How Physicians Can Pay Less Tax

How Physicians Can Pay Less Tax

How Physicians Can Pay Less Tax

 

As a physician, you might be wondering how to pay less in taxes, especially as you move up the ranks from a resident earning $60,000 to an attending earning in the hundreds of thousands. 

Earning more is a good thing. It allows you to provide more for yourself and your family, give back to your community and pursue your goals such as buying a home, investing in real estate, paying off your debt, or taking a vacation.

However, with higher income comes higher taxes. That’s why it is important for you to know how you can reduce your income taxes.

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There are plenty of ways you as a high-income earning physician can pay less income tax. We aren’t talking about illegal schemes here. We are talking about legitimate, tax reduction strategies.

In this article, we will walk you through various ways of how to pay less in taxes as a physician. 

Deductions vs. Credits

Before we start talking about the specific ways to pay less income tax, there is a distinction that you need to understand. 

There are two main ways:

  1. through a deduction, or 
  2. through a tax credit

They are quite different and we will define them below.

How to Pay Less In Taxes With a Tax Deduction

A tax deduction is a reduction to your taxable income. When you contribute to your 401k, a traditional IRA, or take the student loan interest deduction, you are reducing your taxable income.

These deductions reduce your tax owed by your marginal tax rate.

For example, let’s compare two single physicians making $100,000. If Physician 1 contributes $18,000 to her 401(k), she reduces her taxable income to $82,000. If Physician 2 contributes $10,000 to his 401(k) he reduces his taxable income to $90,000. Since Physician 2 now has a higher taxable income, he is going to pay more taxes in the current year.

 

Physician 1 Physician 2
Gross Income $100,000 $100,000
401k Contribution ($18,000) ($10,000)
Taxable Income $82,000 $90,000
Tax Owed $13,904 $15,781
Physician 1 Tax Savings Compared to Physician 2 $1,877

 

That’s how deductions work. 

How to Pay Less In Taxes With a Tax Credit

A tax credit differs from a tax deduction in that it reduces the actual amount of tax you owe (not your taxable income) dollar for dollar based on the amount of the tax credit.

Continuing off the previous example, let’s say both physicians have a kid who qualifies for the Child & Dependent Care Tax Credit and can take a $2,000 credit. This $2,000 directly reduces the tax owed, so Physician 1 would owe $12,904 and Physician 2 would owe $14,781.

You can see why tax credits are so much more valuable than deductions.

Alright, so now that you know the difference between a tax deduction and a tax credit, let’s talk about specific examples of how to pay less taxes as a physician.

Max Out Your Workplace Retirement Accounts

Your workplace likely offers some form of retirement account whether that is a 401(k), 403(b), 457(b) or SIMPLE IRA if you work for a small employer. You want to max out whichever of these accounts are available to you, so you can reduce your taxable income as much as possible.

In 2020, the maximum contribution limit for each plan is as follows:

401(k) Max Contribution – $19,500

403(b) Max Contribution – $19,500

457(b) Max Contribution – $19,500

SIMPLE IRA – $13,500

There are a few things to note when it comes to maxing out your workplace retirement accounts.

You and your spouse can both max out your retirement accounts in the same year.

You and your spouse can both max out your workplace retirement accounts in any given year. That means if you are both working and both have a retirement plan available to you, then you can both max them out and reduce your taxable income by up to $39,000 in 2020! That’s a quick, easy way to reduce the amount of tax you owe.

However, if you or your spouse make under the $19,500 limit, the higher-earning spouse cannot contribute to the other spouse’s account. The contributions must come from your own paycheck.

If you are age 50 or over, you can make an additional $6,500 contribution to your 401(k) or 403(b), or an additional $3,000 if your employer offers a SIMPLE IRA.

This brings the total you can contribute to your individual 401(k) or 403(b) up to $26,000 for 2020 and $16,500 for your SIMPLE IRA.

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If you work for an employer who offers a 457 plan, you are in an amazing position to pay less tax.

