Tax Strategies

13 Tax Mistakes Doctors Make That Cost Thousands

Tax mistakes are the most common financial mistakes physicians make. Errors, oversights and outright blunders cost thousands in unnecessary income taxes so a little tax planning goes a long way to save money for doctors.

If you want to catch mistakes before they cost you, check out the list below. By the way, the financial mistakes you see here are real: we have seen at least one doctor make every error on this list. (See Assumptions at the end of this article.)

1. Overlooking the Health Savings Account means overpaying taxes

A Health Savings Account (HSA) is a tax-advantaged savings vehicle that lets you make tax-deductible contributions, enjoy tax-deferred growth, and make distributions that are tax-free when used to pay qualified medical expenses. it’s also the best tax break you can get as a physician since it’s a permanent benefit.

Anyone who is covered by a qualifying high deductible health plan (HDHP) can contribute to a Health Savings Account. Many doctors don’t know they have a HDHP option or they don’t understand how HSAs work, so they stay the course with first-dollar coverage and lose the tax benefit.

This mistake costs doctors who are eligible for a family HSA plan $2,228 each year.

2. Spending your HSA makes healthcare less affordable in retirement

Health Savings Accounts are poorly understood by most physicians who often mistake them for FSAs (Flexible Spending Accounts). With the balance in a Flexible Spending Account, you must “use it or lose it” by the end of the year. With HSAs though, “using it” means you lose the power of tax-free compound growth. The smart move here is to invest the HSA balance and let it compound over time.

By making the mistake of spending your HSA each year, you throw away more than $390,000 in tax-free earnings over a 30 year period and that’s money you could have used to cover the cost of healthcare in retirement.

3. Skipping the 529 tax deduction is like skipping college

Section 529 college savings plans are tax-deferred accounts that can be used to pay qualified higher education expenses including college tuition, fees, room, board and the cost of a computer.

While almost every physician has heard about 529 plans, it’s no wonder they tend to skip the accounts altogether. The rules— including how much you can contribute, how much you can deduct, how many accounts you need and whether the deduction is granted to one taxpayer, one return or one account—all vary from state to state. Still, it makes sense to puzzle out the rules, especially in more expensive states where the top tax rate can run to 9%.

Physicians who pay taxes in Colorado, Georgia, Idaho, Iowa, Kansas, Louisiana, Maryland, Michigan, Mississippi, Missouri, Montana, Nebraska, New Mexico, New York, Ohio, Oklahoma, Oregon, Rhode Island, South Carolina, Utah, Virginia, West Virginia, and Wisconsin all get a state tax break. In Oregon, the deduction is worth $455 per year. In New York, it’s worth $882 per family. In a handful of states—Colorado, New Mexico, South Carolina and West Virginia—the deduction is unlimited. Perversely, the state with the highest tax rate offers no deduction at all: thanks California!

 No matter where you live, 529 plan accounts can grow tax-deferred until you withdraw the money to pay for college, tax-free. Assuming a savings fate of $500 per month over 18 years, skipping the 529 plan is a mistake that can cost physicians over $90,000 in tax-free growth: enough to send one child to a state college for four years.

4. Believing you cannot contribute to an IRA leaves assets unprotected

Tax advisors often tell physicians “you cannot deduct an IRA contribution” which doctors mistakenly understand to mean, “there’s no reason to do an IRA.” It’s the first logic error in this two-part tax blunder.

Assuming annual household contributions of $11,000 over 30 years, the “tax arbitrage” opportunity—the way you can leverage your current high tax bracket against the lower tax rates you will see in retirement—is worth more than $168,000 to a physician family. The mistake is compounded by the fact that the alternative vehicle to hold these savings is often a taxable account where income and dividends are taxed every year.

When you combine this mistake with the fact that IRAs receive asset protection from creditors under the Bankruptcy Abuse Prevention Act, it’s easy to see how a well-meaning tax man’s casual comment can steer plenty of docs in the wrong direction. But there’s more to this story.

5. Failing to use a Backdoor Roth IRA makes retirement more taxing

A “backdoor Roth IRA” isn’t really a Roth IRA at all. It’s a Traditional IRA that receives a nondeductible contribution that is converted to a Roth IRA.

