As a physician you spend so many years in training and fellowships that it feels like you’re never going to earn the “big bucks”. When you finally do start making that attending pay it can feel awesome until you realize you’re paying Uncle Sam in taxes about as much as you used to earn as a resident.
Today’s article is about highlighting the steps you can take to minimize your tax bill and keep more of what you earn. And if you take these steps you’ll pay less in taxes today and for the rest of your career.
- Maximize your retirement contributions – 401k/403b/457b etc. You’re probably already contributing to these accounts, but make sure you are making the maximum contribution to really juice their impact on reducing your tax bill.
- Don’t forget about your other tax advantaged accounts. Utilize 529 plans, HSA accounts, and backdoor Roth IRA contributions for added savings.
- Make smart decisions in your taxable brokerage account. Tax-loss harvesting, optimal asset location, and donating stock to a Donor Advised Fund can all help minimize your taxable income.
- Investigate Real Estate investing and whether it’s a good fit for you. Investing in Real Estate can provide a way to build additional wealth while reducing your tax bill as long as you meet a few requirements.
Max Out Your Retirement Contributions
It can be hard to contribute to your retirement accounts while you’re still in training, but once you finish with Residency and Fellowships it’s time to boost those contributions into high gear.
One great side effect of increasing your contributions and reducing your taxable income is that it will also lower your required monthly loan payments if you’re on an Income Driven Repayment plan. Great news for those pursuing PSLF!
The maximum you can contribute to a 401k, 403b, or 457b plan for 2023 is $22,500.
* One note for those of you over 50, you can also make what’s called a “catch-up contribution” of an additional $7,500 per year. This can be extremely helpful for physicians who got a late start on their retirement contributions due to working in a specialty with a long training timeline.*
401k and 403b plans are basically interchangeable, and if you have access to both, the total contributions between the two can’t be more than your $22,500 limit. But 457b plans are counted in a different bucket. This means you can make the max contribution to both your 401k/403b and your 457b. That’s $45,000 you can sock away and reduce your taxable income.
457b plans are also great accounts to use to turbocharge your efforts to achieve early retirement. If you want to learn more you can read this post all about 457b plans and how to maximize their effectiveness.
Some employers, like Ohio State University, also offer physicians and staff access to a defined benefit plan (pension) in addition to the other retirement accounts. Your contribution to these plans is usually set at a percentage of salary that you can’t adjust, but is another chunk of money that you are contributing to reduce your taxes today.
How Tax Brackets Work
A quick diversion on how tax brackets work and why it’s so beneficial to reduce your taxable income, especially for those in the highest tax brackets.
In the U.S. we have a progressive income tax system where the tax rate you pay gets progressively higher the more you make. A common mistake that people make is thinking that when they earn enough to get into the next tax bracket, let’s say moving from the 12% to the 22% bracket, that they pay 22% in tax on their entire income.
That’s not the case, a single filer would pay 10% of their income up to $11,000, they would pay 12% on only the income between $11,001 and $44,725, and 22% on any income between $44,726 and $95,375.
For example, here are the tax numbers for someone earning $80,000
While someone earning $80,000 is in the 22% tax bracket their average tax rate over their entire income is only 16.%.
The higher your income the more benefit you get from making contributions to retirement accounts. For someone in the 32% tax bracket, every dollar contributed to a pre-tax retirement account today saves 32 cents in taxes, grows tax free, and is withdrawn in retirement, likely at a much lower tax rate.
If you are in the 32% tax bracket, maxing out your 403b and 457b will save you $14,400 in taxes ($45,000 x 32% = $14,400).
Max out your HSA
If you’re healthy and don’t expect too many healthcare expenses, then selecting a high-deductible health plan with an HSA is a great choice. HSAs are another account where you can contribute pre-tax dollars and reduce your taxable income. The contribution limits are $3,850 for an individual and $7,750 for a family.
HSAs can also serve as a “stealth” retirement account. Most HSAs allow you to invest the money in your account similar to a 401k or brokerage account. If you don’t use or need your funds for health expenses when you reach age 65 you can withdraw them for any use without penalty. In essence they become another IRA, since contributions are pre-tax you will pay tax on your withdrawals if you don’t use the funds for healthcare expenses.
Maximize 529 Plan State Tax Deduction
529 plan accounts are great tool for saving for your children’s college expenses, but some also come with some nice tax advantages as well. Most states that have a state income tax provide a state income tax deduction for contributing to a 529 plan.
The tax benefits vary greatly from state to state. For example:
- States without an income tax offer no state tax deductions
- Ohio offers a $4,000 deduction per beneficiary, meaning if you have 4 children and contribute $4,000 to each child’s 529 in a given year you can deduct $16,000 from your income for state taxes
- Idaho offers a $12k deduction for MFJ (Married Filing Jointly), $6k for single filers regardless of the number of beneficiaries
- Indiana has one of the best perks – a 20% tax credit, instead of a tax deduction, up to a total of $1,500 for a married couple, $750 for a single filer
Invest Smartly in Your Taxable Brokerage Account
You may read the word “taxable” and think that you should stay away, but these are your standard brokerage investment account and the word taxable is mainly used to differentiate them from your pre-tax or Roth accounts.
While you don’t get a tax deduction for contributing to your taxable account, there are many benefits from investing in a taxable account.
- No contribution limits – unlike 401ks, IRAs, or HSAs you can contribute as much as you want.
- No withdrawal penalties – you don’t have to wait until age 59 ½ to access your money, or use it for a specific purpose like an HSA or 529 plan.
- Flexibility – along with the above points, you can invest in whatever you want within a taxable account. Not just the options that your 403b plan provider has available.
