Proactive Tax Planning for Doctors

Surprise!!!

It’s that time of year again when everyone is focused on taxes. Unfortunately for many, this is also the only time of year that people are focused on taxes. For our clients at AWM Capital, tax time starts January 1st and ends December 31st. Often, taxes are reduced to a reactionary response in March to what you did in the previous year.

My objective in this blog is to introduce the concept of tax planning and show you some strategies to use throughout the year to ensure your financial advice is not just focused on your investment returns, but actually growing your net worth through sophisticated and proactive planning.

What Is Tax Planning?

Investopedia defines tax planning as “the analysis of a financial situation or plan from a tax perspective. The purpose of tax planning is to ensure tax efficiency. Through tax planning, all elements of the financial plan work together in the most tax-efficient manner possible.”

This should seem so obvious that it would be how any high income, high net worth person would want their net worth managed. Unfortunately, if you have your assets being managed by the traditional broker dealers, you have probably overlooked the disclaimers at the bottom of their contracts that say something along the lines of:

“FINANCIAL ADVISORS DO NOT PROVIDE LEGAL, TAX OR ACCOUNTING ADVICE. YOU SHOULD CONSULT YOUR LEGAL AND/OR TAX ADVISORS BEFORE MAKING ANY FINANCIAL DECISIONS.”

This arrangement seems very reactionary, and absolutely crippling for those who have complexity in their life.

We all want to pay less in taxes, and tax planning is not a strategy to “cheat” the system so you pay $0, but it is putting together a sophisticated plan to ensure your income and investments are structured in a way so you don’t end up paying more than you should!

So, what strategies can you start now to ensure you are paying the least amount of taxes in 2021?

Pass-Through Income Deduction

Many of you have income through sole proprietorships, LLC’s or S-Corps, but did you know that if you plan this right, you are allowed to take up to a 20% deduction on certain income paid to these types of entities? On top of this, have you exhausted all the opportunities for full deductions and contributions to qualified plans/accounts? Often you will be able to use these types of structures to set up Individual 401k’s and SEP IRAs. These also offer a high level of asset protection! Funding these types of accounts early allow you to diversify your taxes both now and, in the future, and running multi-year tax projections is essential!

Many of you are thinking, “I’m already taking advantage of this, so what else?”  

How many of you still have student debt? Did you know that often, based on your income, the interest on most student loans is not deductible as it gets phased out? But there are ways to “restructure” that debt to potentially increase your itemized deductions and reduce your tax bill.  One way would be to consider the equity you have in your home, take advantage of current interest rates, and complete a cash out refinance (up to $750,000 limit) to pay off the student debt.  Often, this can actually reduce your current student loan interest but allow you to deduct the mortgage interest expense, creating a dual benefit of current cash flow and reduced tax burden!

Tax-Loss Harvesting

Shifting gears slightly, I want to touch on a strategy called Tax-Loss Harvesting. Unfortunately, we see this typically completed at the end of the year (when everyone else does it) which arguably has a net negative impact on your financial situation because, while you might be “realizing” a loss, you are actually taking a steeper loss while everyone else is trying to sell, than if you were proactively managing this strategy throughout the year. To quickly simplify the strategy, TLH is when you intentionally realize a loss to off-set a future gain. But what this strategy also allows you to do is off set up to $3,000 of current income. If you are in the highest federal tax bracket, off-setting $3,000 at 40% saves you roughly $1,200 in taxes annually! Are you sure you are optimizing this?

Asset Location

Staying on investment management. Have you ever heard the term “asset location”? Another advantage of being a physician is most practices are very aggressive in setting up and fully funding retirement plans. Asset location doesn’t matter to most people because most people aren’t and never will be in the highest income tax bracket. All investments have a purpose, and most have different tax implications. Vanguard put out a study that estimated that proper asset-location tax-efficient strategies can add up to 0.75% net return on your portfolio in just the first year, which compounds on itself over time. But how do you know if you’re taking advantage? Look at your retirement account! In a perfect world, using proper asset allocation, you would want the majority of your 401k to hold the assets that produce the highest income (High Yield Bonds, Taxable Bonds, TIPS, REITS). Ideally you have also started to create Roth accounts which is where you would hold the assets you expect to appreciate the highest.

And finally, in your taxable accounts you would have your large cap growth, index funds and muni bonds. If you are spreading those types of investments across your different accounts in any other manner, you are not optimized and need to review immediately.

Safe-Harbor Withholding

The last strategy I will quickly hit on is called Safe-Harbor Withholding. This requires a physician to work closely along their tax planner to optimize withholding throughout the year.  Often, we are seeing several opportunities across many industries to take advantage of this in 2021 because of the impact Covid had on many of our client’s income’s in 2020.

If your previous year AGI is above $150,000, the IRS requires you to withhold the less of 90% of the tax you expect to owe for the current year or 110% of the tax you owed for the previous year. So, to put in perspective, imagine last year because of Covid, you earned $600,000 and were taxed at the 40% tax bracket ($240,000) for 2020. In 2021, you are back to work completely and expect to earn $1,200,000 and owe $480,000 in taxes.  The IRS will only require you to withhold $264,000 to avoid penalty and interest, leaving a final balance due of $216,000. My question is would you rather keep that $216,000 in your account earning interest or let the government earn the interest? The only way to effectively do this is by being very proactive throughout the year with quarterly tax projections. If this is something you are not actively doing, you are missing out on opportunities to increase your net worth.

There are several other strategies that most doctors can employ, but above is the most basic that every doctor should. In summary, tax planning matters. Your average financial advisor is not permitted to give you guidance on how to optimize your tax situation because of their internal regulations. If you have complexity and are in the highest tax bracket, you shouldn’t only be thinking about your taxes in March and April, and neither should your Tax Professional. This is where the value of having an independent advisor is essential. Our goal is to unlock the full potential of your wealth for maximum impact in ALL AREAS OF YOUR LIFE! Anything less is settling.