By Chris J. Roe, CPA, PFS
Are you worried that Biden’s tax plan will get passed by Congress? If not, you should be, as most physicians will see their take-home earnings decrease significantly. Rx Wealth thinks there is a high likelihood tax legislation will be coming by the end of 2021, effective beginning 2022.
It is no surprise we are facing higher income taxes and increases in other taxes with our government spending like drunken sailors. So, how can physicians reduce or minimize the impact of these tax increases?
This article outlines the proposed tax changes and provides some planning opportunities to consider.
Income and Social Security Tax Rates
Currently, the top income tax rate is 37%. Under Biden’s plan, physicians making over $400,000 will likely be in a new tax bracket of 39.6%.
If you own a practice or outside business, the qualified business income deduction will be phased out, causing an immediate 10% increase in your current tax rate.
Currently, physicians are subject to social security taxes on the first $142,800 of wages or self-employed earnings at a rate of 12.4%, split evenly between employer and employee. If you are self-employed, you pay the full rate and get to deduct a portion from your taxable income.
Biden suggested a change in the social security tax. The maximum taxable wage will stay in place, but if your wages or self-employed earnings exceed $400,000, the amount in excess of $400,000 will be subject to social security payroll tax. This creates what we call a “donut hole” in the payroll taxes, where wages between $142,800 and $400,000 are not subject to social security taxes.
Physicians earning up to $1 million will continue to see their capital gains and qualified dividends taxed between 15% and 20%, with a 3.8% net investment income surtax applying to certain taxpayers. But, if you happen to earn over $1 million, you may see a significant increase.
Planning Opportunities
If you are self-employed making over $400,000 in earnings, you may consider forming an S Corporation and limiting your wages to under $400,000, if it is still reasonable compensation for your specialty. You can take the remaining earnings as distributions. Be aware, these types of arrangements are likely to receive even higher IRS scrutiny going forward. You must structure this properly to comply with the law.
If you are a practice owner, consider employing your children to reduce your income below $400,000. Additionally, certain retirement plans allow you to make large contributions, which may help to reduce your income significantly and lower your tax bracket.
Additionally, as a practice owner, review all current retirement plans to ensure they are appropriate and allowing for maximum deferral advantage.
Finally, reviewing all allowable business deductions to make sure you are not missing anything that will reduce your taxable income.
Income Tax on Over $1,000,000 in Household Income
If you are one of the physicians who still earns in excess of $1 million annually, Biden has placed a target on your back. Not only is he planning to increase the taxes on your wages and business income to a maximum rate of 39.6%, but your capital gains and qualified dividends will also now be taxed at your marginal rate of 39.6%. Also, it will include a current net investment income surtax of 3.8%. This brings the total tax rate on interest, dividends, and capital gains to 43.4%.
Planning Opportunities
You need to make sure your investment portfolio is invested in a tax-efficient manner. Where you own assets will become extremely important. Having some investments, such as taxable bonds, real estate, alternative investments, high dividend stocks, or higher turnover investments held in an IRA or other tax-deferred vehicle will reduce your tax bill and allow the portfolio to potentially grow faster.
Consider using low-cost, investment-only annuities as part of your investment plan to shelter current taxation at high rates. Your heirs will pay tax on any annuity proceeds, albeit at a probable lower income tax rate than you.
Finally, a properly structured life insurance policy, used solely for investment purposes and not death benefit, allows you to place large amounts of cash into it and grow tax-deferred over a long period. Additionally, in certain instances, you may be able to borrow from the policy tax-free in the future. I call this strategy a “Super Roth IRA.” Furthermore, at your death, proceeds are paid to your heirs tax-free.
If you are a physician in private practice or self-employed, you should consider implementing a cash balance plan. This may help to lower your taxable income under $1 million, thus lowering tax rates on capital gains and qualified dividends.
Itemized Deductions
Biden’s proposal limits itemized deduction benefits to a maximum marginal rate of 28% for physicians earning over $400,000. Physicians in marginal brackets below 28% get the full benefit. Also, certain deductions, such as mortgage interest, state and local taxes, and charitable contributions, may be capped for physicians earning more than $400,000.
Planning Opportunities
If this should pass, you want to consider accelerating your charitable contribution over the next five-plus years into 2021. You can do this by contributing appreciated investments into a Donor Advised Fund by December 31, 2021.
Depending on your mortgage rate, consider paying down your mortgage more quickly. The after-tax rate you are paying on your mortgage may be less valuable going forward.
Consider accelerating some itemized deductions, such as paying your mortgage for January 2022 in December 2021 to gain a larger mortgage interest deduction.
Retirement Plan Contribution Deductions
Retirement plan contribution deductions will be limited to a 26% flat income tax credit versus a current deduction at your marginal rate. Thus, all taxpayers get the same benefit.
Planning Opportunities
Depending on where you see your future tax rates, using a Roth 401K and Roth IRA if you are in the top tax bracket looks much more attractive.
