While many employed physicians earn side income from things like moonlighting, consulting, speaking, and writing, few are aware of the additional options this income provides when it comes to financial planning. These valuable opportunities include the chance to save more on taxes, save more for retirement, and even consolidate old employer retirement accounts more efficiently. In this post, we’ll discuss each in more detail and explain how to take advantage of them.
Forms of Compensation
We’ll start with a quick note on the different ways physicians are paid. Employed physicians, as the name implies, are employees. Your employer withholds taxes from your paycheck and you receive a W-2 each year that summarizes your compensation. However, when you have side income (often referred to as independent contractor income), you become both the employer and the employee. Instead of receiving a W-2, you receive a 1099 tax form each year. You are also responsible for paying taxes on the side income, whether that’s by making quarterly estimated payments to the government or by increasing the tax withholding in your paycheck from your “day job” employer.
Setting Up a Business
While not required, setting up a business (with its own tax ID number and bank account) for your side income can be helpful. There are different options for business structures, and each has its own pluses and minuses. The simplest type is a sole proprietorship, which you can quickly and easily set up yourself. Some physicians opt for the additional liability protection of an LLC, but there’s additional cost involved in setting one up. Depending on the size of your side income, you might even benefit from setting up an S-Corp, which offers additional tax benefits (but also more annual requirements and tax filing expenses). The specific type of business is going to differ depending on your situation, and it’s worth consulting with a business attorney for guidance. However, for many physicians, a sole proprietorship is perfectly fine and it can be set up online in a few minutes for minimal cost.
The Benefits of Setting Up a Business
There are many benefits to setting up a separate business for your side income. One is that it makes it much easier to track income and expenses related to your outside work. By depositing payments directly into a dedicated bank account, you’ll know exactly how much side income you have each year. This can (hopefully) help you avoid the common mistake of getting hit with a surprise tax bill at year-end because you haven’t been paying/withholding enough in taxes. In addition to tracking income, it’s also useful to track expenses from a business account. Certain expenses related to your side income (home office, work computer, travel, etc.) can be deducted for tax purposes, so having a clear picture here makes it easier to maximize your deductions (a tax professional can provide specific guidance).
A Retirement Plan for Your Business
While the benefits related to cleanly tracking income and expenses are valuable, one of the biggest benefits of setting up a business for your side income is being able to set up a retirement plan for the business. This allows you to save even more for retirement while saving taxes at the same time.
We all have a limited amount of money (set by the IRS) that we are allowed to contribute to qualified employer retirement accounts (403b or 401k) each year. The limits apply to employee contributions, as well as the overall sum of employee and employer contributions. In 2020, these limits are $19,500 for employee contributions ($26,000 if over 50) and $57,000 for total contributions ($62,500 if over 50).
Most employed physicians, even those who are making the maximum employee contribution to their employer’s retirement plan, don’t hit the maximum total contribution limit. This is where a retirement plan for your business comes into play. While we won’t dive into the nuances of the calculations in this post, setting up a retirement account (such as a SEP-IRA or an individual 401k) often allows you to make employer contributions to the account. This not only gives you the chance to save and invest more for retirement, but it also allows you to receive additional tax deductions.
As a simple example, let’s look at a physician who’s making $200,000 and receives a 10% retirement plan match from their employer. If this physician maximizes their employee contribution to their employer’s retirement plan, they’ll end up contributing the $19,500 employee contribution plus a $20,000 employer contribution ($200,000 x 10%), or $39,500 total. This leaves $17,500 ($57,000 – $39,500) in remaining potential space to make contributions to the retirement account for their side income. Assuming they were able to make the full contribution, that would be an additional $17,500 tax deduction for them.
The Options for Retirement Plans
The two most common options when it comes to setting up a retirement plan for your side income business are a SEP-IRA and an individual 401k. These accounts are designed for self-employed people. The SEP-IRA allows you to contribute up to $57,000 annually, all of which is considered an employer contribution. The main drawback to a SEP-IRA is that it precludes you from making backdoor Roth IRA contributions, which is why we generally prefer an individual 401k instead.
An individual 401k is similar to your 403b or 401k through your employer, to which you can make employee or employer contributions. All employed physicians are limited to the same maximum $19,500 ($26,000 if over 50) employee contribution across their employer’s retirement plan or their side business retirement plan, but employer contributions can be made to both plans to get up to the maximum total contribution of $57,000 (or $62,500 if over 50). There are detailed calculations that determine the employer contributions you can make to an individual 401k, so we recommend consulting with a tax professional before making these types of contributions.
Independent contractor work is a great way to leverage your expertise and increase your cash flow. It’s also a unique opportunity to save more for retirement and be strategic with your tax planning. By being proactive with maximizing your tax deductions and setting up a retirement account, you can stretch the income even further. One of our clients jokingly described tax planning as “legal tax evasion,” but the point is valid – the goal is to play within the rules and maximize all the opportunities available to you in order to avoid paying more in taxes than what’s required. Having side income as a physician opens up the playing field.
Note: We are not licensed tax professionals and the content of this post does not constitute the issuance of tax advice. Please consult with a licensed tax professional to understand what is best for your personal situation.
About MD Wealth Management: We are a financial planner near Ann Arbor that specializes in providing financial planning for physicians and retirees. We are CERTIFIED FINANCIAL PLANNER™ professionals and fiduciary financial advisors who operate on a fee-only basis, which means we do not sell financial products or collect commissions. We enjoy working with clients both locally and remotely.