Nearly every physician I know thinks he pays too much in taxes. Most of them are right. This largely stems from not understanding how the tax code works. Doctors assume that reducing their tax burden is a function of finding the right accountant to prepare their taxes when in reality it is more a function of changing the way they live their financial life. Here are five changes in your financial life that you can take this year that will reduce your tax burden.
# 1 Save More and Do It in Tax-deferred Retirement Accounts
Most doctors have at least one tax-deferred retirement account available to them. This might be a 401(k), 403(b), 457(b), 401(a), individual 401(k), SEP-IRA, SIMPLE IRA, profit-sharing plan, or a cash value plan. Surprisingly few however, maximize their potential contributions to these accounts. Many doctors aren’t even aware that they can have multiple 401(k)s if they have multiple employers. These accounts are the single best tax break available. Not only do you get a big discount off this year’s tax bill, but the money grows in a tax-protected manner, and if you are like most doctors, you will withdraw the money at a lower marginal tax rate than you had when you made the contribution. Basically, you get a tax break AND you get to keep the money.
A Health Savings Account (HSA) is even better. Not only do you get the same tax break for the contribution and the same tax-protected growth, but as long as you spend the money on health care, you also don’t pay taxes on the money when it comes out. An HSA is your only “triple-tax-free” account. It also functions as a “Stealth” IRA. If you don’t spend the money on health care, you can take it out penalty-free after age 65. In that situation, you do have to pay taxes on it, but that is no different from your tax-deferred retirement accounts. If you are self-employed, your health insurance premiums are tax-deductible as well.
# 3 A Backdoor Roth IRA
Roth IRA contributions don’t reduce your tax bill in the year you make them, but their earnings are never taxed again. Many physicians stop making Roth IRA contributions after residency because their income prohibits them from contributing directly. However, they are still allowed to make contributions “through the backdoor.” This is done by contributing to a traditional IRA (that contribution is non-deductible due to the physician’s high income) and then converting the traditional IRA to a Roth IRA.
# 4 Tax Loss Harvesting
Many investors hate to sell investments after they have gone down in value. However, there is almost no reason to hold on to a losing investment in a taxable account. You don’t want to “sell low” and abandon a good investment just because it temporarily went down in value, however. What you should do is sell the investment and buy one that is very similar to it, but not, in the words of the IRS, “substantially identical.” This allows you to hold the same investing position, while harvesting a loss you can use on your taxes. Not only can you use these losses to avoid paying capital gains taxes, but you can use up to $3,000 of these losses to reduce your regular income each year. If you can’t use the whole loss this year, you can carry it for indefinitely. When you eventually sell that investment, you will have a lower basis on it (and thus owe more taxes) but even that can be eliminated by using the appreciated shares for charitable giving or taking advantage of the step-up in basis at death by never selling them.
# 5 Spending Money in IRS Approved Ways
If you read the tax code carefully, you will see that the IRS will subsidize your lifestyle if you align your lifestyle with the values of the IRS. For example, the IRS subsidizes home owners (property taxes are deductible), givers (charitable contributions are deductible), borrowers, (mortgage interest, margin interest, and even student loan interest can be deductible), and business owners (anything justifiable as a business expense is deductible.) It isn’t as if these are a “free lunch,” since you always spend more than you get back on your taxes, but at least the tax code will reduce the cost of these purchases.
Understanding how the tax code works, saving money, and living your financial life in IRS approved ways will reduce your tax burden now and in the future.
James M. Dahle, MD, FACEP is the author of The White Coat Investor: A Doctor’s Guide to Personal Finance and Investing and blogs at whitecoatinvestor.com. He is not a licensed financial adviser, accountant, or attorney and recommends you consult with your own advisors prior to acting on any information you read here.