- Capital gains tax rates – Rather than paying income tax on your withdrawals like in a retirement account, you only pay taxes on your gains, and at the much more favorable long-term capital gains rates (own your holdings for at least 1 year + 1 day).
As long as you own your holdings for at least 1 year + 1 day before selling you will be taxed at the long-term capital gains rates rather than the federal income tax rates.
For holdings that have lost value you can take advantage of tax-loss harvesting, where you use the losses in parts of your portfolio to offset gains in other parts of your portfolio. When using this strategy be mindful of the wash-sale rule. You can’t purchase the same thing you just sold within 30 days or else you face a penalty.
But even if you don’t have any gains in your portfolio to offset this is still beneficial because you can use your loss to offset up to $3,000 per year in ordinary income, which is usually taxed at a much higher rate than the long-term capital gains rate.
Optimize for Asset Location
A way to improve the tax efficiency of your taxable brokerage account is to own assets that will appreciate, rather than provide dividends or interest payments. A share of stock that appreciates in value can later be sold and the gain can be taxed at capital gains rates. While a bond or dividend stock will produce interest or dividend payments that are taxed at income tax rates.
Optimizing for asset location is more art than science, because there will be times when you don’t want your entire taxable account to consist of risky assets like stocks, but it’s a good thing to keep in mind when you start investing in a taxable account.
A champagne problem to have in your taxable account is a stock or fund that’s experienced a massive gain, and will still incur a hefty tax bill, even at long-term capital gains rates. Think Apple stock that you bought in 2010 for $10 per share that’s now worth $200 per share.
For cases like this a donor advised fund (DAF) can really come in handy.
Donor Advised Fund
This is a really handy account that can help you out tax-wise in a number of ways while also helping you meet your charitable giving goals. A DAF is an account that you can donate stocks to and then the DAF can sell the stocks and give the proceeds to the charities you designate.
In the case of our Apple stock above, you receive the charitable tax deduction for the full value of the stock donated to the DAF, and neither you nor the DAF owe taxes on the gain, win-win!
Why would you go through this process rather than donating the stock directly to the charity? One reason is that some charities can’t receive stocks, and in most cases would much rather just get cash. Another is you can make the donation to the DAF and dole out the proceeds over as much time and to as many different charities as you like.
DAFs are also a great tool if you regularly give to charity but your total deductions aren’t enough for you to itemize (i.e. you still end up using the standard deduction when you file your taxes: $13,850 single, $27,700 MFJ).
With a DAF you can make a larger contribution in one year, in order to itemize your deductions, and then make contributions to your chosen charities from the DAF for multiple years.
Backdoor Roth IRA
While it technically won’t save you taxes this year, contributing to a backdoor Roth IRA will save you from paying taxes on those contributions ever again. If you’re not familiar with it, a backdoor Roth IRA is a two-step process to contribute to your Roth IRA even if you make too much income to qualify. The income limits to contribute to a Roth IRA for 2023 are $153k for single filers and $228k for MFJ.
To perform a backdoor Roth IRA, you contribute after-tax dollars (i.e., you don’t deduct them from your income) to a traditional IRA, and then do a Roth conversion on that contribution. Voila! Your after-tax traditional IRA contribution is now a Roth contribution. Since the funds are now in a Roth account they will grow tax-free, withdrawals will be tax-free, and you won’t have to worry about RMDs!
You do need to make sure you don’t have an existing balance in your IRA before conducting a backdoor Roth or you’ll run afoul of the pro-rata rule, where you will end up owing taxes on part of your contributions, which is the opposite of what we want here.
The last item in this article is probably one that most physicians have heard about or thought about investigating. With good reason. Investing in Real Estate is a great way to diversify your investment portfolio while also potentially lowering your tax bill, but there are some hoops you’ll need to jump through.
First off, real estate investing isn’t for everyone. For every story of a low-maintenance property and perfect tenants, you’ll hear one about midnight water heater leaks and busted pipes. This article is focused on ways to lower your tax bill and real estate investing is certainly an attractive option, but do your homework before jumping in to becoming a landlord.
One of the biggest advantages for real estate from a tax perspective is that you can own a property that provides real world cash flow, while showing an on-paper loss due to depreciation and other factors. The challenge for physicians is capturing that on-paper loss and deducting it against your earned income. The IRS says you can’t deduct your passive real estate losses against your income if your earned income is above $150k. However, you can get around this rule in one of two ways.
Real Estate Professional Status (REPS)
The first way to be able to deduct your real estate losses is by obtaining Real Estate Professional Status. To do this you need to spend over 750 hours per year in real estate and not spend more than 750 hours per year doing another job, like being a doctor.
The easiest way to accomplish this in a physician household is if one non-working spouse manages the real estate duties, so this is not a possibility for everyone. You need to be careful with this and take detailed records of your involvement in managing your properties. You don’t want to run afoul of the IRS on this one.
Short-Term Rental Loophole
With the Short-Term Rental (STR) Loophole, you don’t need to obtain REPS to be able to deduct your real estate losses. There are a few criteria you still need to meet, but they are much easier than obtaining REPS and don’t preclude you from also working a full-time job.
There are several different criteria you can meet to qualify, but I’ll mention two here. If you own a short-term rental where renter stays are less than seven days, and your participation was greater than 100 hours and equal to that of any other individual, then you would potentially meet the STR loophole and be able to deduct your losses against your income!
As you can see there are many strategies that you can use to reduce the amount of taxes you pay as a physician. And many of these tips only require you to maximize your use of accounts that you already contribute to.
My hope is that after reading this article you can take few steps today to reduce your tax bill for this year and for the rest of your career going forward.