You pay more than your 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, it’s 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.
Slip Contributions in Through the “Back Door”
If you are a rheumatologist or rheumatology practice manager 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 don’t 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 “backdoor Roth IRA.” This lets the balance in your Roth IRA grow tax-deferred indefinitely, with no requirement for mandatory distributions at age 70½ 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 “pro-rata rule,” 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.
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.
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, 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-of-pocket 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 age—the cost of healthcare.
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 kids’ 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 one’s taxes.”