but probably not most doctors given the average physician income around $200K. Only in really expensive areas of the country and for really highly paid docs should they be having $1M mortgages. Much less $2M mortgages.
Sadly it’s us Californians New Yorkers etc living in million dollar homes with tiny yards. Turbo Tax, HR block etc does not prompt you about limitations of mortgage interest deduction so very important to be aware of. You have to manually calculate then enter into TT. For us, significant difference between what we paid and what we claimed.
Yeah this is a big deal for a lot of people. Whether or not they should have a $1M mortgage, many, many doctors do. And it’s not just New York, San Francisco, and so on. Even here in New Orleans, a reasonably nice home in the nicer neighborhoods will easily eclipse $1M very quickly. Not every MD lives in Utah where you can get a new McMansion for the loose change in your sofa 😉
Also just because avg income is $200k, half are above that, and half of those even further above that. If docs making $500k-$1M+ account for only 5% of MDs, that’s still probably like 50,000 some odd taxpayers.
What if you have multiple homes and file MFJ? Does the 1million rule apply?
Yes, the rule still applies.
Wow. New Orleans is expensive. The average home there is $100K more than in Utah. I usually think of the Salt Lake area as about midway between the really expensive cities and the really cheap, Midwestern/Texas type places.
My guideline for housing is that your mortgage amount should not be more than 2X your gross income. So if you’re making $200K a year, and put $100K down, that gives you a $500K house with a $400K mortgage. Are there some physicians and particularly two physician couples who can afford a $1M mortgage? Sure. But it should still be pretty rare.
Just remember, its not the $1Million rule, call it the $1.1 Million rule (since Nov 2010). Because you may not think that extra $100K makes a difference, but you would be wrong. In fact, if you hit the AMT (and a lot of physicians do) then that extra $100K goes an incredibly long way to saving you taxes. Why? Because when you hit the AMT, all your deductions fall away EXCEPT your home mortgage interest deduction.
I don’t advocate buying a large house just for tax savings, but the truth is that (as many here have mentioned) prices are very high in certain areas of the country. Being a physician, you are able to leverage your stability for a no-money down $1.1 Million mortgage at an outstandingly low rate without PMI.
This creates a situation where you are using leverage to buy into an investment that you can use and avoid the necessity of carrying REIT (Real Estate) in your portfolio. It also is an excellent hedge against inflation which will eventually take off.
So, I understand Jim’s position. My take is a little different. If you plan to live in an expensive area of the country for a period greater than 6 years, look for the cheapest house in the most expensive neighborhood, lowball an offer, keep it below $1.1 Million, and take a no money down/ no PMI/ no closing cost 30 year mortgage. With some luck, you’ll be there more than 6 years, inflation will skyrocket, and the area you are living along with the home’s value will too.
You’ll make some money, save on your taxes, keep REITs out of your portfolio, and have a leveraged investment that is about as good as it gets because you use it everyday.
Turbo Tax will not help you with any of this (above $1M) and it is a little obscure until you know the rules.
I disagree that REITs and a large residence are in any way interchangeable. A home is mostly a consumption item with some investment qualities. No reason to keep the mortgage below $1.1M, since interest on the first $1.1M is deductible either way, even if it is $1.2M or $1.3M.
Excellent article. It would be great if you did one of these on each of the common tax forms over the coming months. Definitely enlightening for someone so early in their financial (and tax preparation) career!
What if I then compiled those posts into a book and published it as The White Coat Investor’s Guide to Tax Reduction? 🙂
I would read it!
As long as it’s in digital format the I would read it. What are you going to call it “White coat investor: a doctors guide to the us tax code”?
Dunno, lots of writing still ahead of me.
If you’re compiling a list of ideas, I have to start filling out a Schedule K-1 next year and would love an article on it from you.
Great post.
Is gambling losses deductible? If so.. How’s this defensible if audited? Just curious.. Not for me but for someone I know who makes a lot but unfortunately like a dumbass… Loses half of it on gambling?
Great article!