A 457 plan is a retirement plan established by state or local governments or by tax-exempt organizations under IRC 501(c). Most non-profit hospitals are set up under the IRC 501(c) designation, so if you work for one of these organizations, your employer may offer a 457 plan.

A 457 plan allows you to contribute up to $19,500 through pre-tax salary reductions in 2020. 

This $19,500 is in addition to any contributions you make to your 401(k), 403(b) or SIMPLE IRA plan.

That means if you have access to a 401(k), 403(b) or SIMPLE IRA, and a 457 plan, you can double the amount of pre-tax contributions you make in any given year.

If you have a 401(k) or 403(b) and a 457 plan, you can contribute a total of $39,000 pre-tax to your retirement accounts in 2020 ($19,500 to each).

If you have a SIMPLE IRA and a 457 plan, you can contribute a total of $33,000 pre-tax to your retirement accounts in 2020 ($13,500 to your SIMPLE IRA and $19,500 to your 457 plan).

Knowing how to pay less in taxes by contributing to your workplace retirement plan is one of the easiest ways to lower your tax bill every year.

Do this every year, and you will be amazed at how quickly your retirement balance grows. 

Max Out Your Individual Retirement Accounts

In addition to your workplace retirement plan, you can also open up an individual retirement account (IRA) to start saving money for your future and pay less tax in the current year.

While this is a great way to reduce your tax bill, even more, you need to be aware of certain income limits. In this section, we will define the two main types of IRAs, their contribution limits, and the income limits that apply to each account.

Traditional IRA

A traditional IRA is a pre-tax retirement account that you can open on your own through companies like Vanguard, Fidelity, and Charles Schwab. Contributing to a traditional IRA reduces your current year taxable income by the amount you contribute.  

One of the great things about an IRA is that you can invest your money however you want, unlike your workplace retirement plans which may only have limited investment options.

For 2020, you can contribute up to $6,000 to your traditional IRA (or $7,000 if you are over 50 years old). A great feature of IRAs is that you can contribute to them up until the tax filing deadline for a given year.

For example, if you have not yet contributed to a traditional IRA for the 2019 tax year, you would normally have until April 15, 2020, to make a contribution for the 2019 tax year and reduce your 2019 taxable income. With the special circumstances, we are now under, the IRS has extended the federal tax filing deadline to July 15, 2020, and with that, the deadline for making IRA contributions.

That means you can contribute to your IRA for the 2019 tax year all the way up to July 15, 2020. This could be a great way to reduce your 2019 tax bill even after 2019 has long passed. 

The catch with all of this is if you make more than a certain amount of income each year, you won’t be able to deduct all of your traditional IRA contributions.

If you are covered by a workplace retirement plan and your modified AGI is within or above certain limits, the amount you can contribute to a traditional IRA and deduct on your tax return will be limited.

The limits are as follows for the 2020 tax year.

For Single and Head of Household taxpayers

If you have a modified AGI greater than $75,000, you cannot contribute to a traditional IRA. If your modified AGI is less than $65,000, then you can contribute up to the max. If your modified AGI falls within this range, you will be limited to the amount you can contribute for a given year.

For Married Filing Jointly and Qualifying Widower taxpayers

If you have a modified AGI greater than $124,000, you cannot contribute to a traditional IRA. If your modified AGI is less than $104,000, then you can contribute up to the max. If your modified AGI falls within this range, you will be limited to the amount you can contribute for a given year.

While most attending physician and physician families will likely be above these income limits, taking advantage of a traditional IRA while you are a resident could be a great way to set aside some more pre-tax dollars for your future.

 

Filing Status Can Contribute and Deduct Full Amount If MAGI Less Than: Cannot Contribute and Deduct Full Amount If MAGI Greater Than:
Single & Head of Household $65,000 $75,000
Married Filing Jointly & Qualified Widow  $104,000 $124,000

 

Roth IRA

The other type of IRA is a Roth IRA. 

Like a traditional IRA, you can open a Roth IRA with companies like Vanguard and Fidelity and can direct your investments however you like. 