Using tax-deferred investment vehicles, such as annuities and life insurance, in lieu of maximizing annual retirement plan contributions may prove to be more beneficial over the long run.
First Time Homebuyers
Are you a new physician looking to purchase your first home? Should the Biden plan pass, you may be eligible for a refundable and advanceable first-time home buyer’s credit of up to $15K.
Estate and Gift Taxes
Currently, each individual has a lifetime estate and gift tax exemption of $11.58 million ($23.16 million per married couple). Furthermore, assets includible in your estate get what we call a “step-up” in cost basis to fair market value. For example, if you own the Vanguard S&P 500 mutual fund with a cost basis of $50,000, and at your death, it is worth $250,000, your heirs will avoid capital gains tax on the $200,000 in gain—a savings of approximately $40,000 in capital gains tax.
Biden’s plan reduces the lifetime exemption to between $3.5 million and $5 million per person. Moreover, it eliminates step up in cost basis.
The step-up elimination affects all taxpayers, not just the “rich,” unless an exemption is provided.
Furthermore, an increase in the federal estate tax rate from 40% to 45% is desired.
You may be thinking, “How does this affect me as my estate is not large?” Bear in mind that if you own any life insurance in your own name, the death benefit will be included in your estate. A reduced exemption also puts many more physicians in the path of federal estate taxes.
For example, let us say you are a divorced, mid-career physician with total assets of $3 million. Additionally, you own a term life insurance policy on yourself for $2 million with your children as beneficiaries of your estate and the life insurance. When you pass, your estate is worth $5 million, and your children will owe a 45% estate tax on $1,500,000 ($5 million less the $3.5 million exemption) or $675,000 in federal estate tax. In 2021, you will owe zero federal estate tax. The law change may cost your heirs $675,000, if you do not plan properly.
Moreover, there is legislative chatter of plans to eliminate some popular estate planning strategies, such as grantor trusts, grantor retained annuity trusts, and the like. This may affect a popular strategy of owning life insurance in a grantor trust to keep it out of your estate.
Planning Opportunities
There is generally a grandfathering of certain strategies implemented before a law passes. You will want to review your estate plan and life insurance under this new lens.
If you own life insurance in your own name, consider owning it in a trust if it is a large death benefit.
If you are happily married for a long time, consider setting up a trust for your spouse to exempt the money from future estate tax. If you have reservations about gifting in trust to your spouse, consider having your spouse create a trust for you and your children and make a gift. Be aware, you can not create identical trusts for you and your spouse.
Purchasing life insurance on you and your spouse that pays when the second spouse passes may be a great way to offset the loss of a step-up in basis and higher estate tax. Remember to consider how the policy is owned to avoid it being included in the estate of the second-to-die spouse.
Consider gifting your IRAs at death to charity or using certain charitable trusts to provide an income stream to your heirs while reducing your taxable estate. This is also a beneficial strategy in light of the Secure Act eliminating the stretch IRA technique.
Finally, if your parents have significant assets and are expecting to leave an inheritance, consider how you should receive the assets so as not to increase your estate size and potential federal estate tax liability any further. Additionally, consider how this inheritance should be structured to avoid potential future creditors, an ex-spouse, and the like. This planning is frequently ignored.
Certain Tax Credits
Under Biden’s plan, the child tax credit may increase to $3,600 for children under 6 and $3,000 for all other children under 17. The child and dependent care credit will allow up to $8,000 for one child and $16,000 for two or more.
Additionally, an informal caregiver credit of up to $5,000 is proposed if you are an informal caregiver of an individual needing long-term care.
Qualified Business Income Tax Deduction for High Earners
Eliminating the qualified business income deduction for physicians making over $400,000 will increase the income tax rate by 10%. Physicians need to consider ways to reduce income below the threshold.
Corporate Tax Rate
Corporate tax rates are proposed to increase from 21% to 28%.
Planning Opportunity
Operating your practice or outside businesses as a self-employed individual or an S corporation generally made the most tax sense; however, high-earning physicians need to reevaluate their business structure. Given a potential increase in tax rates for income over $400,000, the change to taxing investment for earners of $1 million, and the qualified business deduction elimination, operating as a C corporation may become beneficial in certain instances.
There appear to be significant and wide-sweeping tax changes coming down the road. All physicians will be impacted by these changes. As a physician, you should be talking to your professional advisors about the potential impact these tax changes have on growing your wealth. Your financial advisor should be leading this charge.
If you are failing to plan, plan on failing. You will be paying a large portion of your earnings to the federal government, not to mention your state, in the future.
Disclaimer:
Rx Wealth Advisors is a physician-focused financial advisory firm located in the Pittsburgh, Pennsylvania metropolitan area. Their primary focus is to help medical doctors maximize their earnings, keep more money in their pocket, and cultivate wealth so they can live the life they’ve earned and deserve. Rx Wealth can be reached at 412-227-9007, via email at croe@rxwealthadvisors.com, or on the web at rxwealthadvisors.com.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.