The physician family who contributes $11,000 to Traditional IRAs each year for 30 years ($5500 per spouse) and then dutifully converts those contributions to a Roth IRA will owe no income taxes to withdraw the money.

On the other hand, physician families who merely contribute to a Traditional IRA and fail to do the conversion will be forced to begin withdrawing the money at age 70½ and pay more than $90,000 in income taxes.

6. Ignoring Roth rules makes the Backdoor Roth (surprisingly) taxable

The rules surrounding IRA conversions are so complicated that many physicians wind up paying taxes for something intended to save them.

First, physicians need to understand there are two kinds of money in most IRAs: pre-tax money (that comes from 401k rollovers and previously deducted direct IRA contributions) and post-tax money (that comes from direct contributions that were not tax-deductible). You can think of this as “bad money” (pre-tax) and “good money” (after-tax). To effect a successful Roth conversion, you have to separate the good money from the bad (using a 401k rollover) or you will pay taxes on the bad money that is converted.

Second, doctors need to know that “IRA” means all of your Traditional IRAs, no matter where they are held, and your SIMPLE and SEP-IRA balances. The IRS sees all of these accounts as “your IRA” such that when you convert one, you are deemed to have converted a pro rata portion of all your IRAs.

Finally, even if you manage to separate the good money from the bad, you still need to handle your tax return correctly. If you fail to tell your tax specialist that you “converted a Traditional IRA with basis to a Roth IRA” or if someone fouled up Form 8606 of your tax return somewhere along the way, you are very likely to (unknowingly) pay unnecessary taxes which might conservatively be estimated at $3,600 for a physician family with two IRAs.

7. Rocking the wrong Roth makes doctors pay more tax now and less later

Did you know there are three Roths? It’s true. There’s the “front door” Roth IRA that’s right for interns, residents and hardworking but underpaid doctors who can contribute directly to a Roth IRA. Then there’s the backdoor Roth IRA that’s right for docs who cannot directly contribute to a Roth IRA. And finally there’s the Roth 401k that’s right for low earners but disastrous for high earners.

When you contribute to the non-Roth portion of your 401k, you are able to defer taxes into the future, when rates may be lower for you.

But when you contribute directly to a Roth 401k, you are essentially raising your hand to the IRS and saying, “please tax me now.” If you’re a high earner, you’ll pay an extra $6000 in taxes each year by rocking this Roth.

8. Underfunding your 401k is like giving extra money to the tax man

Sometimes it makes sense not to fund your 401k, like when there’s no employer match, when you’ve got a ton of high interest rate student loan debt and when you have zero dollars in your Emergency Fund. But for all but a few physicians, the best bet is to stuff your 401k as full as you can.

Even knowing this, many physicians fail to do so. Sometimes there’s a mix up and they fail to enroll. Other times they enroll but fail to contribute enough to get the match. And occasionally the contribution limits change but they have elected a flat-dollar contribution amount that’s never reviewed, resulting in a contribution gap.

To avoid paying an extra $6,000 to $8,000 a year in taxes, check your 401k account every year in September to see if you’re on track to make the maximum contribution by year’s end. If not, you still have time to fix it.

9. Working extra hard to pay extra taxes for self-employed physicians

Moonlighting, doing locums, researching, lecturing, teaching, acting as a contracted medical director and other sideline doctor gigs are a great way to pick up some extra cash—and extra taxes— if you overlook special deductions available only to self-employed physicians.

If you don’t have a 401k at work, you can easily set aside $18,000 in a tax-deferred self-employed retirement plan. Physicians who do have a 401k at work can establish a profit sharing retirement plan for their own business and contribute up to $36,000 in 2017. If you have a whole bunch of self-employment income, you can even establish a defined benefit plan and save even more. But doctors who didn’t know about these opportunities will likely pay somewhere between $2,000 and $9,000 in extra taxes.

10. Blowing up your retirement plan by overlooking the fine print

While this is a less common mistake, the consequences are dire. Small physician practices who lack a skilled business manager—often radiologists and ER docs—sometimes have an “everybody does their own thing” style of retirement plan in which everyone opens a SEP-IRA wherever they like and everyone contributes as much as they like.