The contribution limit is also the same at $6,000 per year (or $7,000 if over age 50).

The difference with a Roth IRA is that contributing to it allows you to save money in the future, not today. When you contribute to a Roth IRA, you pay taxes on the dollars you put in today, but then never have to pay taxes on that money again, no matter how much it grows into the future. 

So while you aren’t reducing your taxes in the current year, you will be earning many years of tax free growth and have tax free withdraws once you reach age 59 ½. This is a great way to save your future self from taxes.

Roth IRAs also have income limits on them which are a little more favorable than the traditional IRA limits. They are as follows. 

For Single and Head of Household taxpayers

If you have a modified AGI greater than $139,000, you cannot contribute to a Roth IRA. If your modified AGI is less than $124,000, then you can contribute up to the max. If your modified AGI falls within this range, you will be limited to the amount you can contribute for a given year.

For Married Filing Jointly and Qualifying Widower taxpayers

If you have a modified AGI greater than $206,000, you cannot contribute to a Roth IRA. If your modified AGI is less than $196,000, then you can contribute up to the max. If your modified AGI falls within this range, you will be limited to the amount you can contribute for a given year.

 

Filing Status Can Contribute and Deduct Full Amount If MAGI Less Than: Cannot Contribute and Deduct Full Amount If MAGI Greater Than:
Single & Head of Household $124,000 $139,000
Married Filing Jointly & Qualified Widow  $196,000 $206,000

 

Again, a lot of physician and physician families may be outside of these income limits, but if you are a resident or new attending, and have a low enough salary, you should definitely consider saving some money in a Roth IRA. 

Two final things to note about IRAs. 

First, if neither you nor your spouse is covered by a workplace retirement plan, then you can contribute up to the max contribution limit into an IRA in a given year, regardless of your income. This would be a great way for physicians who only earn 1099 income or own a business to reduce their taxable income each year.

Second, if you or your spouse is covered by a workplace retirement plan, but the other one isn’t then special limitations apply to how much you can contribute to a traditional or Roth IRA.

How to Pay Less In Taxes as an Independent Contractor or Business Owner

If you are an independent contractor or business owner, you likely won’t have access to a workplace 401(k), 403(b) or 457 plan.

So what are your options to reduce your taxes?

The first way is by setting up a solo 401(k).

Business owners, including independent contractors who have formed a business entity, can set up a solo 401(k) to make retirement contributions and lower their taxes. This option is only available to business owners who have no employees and the plan covers both the employee-owner and his or her spouse. 

Since the business owner acts as the employee and the owner of the business, contributions to the solo 401(k) can be made in both capacities.

Through pre-tax salary reductions, you as an employee in your own business can contribute up to $19,500 in 2020. 

Your business can then contribute additional funds to your solo 401(k). The total your business can contribute to your solo 401(k) is limited to 25% of your compensation as defined by the plan documents or as by the IRS if you are considered self-employed. 

The total amount that can be contributed to your solo 401(k) through employee salary reductions and contributions from your business is $57,000 in 2020. 

This can generate tons of tax savings for you if you own your own business.

The second way you can reduce your taxes as an independent contractor or business owner is to set up and contribute to a traditional or Roth IRA. Since you are not covered by a workplace retirement plan (unless you set up a solo 401k too), you can contribute up to the max into an IRA in any given year.

The third way you can reduce your taxes as an independent contractor or business owner is to deduct as many legitimate business expenses as you possibly can. These expenses include work-related clothing (scrubs, white coat, shoes, etc.), licenses & fees, training materials, mileage, cell phone, computer, home office, and many other expenses. 

These expenses are deducted from your income before you pay any income tax on the money you have made. This is huge, and also why it is so important to have some sort of accounting software or expense tracking system, so you can maximize the number of deductions you can take, thus reducing your taxable income.

Working with a CPA can also help you maximize your deductions, as there may be deductions you are not aware of or that require more in-depth calculations.