If it’s a big loss the casino should send you a w-2g. Otherwise you need to make a log of winnings and losses, dates etcjust like a travel journal to get the mileage deduction
Yes, they are deductible. Line 28 of Schedule A. https://www.irs.gov/instructions/i1040sca/ar01.html#d0e1855
Interesting.. It feels almost silly that we could deduct gambling losses as though it’s some sort of business expense when for most it’s an entertainment expense? I get it for the professional poker player.
Gambling gains r taxable so I guess it’s only fair….please note you can only deduct up to the amount you have won … So if you win 10,000 and lose 15000 you can only claim 10,000 in losses to offset the winnings
JN,
Yes, but NO. If you won $15k you could put $10k on the schedule A, but it doesn’t really get you a $10,000 credit against your loses. For example if you had no other Sch A deductions you would not even make it over the $12,600 standard deduction where filing the Sch A makes sense.
Should have said if you won $10k you could put $10k on the Sch A. — where’s the edit button?
In the forum! Part of the reason for starting it was some comments threads were just getting so long. It’s a bit of an unwieldy medium for a conversation. Hopefully better since the redesign, but nowhere near as good as the forum.
Gambling losses traditionally are deductible only to the extent you have gambling winnings. I.e., not really a handout to those who blow money at the casino.
I add up all my sales tax and deduct that. It is always significantly more than the standard IRS estimate and I consider myself pretty frugal. Last year, I saved about 800 dollars in tax and it prob took about 8-10 hrs of effort over the year. A lot of it is dead time (e.g., waiting for the server at restaurant to run your credit card), so I guess I don’t mind. However, I suppose that amount of $/hr is probably not enough to justify the time spent.
Girlfriend doc’s biggest deduction is always charity. She donates to everything under the sun, church, non profits, etc. and good for her she’s a generous person. Didn’t realize that med expenses had a floor on them before they’re deductible good to know
I think med expenses have to be > 10% of your AGI. As WCI said, for most docs, you’ll pass the maximum out of pocket on your health insurance plan before getting to that number
One of the most useful posts I’ve seen on WCI. THANK YOU THANK YOU!!!! Please continue with posts like these on having a better understanding of how the tax “negotiations” (to borrow from your book) should go. This is the kind of straight forward, incredibly enlightening, and empowering discussion that I have hoped to have with multiple accountants over the years that I have paid well for, and unfortunately never had. And here you are sharing his info at no cost. Please continue with more posts like this! Thank you Saint WCI. 🙂
You’re welcome. Glad you found it helpful.
WCI says:
“By the way, if you are paying AUM fees, try to get your advisor to take them out of your tax-deferred accounts- then you can pay them with pre-tax dollars. Way better than a Line 23 deduction.”
I have always looked at this differently and would like guidance on how my thinking could be flawed. I would rather pay all of the fees out of my brokerage account (and deduct them) to enable our tax-deferred and tax-free accounts to grow for an extended period of time without getting hit by fees that reduce the principal. Is this logic flawed?
Daniel S. – This is what we recommend (out of taxable accounts). “We” also means financial planners in general. I think WCI might have gotten this backward. Not only do you want to leave your tax-deferred accounts untouched, but, because this is a rather gray area, there is a chance that the IRS could treat a payment from your tax-deferred accounts as an early distribution subject to tax and penalties.
JF has a good point to my argument below — if it is a “fixed fee” as opposed to say a “load fee” then it could be considered an early withdrawal with penalties due.
So it really depends on the fees involved.
I’m not at all convinced that the additional tax-protected space is worth paying 100% of the fee rather than 50-60% of the fee. I don’t think this is all that gray either. Do you know of any instance where the IRS treated paying AUM fees for a tax-protected account out of the tax-protected account as an early distribution? I’ve never heard of such a thing. Sure, there is value to a higher ratio of tax-protected to taxable, but look at what it costs you to do so!
I mixed a couple of PLRs up when posting as I didn’t do my homework first (sorry!) This is no longer a gray area. The IRS has ruled that fees CAN be paid with tax-deferred (TIRAs) and tax-free (Roth’s) money, but the fees are not deductible. This makes perfect sense since they are being paid with money that has not yet been taxed.
There is absolutely no reason to use valuable IRA space to pay investment management fees unless this is the only way you can do so. (And if you do, your problems go beyond the scope of this discussion!)