In these cases, there is a de facto qualified retirement plan in place for the entire practice but there is no documentation and no one checking to make sure the contributions meet IRS guidelines. Occasionally these groups will hire a W2 employee and exclude them from the plan, which runs afoul of the rules surrounding “affiliated service groups.”

These situations are complex and often require an ERISA attorney and an accountant to straighten out the plan. Those who fail to get with the program run the risk of having their plan “disqualified” which leads to immediate taxation of the entire plan balance plus the payment of penalties, undoing all the tax savings from the plan. It’s impossible to estimate the cost of this mistake but know that the low end is on the order of tens of thousands of dollars.

11. Holding taxable bond funds in a taxable account

Although veteran investors know that a taxable bond fund generates income that causes state and federal income taxes, many physicians—even those under the care of financial advisors who should know better—own taxable bond funds in taxable accounts.

For example, a surgeon owns a joint account with her husband that holds $1.2 million in mutual funds, including $400,000 invested in corporate bonds. Those bonds yield dividends of approximately $13,000 this year. Their tax bill for these dividends is approximately $4,000, so only $9,000 remains of the return they garnered.

Had this couple purchased a tax-exempt bond fund that pays dividends of $11,000, they may owe no taxes. As a result, this couple would have an additional $2,000 this year and years to come.

12. Giving away tax benefits when donating to charity

When you give to charity, you can donate cash or you could donate securities. Since qualified charities are treated as non-profit organizations under the tax code, giving them appreciated securities means physicians not only receive a tax deduction but they avoid paying capital gains tax.

For example, a physician family owns mutual fund shares worth $50,000 for which they paid $30,000. If they donate the shares to charity, the charity can sell the shares to raise $50,000 cash and sidestep the capital gain. However, if that couple makes the mistake of first selling the shares, they will pay unnecessary capital gains tax of $2,000.

13. Just saying “yes” to stupid tax penalties

While many physicians assume the Internal Revenue Service is a bunch of jack-booted thugs intent on making life difficult, the IRS tends to be a little more understanding, particularly in the case of honest first-time mistakes.

If you have failed to file or failed to pay your taxes and it’s your first offense, you can ask for an “abatement” by writing a well-worded letter to the IRS asking them to waive the penalty. We all make mistakes but failure to ask for an abatement means sending good money after bad. Remember, if they say “no,” you are no worse off than if you hadn’t asked at all.

 

The biggest tax mistake physicians make is to think of taxes only at “tax time” when it’s too late to do anything about it. Most doctors file their personal taxes on a calendar year basis which means that you pay on April 15th for everything that happened between January 1 and December 31 of the prior year… after the fact.

To avoid making tax mistakes that cost thousands, start thinking about this year’s tax bill right now, and check in with your financial advisor and your tax specialist throughout the year to see what you can do to pay no more than what you truly owe.

ASSUMPTIONS: Federal marginal income tax rate of 33% (which kicks in at $230K for joint filers), a 20% capital gains tax rate, no state income tax, no Medicare surtax and a hypothetical 7% return. For post-retirement tax calculations, we assume a 25% federal marginal income tax bracket. These are conservative assumptions which means a few physicians will save less by avoiding the mistakes above but many doctors can save much more than what is demonstrated.

3 Ways to Save Taxes While You Invest | Oncology Practice Management

Physicians pay more than their fair share of taxes, so when it comes to your investments, why would you pay more than you absolutely have to? While it may be too late to save taxes on investments you made last year, itís the perfect time to focus on saving money this year, so we want to share some tax tactics to keep your tax bill for 2016 in check.

1. Slip Contributions in Through the Back Door

If you are a physician who is covered by a retirement plan at work, your accountant may have told you that you do not qualify to contribute to an Individual Retirement Account (IRA). That is simply false. Physicians who have earned income can indeed contribute to an IRA, even if they cannot deduct the contribution from their taxable income.

This may leave you wondering why you should make an effort to contribute if you donít receive any immediate tax benefit. The answer is that your nondeductible contribution puts you in an ideal position to convert your traditional IRA to a Roth IRA, using a strategy known as a ìbackdoor Roth IRA. This lets the balance in your Roth IRA grow tax-deferred indefinitely, with no requirement for mandatory distributions at age 70Ω years, and no taxes due on qualified withdrawals.

