As a financial planner for physicians, I know you've heard about the “Fiscal Cliff” but you might not know what it means to your family, or what you can do about it. Don't worry. I’m here to help you pack your parachute. The Fiscal Cliff is a mountain of changes to federal law that increase taxes and cut federal expenditures. And it’s complicated. Much of what’s going to happen is completely out of your control (like cuts to federal spending, including Medicare reimbursements and the AMT tax patch) so I’m going to focus on the parts that you can control.
Fiscal Cliff-Hanger Part 1: Higher Taxes on Physicians' Earned Income
Unless the folks on Capitol Hill do something before year-end, the Bush-era tax cuts will go away on January 1 of next year. That means your marginal tax rate is going up.
For example, Physician families who earn between $142,700 and $217,450 are now in the 28% federal tax bracket but they will be paying 31% next year. Those in the 33% bracket will be paying 36%, and those in the 35% bracket will be paying 39.6%.
Now, these tiny little percentage point increases—3 and 4.6—may seem small but when you take 4.6 over 35, you realize this is actually a thirteen percent increase in your tax bill!
What financial planning can physicians do to protect their earnings?
- Defer, defer, defer: Stuff your 401k or 403b plan to the max. You can only “elect” to put away $17,000 per year but your employer may kick in a profit sharing contribution that brings your whole benefit up to $50,000, saving you as much as $19,000 in taxes this year. (If you’re over 50, your limits are higher.)
- Stuff your IRA: Now that you’re earning six figures, you may have heard someone say, “You can’t do an IRA.” Not true. You probably cannot deduct contributions to a Traditional IRA but you can certainly make a contribution if you have earned income. And if you—the earning physician—max out your IRA, your non-working spouse can max out their IRA too. A married physician family can sock away a total of $10,000 in 2012 (more if you’re over 50).
- Think about converting your IRA: If you have a Traditional IRA that contains exclusively contributions that were not tax-deductible, you should consider a Roth conversion. Roth IRA’s grow tax deferred and there’s no tax for qualified withdrawals, so essentially they grow tax-free forever. Now that’s a good thing! When you make a Traditional IRA contribution and convert it immediately, it’s known as a “Backdoor” Roth IRA contribution.
- Discontinue Roth 401k deferrals: The tax deferral allowed by traditional, non-Roth 401k and 403b deferrals will be much more valuable after 2013, so the Roth-type 401k/403b deferral probably makes less sense for you now than ever before. To make the change, contact your HR or benefits person and ask to change your deferrals. While you’re at it, ask them how you can get the maximum benefit from your 401k/403b plan.
Fiscal Cliff-Hanger Part 2: Higher Taxes on Physicians' Un-Earned Income
Here again, the Bush-era tax cuts are scheduled to go away on January 1 unless our leadership changes their minds. In this case, there’s one more thing to worry about: the Medicare Surtax. Fortunately, this surtax does not apply to your paycheck but it does apply to your “unearned” income, including the dividends from mutual funds and interest from most bonds and bank deposits.
The tax on unearned income is a double-whammy. First, capital gains taxes for most physicians will rise from 15% to 20%. Then, the Medicare Surtax is added on. The overall increase is 8.8 percentage points.
If that doesn’t sound like much, consider this: 8.8 percentage points divided by 15 percentage points is an increase of more than fifty-eight percent!
What financial planning can physicians do to keep more of what the market delivers?
- Put taxable investments in their place: Since stocks tend to generate returns by gaining value and bonds generate most of their returns in the form of interest, you can reduce your tax bill by putting taxable bonds and taxable bond mutual funds in your tax-deferred accounts like your Traditional IRA, your 401k/403b, or your variable annuity (should you have been so unfortunate as to have purchased one). You can put low-yielding stock funds in your joint/taxable brokerage account, and put higher-yielding or fast growing stocks funds in your Roth IRA. This will save you a little bit of tax money right now but will save a lot more over the long haul.
- Own tax-exempt bonds: The interest payments from most municipal bonds and municipal bond funds are tax-exempt at the federal level, and some are tax-exempt at the state level too. So if you must own a bond fund in your regular joint/taxable investment account, consider municipal bonds/funds. The interest, in most cases, is exempt from the Medicare Surtax too.
- Think passive: The in-the-know term of art for owning index mutual funds is “passive investing”. Index funds, including exchange-traded funds (ETFs), pursue a passive, buy-and-hold strategy that keeps turnover and capital gains taxable events to a minimum, which can keep your capital gains tax bill in check.
- Harvest losses now: Nobody likes to lose money but the IRS gives you a tax break when you do. If you have an investment in a taxable account that’s worth less than you paid for it, you have an unrealized loss. When you sell that position, you “realize” the loss. In situations where you have both a loss and a gain, you can net the two together, offsetting one with the other. Now, these losses will become more valuable when the capital gains tax rate rises, so if you have the opportunity to harvest losses, you can do so right now and use them to offset gains in the future. This tax strategy is known as a “capital loss carry forward”.
Fiscal Cliff-Hanger Part 3: Enough about financial planning for physicians' taxes... what about that cliff?
Some people believe that Congress and the President will get their act together before the end of the year and find a way to jerk us all back from the brink of this precipice but I’m not one of them.
The last time we had a major tax overhaul—one that closed tons of loopholes—was way back in the 80’s when we got the Tax Reform Act of 1986 (known to tax geeks as “T.R.A. 86”). I was in high school back then but and I couldn’t help Congress craft the legislation, so it took two years and a non-divided Congress to get the last major tax reform passed. That’s why I believe the odds of pulling off another piece of major tax reform in six weeks with Congressional gridlock are about as good as the odds that it won’t rain here in Oregon.
Overall, it's not clear to me whether the Fiscal Cliff will prove to be a good thing or a bad thing but I am certain it will be years, if not decades, before we can judge it fairly. In the meantime, I believe it is wise to understand what we can and cannot control, and take action to make the best of the situation.
What's the one thing physicians should do about the Fiscal Cliff right now?
The best financial planning move for physicians right now is not really a financial planning move at all. It's a team-building move. The best thing you can do is make sure you have a rock-solid tax guru who can take a good long look at your tax situation and help you make the right move--right now--before it's too late.
If you don't have a tax guru or you don't like the one you've got now and you need a referral, just give me a call at 541-463-0899 and I’ll hook you up with one who knows the ins and outs of tax planning for physician families. The ultimate defense against higher taxes is a sharp tax specialist, and I know a few great CPA's who work with clients nationwide.