Michale Kitces has an excellent post on this at https://www.kitces.com/blog/irs-rules-for-paying-investment-fees-from-taxable-and-retirement-accounts/
Nonsense. If you’re paying them with a pre-tax traditional IRA you’re paying them with pre-tax dollars. That’s a huge advantage. While you don’t get ANOTHER deduction, you don’t have to pay the taxes on the money used to pay the fees, which is really the same thing.
I disagree that you have issues if you can’t afford to pay the AUM fees on a huge IRA with taxable money. Imagine someone paying 1% on a $2M IRA. That’s $20K. That could quickly bleed dry a small taxable account.
So you’ve worked your budget around so that you can contribute the maximum to your 401k, rolled out to an IRA, and then you think it’s ok to begin depleting it by paying your bills while you’re in your 30s, 40s, or 50s? We’ll just have to agree to disagree. I see reducing the future tax-deferred growth of $20k from your IRA (your example) for current expenses as a huge disadvantage. If you didn’t have to pay tax and penalty on the distribution, would you recommend taking $20k out of your IRA today to buy a car? Just interested in your definition of what “huge advantage” is…
I stand by my comment that you have issues if you can’t afford to pay AUM fees on a $2M IRA from outside sources. First, it is not so difficult to find a fee-only planner who will charge a flat fee (starting with me 🙂 ) and/or charges less than 1% for larger accounts. Someone who has been able to amass a $2M portfolio typically has the money skills to afford AUM fees in the budget (at least in my experience). If not, get a plan.
Yes, if I could buy a car with pre-tax money today instead of pulling tax-deferred IRA money out in 20 years and paying tax on it I would do so.
It takes many years of tax-protected growth to make up for such a huge discount. Let’s run the numbers on it since apparently this isn’t obvious to anyone else but me.
Let’s say you have a $2M IRA and you’re paying 1%. You have $20K sitting around outside the IRA. Your marginal tax rate is 45%. So your options are to pay $20K in taxable money, or $20K in IRA money (currently the equivalent of $11K, perhaps later the equivalent of $16K.) How long would that money have to stay in the IRA to make up that $4-9K difference? Let’s assume a LTCG/dividend rate of 20%, a 2% a year distribution, buy and hold behavior, and an 8% pre-tax return on investments. Let’s use a term of 20 years.
Option 1: Pay from the IRA. The IRA now has $20K less but you still have that taxable $20K which grows at 8% – 2% *20% = 7.6% a year. After 20 years, that taxable money is worth $86,552. After tax, $73,241.
Option 2: Pay from the taxable account. Now you have $20K in an IRA, but the taxable $20K is gone. The IRA grows at 8%. After 20 years it is worth $93,219. If you apply the 45% tax rate, that’s $51,271. Even if you apply a 20% rate (to account for filling the lower tax brackets, lower bracket in retirement etc), it’s $74,575.
So it took nearly 20 years and a much lower effective rate in retirement for it to be better to pay from a taxable account.
You and most others on the site vary your calculations based upon lower tax rates in retirement or higher rates whenever it suits your argument. Using the most common argument promulgated on WCI, that taxes will be lower in retirement (the typical assumption is 15%), your hypothesis doesn’t work.
You are also assuming that you will withdraw all of the account balance immediately in 20 years, which is doubtful.
Finally, you are assuming that you aren’t my client, in which case we would have followed a prescribed plan to convert the pre-tax dollars to Roth dollars during bear markets and corrections, making them permanantly tax free. (I think if you can take liberties to make your case, so can I 🙂 )
Even using your 20% rate, the results are better by having paid the expense out of your after-tax account.
You make good arguments, but the point is you’ve got to run the numbers. It’s not a no-brainer. If you’re in the highest bracket now and will be later (or have lots of rental income or something), or you’re 80 then paying out of the IRA may be the right move.
Daniel,
I believe WCI is right in that it is better to let essentially the “taxman” fund your AUM fees. The line 23 deduction is usually quite useless in my experience for two reasons:
1. It is subject to a 2% limit that you first need to get over.
2. Next it is subject to the reduced affect of being on Schedule A to begin with — which has a $12,600 limit you need to get over.