To make a backdoor Roth IRA contribution, you need 2 accounts – a traditional IRA (preferably an empty account) and a Roth IRA. To do that, start by contributing the maximum allowed amount to your traditional IRA ($5500 for 2016, or $6500 if you are age 50 years or older). Next, you can instruct your financial institution to convert your traditional IRA balance to a Roth IRA account. The institution will distribute the balance from your traditional IRA and then deposit that amount to your Roth IRA, generating a Form 1099-R that is sent to you in January of the following year.

If you are taking advantage of this strategy, however, you must be careful. It is simple if the entire balance in your traditional IRA hails from nondeductible contributions, and if the account has not gained value. If that is the case, you should owe no taxes on this transaction; however, if you have any other IRA accounts (including SEP-IRAs, SIMPLE IRAs, and/or rollover IRAs) that were funded with pretax dollars, the taxable portion of any conversion made from these accounts will be prorated over all your IRA accounts.

Therefore, to truly benefit from the backdoor Roth IRA and avoid the ìpro-rata rule,î you must either convert your other IRA accounts as well, or you must transfer your IRA contributions that were funded with pretax dollars to an employer-sponsored plan that accepts IRA rollovers, so all that remains are IRA accounts funded with posttax dollars.

2. Put Taxable Income in Its Place

Although veteran investors know that a taxable bond fund generates ordinary income that is fully taxable, for some reason we continue to see physicians, even those who are under the care of financial advisors who should know better, owning taxable bond funds in taxable accounts.

For example, an oncologist earning $700,000 owns a joint account with her husband that holds $1.2 million in mutual funds, including $400,000 invested in corporate bonds. Those bonds yield dividends of approximately $13,000 this year. Since this couple is in the top marginal income tax bracket (39.6% for federal income), their tax bill for these dividends is approximately $5000, so only $8000 remains in the account after the taxes are paid.

Had this couple purchased a tax-exempt bond fund that pays dividends of $11,000, they may owe no taxes. As a result, this couple would have an additional $3000 this year, and every year thereafter.

It is easy to understand why this mistake happens. Investors routinely focus on the yield or the income from the securities they buy, while ignoring the after-tax total return that the security generates.

3. Save Your Health Savings Account

While Health Savings Accounts (HSAs) were signed into law more than a decade ago, physicians are just now beginning to take advantage of the sizable tax deduction that contributions to these accounts provide. If your family is covered by a qualifying high-deductible health insurance plan (HDHP), you can contribute $6750 to an HSA this year (or up to $3350 if you are covered individually). If you are a physician in the top marginal tax bracket of 39.6%, this contribution can provide you approximately $2700 in tax-savings income.

Having made your contribution and deducted it from your income, now you are in the right position to do the wrong thing: spend the money. Although many physicians will use their HSA balances to cover out-ofpocket healthcare expenses, a better strategy is to leave the balance in the HSA account for as long as you can. Here, the balance can be invested and allowed to grow tax-deferred until retirement. At that time it can be withdrawn tax-free to cover one of the biggest expenses we will all face in our old ageóthe cost of healthcare.

Conclusion

When you understand the ins and outs of tax-advantaged investing, you can stop paying unnecessary taxes and start putting more money toward your retirement, your kidsí college, and anything else money can buy. In fact, Judge Billings Learned Hand once said, 'Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the Treasury. There is not even a patriotic duty to increase oneís taxes.'

W. Ben Utley, CFP, is the lead advisor with Physician Family Financial Advisors, a fee-only financial planning firm helping doctors throughout the United States to save for college, retirement or other financial goals. He can be reached at 541-463-0899 or by e-mail at ben@physicianfamily.com.

Lawrence B. Keller, CFP, CLU, ChFC, RHU, LUTCF, is the founder of Physician Financial Services, a New Yorkñbased firm specializing in income protection and wealth accumulation strategies for physicians. He can be reached at 516-677-6211 or by e-mail at Lkeller@physicianfinancialservices.com with comments or questions.

This article originally appeared in page 48 of the March 2016 print edition of Oncology Practice Management.

5 Tips for physicians during open enrollment

It’s that time of year again: open enrollment. The folks in HR have just sent you either the cryptic email or the packet-o-stuff that gives you all the features and benefits of your health insurance, life insurance, disability insurance, and 401k/403b plans.

Whoa.