Other Strategies to Help You Pay Less Tax

So far, we have mainly talked about how to pay less in taxes as a physician by using retirement accounts or by deducting business expenses.

What other strategies can you use to pay less tax?

Using a Health Savings Account (HSA) is another great way to reduce your taxable income. 

Known for its triple tax savings, an HSA allows you to contribute pre-tax dollars, let that money grow tax-free, and then take a tax-free distribution as long as the distribution is used for qualifying medical expenses for you, your spouse or your dependents. 

You are eligible to contribute to an HSA if you are enrolled in a high deductible health plan (HDHP) as defined by the IRS. The chart below shows how the IRS defines an HDHP. 

 

Can Contribute and Deduct Full Amount If MAGI Less Than: Cannot Contribute and Deduct Full Amount If MAGI Greater Than:
Minimum Annual Deductible $1,400 $2,800
Maximum Annual Deductible and Other Out of Pocket Expenses $6,900 $13,800

 

Contributions are limited based on whether you have self-only coverage or family coverage.

If you have self-only coverage, you can contribute and deduct up to $3,550 in 2020. The limit for family coverage is $7,100

If you take a distribution from your HSA that is not for a qualifying medical expense, then you will own income tax on the distribution as well as an additional 20% tax penalty.

Don’t do this!

But what if you contribute to an HSA and then never have to take a distribution for qualifying medical expenses?

First, tell me your secret to never having a medical expense in your life!

Second, once you reach age 65, you can take distributions from your HSA that aren’t for qualifying medical expenses and only pay income tax on the distributions. You won’t have to pay the additional 20% tax penalty.

This is a huge advantage of using an HSA. It essentially acts like a traditional IRA (pre-tax contributions, tax-free growth, and taxed distributions), but with an increased distribution age of 65.

If you have access to an HSA, you should be using it.

Move to a state with no income tax.

There are currently seven states that do not levy personal income tax including Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. New Hampshire and Tennessee don’t tax wages, but they do tax investment income and interest. 

If you are able to use geographic arbitrage to move to a state with no income tax, this could significantly reduce your tax bill each year. Especially if you are currently living in a state that has high-income taxes. 

While no state income tax sounds great, just remember that decreased income tax revenue likely means other taxes are levied in these states and the number of services and governmental support may be decreased.

Own real estate.

You should not own rental real estate just because it offers a “tax break”. However, if you have the time, money, and dedication to invest in real estate, you can possibly achieve positive cash flow while incurring a “paper loss” on your tax return. 

Just like owning a business, you can deduct expenses incurred relating to owning your rental property to offset the income you receive. These expenses include repairs, management fees, and general maintenance. 

You can also deduct depreciation on your property every year. This is an example of a non-cash expense that could allow you to achieve the positive cash flow and “paper loss” scenario previously mentioned.

Residential rental properties are depreciated over their useful life which is defined as 27.5 years by the IRS. So, if you own a rental property with a cost basis of $100,000 for the structure and $50,000 for the land, you could deduct $3,636 ($100,000/27.5) a year as depreciation expense related to your property.

If your deductions related to your rental property result in a loss on your tax return, you could be eligible to deduct up to $25,000 to $50,000 on your tax return depending on whether or not you are considered a passive or active real estate investor.

Physician Wealth ServicesTax Deductions and Credits

There are many tax deductions and credits available to physicians and physician families. While we won’t go into specific details about all of them here, lookout for a future post that will dive deeper into the various deductions and credits available to physicians.

These deductions and credits include the student loan interest deduction, itemized deductions, Child Tax Credit, the Child, and Dependent Care Tax Credit, and Adoption Credit. 

Wrapping Up

There are many ways that you as a physician can reduce your tax bill now and in the future. Knowing how to pay less in taxes, especially as a high-income earner, can help you decrease what is likely a major expense item for you. Using the strategies outlined above, you can decrease your tax bill, save more for retirement, and be on your way towards achieving the financial goals you have set for you and your family.

 

Ryan Inman