After all that is said and done even if you increased the Sch A deductions by the amount of the AUM you still only get to reduce your taxes by your marginal tax rate which is sort of what is happening inside your pre-tax account.
I have never had to personally pay AUM fees, as I am the one usually collecting the fees, but if you can pay anything with pre-tax dollars you will be ahead over paying the fees out of after-tax dollars, which would be the case in either a Roth or taxable brokerage account.
Plus the Pease phaseouts at the upper brackets.
Both effects exist. Run the numbers to see which is larger. For a very long period of time or with significant asset protection needs, the additional IRA space may win out. But for most, being able to pay for something with pre-tax dollars is going to win. The rules are basically that only the AUM/management fees for the pre-tax money can be paid with the pre-tax money though. If you have a $10K IRA and a $1M taxable portfolio you can’t pay all of the fees out of the IRA.
I think you missed the whole retirement community (like me) by not pointing out it is even tougher to use a Schedule A, because each person over age 65 gets another $1250 in standard deduction, so for a MFJ return with both over age 65 then the standard deduction is $15,100, at a time when maybe your deductible expenses such as your house are much lower. 🙁
Excellent point.
Or I guess you could look at the higher standard deduction as an additional tax break.
I just look at it as more of a reason not to have to save all those receipts during the year such as trips to Goodwill and such because even if you get above the SD by a few hundred dollars it is hardly worth my time. I can also put $20 in the church collection plate and not have to worry about writing a check to get the deduction!
You have to consider what is the benefit from say $16,100 of deductions if your SD is $15,100. The benefit is $1000 of extra deductions, which at a 25% tax rate is $250 or in that case 1.6% – not really the 25% you were expecting when you generated those $16k of deductions!
With respect to the sales tax deduction, I think that if you have “big ticket” purchase (like a boat or car) you can take a deduction for the sales tax paid on that item in addition to the IRS sales tax estimate.
You are correct. Big ticket items include many things, not just vehicles (the usual suspects). We have taken “additional” sales tax deduction for as low as $150, so don’t limit yourself to really big purchases. Another reason to go sales tax if your income tax deduction is bumping into AMT.
That’s correct and described on page A-6 of the Schedule A instructions:
https://www.irs.gov/pub/irs-pdf/i1040sca.pdf
I should have mentioned that I suppose as it is an important point. But even so, still way less than my state income tax.
In your subsection here titled “Dumping Your Whole Life Policy,” you discuss the situation where someone does a 1035 exchange into a VA, and then cashes out the VA to claim the loss on one’s taxes.
You then say “Those in the know are saying this loss should go on Line 23, as an ordinary loss subject to the 2% floor.” Has something changed, or have some experts formed more solid opinions on this recently?
Just wondering because my understanding was that camps were split pretty evenly on whether the approach you describe is correct, or whether the more aggressive approach (claiming the loss as “Other gains or losss” on 1040 line 14), and that it really wasn’t clear at all as to which approach is likely correct.
I agree it isn’t all that clear. If you find clarity, please share.
We live in Nebraska, we file married jointly, our house is paid for, we have zero debt. Usually we file with the standard deduction. This year my wife won 7000 dollars on a scratch ticket, a form of gambling. I have saved 7000 dollars in losing gambling receipts. My thought was to pay my property taxes ahead one year, we are in arrears in Ne on property taxes. So 7000 on gambling 3000 on 2016 real estate taxes, and 3000 on 2017 real estate taxes, should be 13000 in itemized deductions. The lottery commission withdrew 30 percent from 7000 when we took our winning ticket in to be cashed. I was hoping to recoup some of this lottery tax. What do you think????Thank you for listening.
Are you just asking whether you should itemize? Your tax software should be able to determine that in a millisecond after you put your info in.
Was just looking for any thoughts on this idea,
What idea? The idea of putting income on your tax return? That’s a good idea. The idea of taking deductions you legitimately deserve? That’s a good idea. I’m not sure I understand what your alternative is. The only question I see is whether you take your property taxes this year or next. I suspect you may be better off with the standard deduction next year, in which case you would want to pay your property taxes this year since they won’t help you a bit next year. But honestly, I don’t have enough info to give any kind of advice.