Do they expect you to actually read AND understand all that stuff?

No way.

Each year we field a bunch of questions about employee benefits for the physicians we serve, so I want to share the top things we look for as we review these plans for clients.

1. Save taxes with the right health insurance. If you are expecting to have huge medical bills next year or if a member of your family faces chronic health issues, then you should stick with low deductible health insurance.

However, if you and the other people in your family are in good health, you might be better off with a high deductlble health plan (HDHP).

Having the HDHP makes you eligible for a Health Savings Account (HSA) which lets you sock away up to $6750 next year, tax-free.

That can save you two or three thousand dollars in taxes… permanently.

2. Get insurance even if you’re “sick”. Is there something about your health that makes the insurance company queasy?

if you are uninsurable, group life insurance may be the perfect fit for you since most group life plans will allow you to buy a certain amount (usually about $250,000) without medical underwriting.

While $250,000 won’t be enough for any physician family who wants to become financially secure, it might be enough to pay off a mortgage or send two kids to a public, in-state college.

And if you are healthy but it’s been a while since you looked at your coverage, you will find a better deal if you buy coverage outside your group plan, where higher underwriting standards keep the costs low.

3. Don’t miss the match. Would you believe that some of your colleagues are missing out on free money?

How? By contributing less than they should to their 401k’s.

If you’re not maxing out your 401k/403b, there should be a very good reason (like saving for an emergency or paying off debt with a super high interest rate). Everybody else should max this out.

4. Skip the Roth. Now that we’re all in a higher tax bracket, I can think of precious few situations where physicians should contribute to the Roth 401k plan at work.

Yet, there is still a great deal of confusion on this topic that, evidently, was not cover in med school.

Simply put, the Roth vs. Traditional decision is a decision to pay taxes NOW (when you’re in the top marginal bracket) or later, when you may be in a lower bracket and have more control over your tax rate.

I could go into great detail here about Roth versus Traditional but let me save you some time. If you are reading this and you have M.D. or D.O. after your name, your best bet is to go with the regular old Traditional 401k. And if I’m wrong, you can still convert your Traditional 401k to a Roth 401k and pay all those taxes later.

5. Save big taxes later by paying little taxes now. If your employer pays the premium for your group disability insurance plan, you need to know that—if you become disabled—the benefit you receive will be taxable at the state and federal levels.

Occasionally though, I see plans where an employer allows physicians to elect to have this premium payment taxed as ordinary income.

I know, I know. Paying taxes is a bad thing, but not in this case.

If that premium is $100 but the benefit is $10,000, which would you rather pay: the tax on $100, or the tax on $10,000?

Make sure you check to see if this is an option for you.

During this important time of open enrollment, a little bit of time spent digging through your benefit packet may save you a bunch of money, and help put your family on the path to financial security.

Three ways to make the best of a bad (401k) situation | W. Ben Utley CFP® writes for Orthopreneur

We see the changes that physicians make to improve their financial security, but one item is usually beyond their control: their 401(k) plans. Unless you are self-employed, there is practically nothing you can do about your 401(k)’s underwhelming investment options, ridiculously low contribution limits or perverse tax consequences. If your 401(k) is your main (or maybe your only) investment vehicle for retirement, we have good news for you. It is possible to work around your 401(k) plan’s limitations, so that you can get back on track toward retirement.

Low Limits Many physicians operate under the mistaken belief that if they max out their 401(k) plan contributions, they will be set for retirement. But did you know that the maximum amount of money you can elect to defer into your 401(k) this year is only $17,500 ($23,000 if you will be age 50 or older by December 31)? That’s roughly $1,400 deducted from your paycheck each month ($1,900 per month if you are age 50 or older).

Have you ever met a physician who could live well on $1,400 a month? We haven’t. In fact, the physicians whom we serve are planning to spend more like $10,000 per month in retirement, and that’s after tax. It would take a miraculously high rate of return to turn $1,400 per month pre-tax into $10,000 per month after-tax. As you can see, many physicians are well on their way to a retirement disaster.

To improve your odds of reaching your retirement goal, you can save outside of your 401(k) plan. Even if you cannot deduct the contributions you make to a Traditional IRA, you can still contribute $5,500 this year ($6,500 if you will be age 50 or older by December 31), and if you max out your own IRA, your spouse can also contribute up to $5,500 to his or her IRA ($6,500 if he or she will be age 50 or older by December 31), even if they are not earning an income. Depending upon your tax situation, it might also make sense to convert these contributions to a Roth IRA, doing what is known as a backdoor Roth IRA contribution. Once the money is in a Roth IRA, it can grow tax-free for the rest of your life. Of course, this still might not be enough to allow you to retire comfortably, so you should consider investments outside of your 401(k) plan and IRAs.

Underwhelming Options You probably haven’t read the fine print behind your 401(k) plan, but you are betting that your practice manager has carefully vetted both your 401(k) plan provider and the investments offered inside your plan. Don’t believe it! We have found that busy managers either fail to read the fine print or lack the experience to understand what they have read. Despite new laws requiring plain English disclosures of investment-related fees, many employers continue to keep physicians locked into expensive plans with unpalatable investment options.

If your plan charges more than 50 basis points (0.50 percent) on top of mutual fund operating expenses, your plan’s costs are draining an unfair share of your retirement savings. To get this under control, you need to raise your voice, but carefully. We regularly see very expensive plans that persist simply because of office politics.

It’s more common to see an investment lineup consisting mostly, if not entirely, of actively managed mutual funds. This is a sign of ignorance on the part of your plan fiduciaries. At a time when most prudent investors recognize that passively managed index funds have been shown to have delivered better results at a lower cost than the average actively-managed fund, there’s no good reason that your plan should continue to limit you to subpar investment options.

To work around these issues, look at your retirement investments holistically. Think about your 401(k) plan, your Traditional IRAs and your after-tax accounts (mutual funds and brokerage accounts) as if they were all one retirement portfolio. Then use the least-bad investment options from your 401(k) and pair them with the best options available within other accounts that make up the balance of your portfolio.

Tax Time Bomb You already know that physicians pay more than their fair share of taxes. But did you know that you are probably setting yourself up to pay more taxes on your 401(k) than you really should? That’s right. There’s a perverse little wrinkle in the tax code that can turn your 401(k) plan into a tax time bomb.

To understand this trap, you need to know a little bit about how investments are taxed. Withdrawals from your 401(k) plan will be taxed at your marginal income tax rate, which may be as high as 39.6 percent for Federal income tax. At the same time, capital gains and qualified dividends from mutual funds held in taxable accounts outside your 401(k) plan are taxed at a maximum Federal rate of 23.8 percent (which is 20 percent plus the new 3.8 percent Medicare surtax).

This means that your 401(k) nearly doubles the tax rate you pay on capital gains and qualified income by effectively converting these tax-favored returns into tax-trapped ordinary income. Consider holding equity mutual funds in a taxable account, or better yet, own them in your Roth IRA or the Roth subaccount of your 401(k) if you have one.

If your 401(k) is a lousy place to stash your stock funds, what should you hold there instead? Consider low growth, income-producing investments, including bond funds and stable value funds. If you have an appetite for more aggressive fare, consider high yield (junk) bond funds or emerging market bond funds. Outside of your 401(k) plan, these investments may be taxed at your highest marginal rate, so it’s a good idea to protect your income by keeping it inside of the tax shelter of your 401(k) plan.

Again, the best workaround for this tax trap is to view your entire retirement portfolio, including your 401(k) plan, your IRAs and your other accounts that are earmarked for retirement, as one portfolio. Choose to own the best investments in the accounts that make the most sense from the standpoint of expense, risk, return and taxation.

Summary Even if you are stuck with a stinky 401(k) plan, you can still make the best of a bad situation. All you have to do is take a look at the big picture, think outside the box and make smart moves to put yourself on track for a solid retirement.

 

W. Ben Utley, CFP®, is an attending advisor with Physician Family Financial Advisors, a fee-only financial planning firm helping physicians throughout the U.S. to save for college and invest for retirement.

Lawrence B. Keller, CFP®, CLU®, ChFC®, RHU®, LUTCF, is the founder of Physician Financial Services. Based in New York. He offers income protection and wealth accumulation strategies for physicians nationwide.

This article originally appeared in Orthopreneur with the title "Overcome 401 (k) LImitations: Three Ways to Make the Best of a Bad Situation".