As Ben Franklin famously said, “In this world nothing can be said to be certain, except death and taxes.” Although nobody likes paying taxes, if you plan to make money, you are going to pay them. And while you can’t do anything about the fact that you have to pay taxes, you can do certain things to minimize the amount that goes to the IRS. This is where tax planning comes into play.
Tax Preparation Versus Tax Planning
It’s important to understand the difference between tax preparation and tax planning. Tax preparation is reactive, while tax planning is proactive. Tax preparation is looking at what happened over the past year and using that information to figure out how much you owe in taxes. Tax planning, on the other hand, is looking ahead and incorporating anticipated future events (changes in income, expenses, etc.) in order to minimize your lifetime tax bill. If you think about managing your taxes like driving a car, tax preparation is driving by looking in the rearview mirror while tax planning is driving by looking through the front windshield.
Tax Planning Opportunities for Physicians Change as Their Careers Progress
When it comes to tax planning for physicians, we like to think about it in three phases. Each phase corresponds to a different point in a doctor’s life and career, and each presents unique opportunities to make smarter tax decisions. In this three-part series, we’ll go through each phase in sequential order and share some thoughts on how to look at each, as well as things to consider when trying to minimize your lifetime tax bill. Let’s start with training.
Phase 1 – Residency or Fellowship
Consider Roth Contributions
During your first year of training, you (finally) start receiving a paycheck, although the size of that paycheck doesn’t exactly make you feel rich. However, the silver lining of this period is that (barring a high-earning spouse) you are likely in the lowest tax bracket you will ever be in. Since you are already in such a low tax bracket, instead of focusing on further lowering your tax bracket, you should focus on putting yourself in a better position for phase three of your tax life (retirement) by taking advantage of your low tax bracket.
A great example of something you can do is to make Roth contributions to retirement accounts (IRA, 403b, 401k, 457b, etc.). Roth contributions are made with after-tax dollars, and once the contribution is made, you never have to pay taxes on that money again (assuming you make a qualified distribution – typically after age 59 ½). This contrasts with traditional retirement plan contributions, where you don’t pay taxes when you contribute the money, but you do pay taxes when you withdraw it.
How to Think About Roth Versus Traditional Contributions
It’s worth noting that neither Roth nor traditional retirement account contributions are inherently “better,” it just depends on when you want to pay the taxes. A general rule of thumb is that if your tax bracket is going to be lower when you contribute the money than when you withdraw it, Roth contributions make financial sense. For example, when you are in training, your tax bracket will likely be lower than it will be in retirement, however when you are an attending, this is probably no longer true. At that point, it might make sense to follow a different strategy (more on this in our next post).
Roth Conversions During Your Final Year of Training
Since your last year of training is often your last year of being in a low tax bracket, one additional strategy to consider during this time is making a Roth IRA conversion. A Roth IRA conversion is the process of converting traditional (pre-tax) IRA money into Roth (after-tax) IRA money. When you do this, you pay taxes on the amount of money you convert into a Roth IRA.
The reason this is beneficial is that you are paying taxes today, while your tax bracket is likely at its lowest point, for the benefit of taking the converted Roth IRA money out tax-free in the future, when your tax bracket will likely be higher. Therefore, if you have money in a traditional IRA, you might want to consider “converting” to a Roth IRA so that you can pay taxes at your training tax bracket, before jumping to your attending tax bracket where this strategy is no longer beneficial.
Tax Planning With Student Loans
If you are going for Public Service Loan Forgiveness, there are additional things to consider when it comes to your taxes. The goal when going for Public Service Loan Forgiveness should be to minimize the amount you pay toward your loans, thereby maximizing the value of forgiveness. The required payments for income-based repayment programs are calculated as a percentage of your income. If you are married, depending on your repayment plan, you might have the option to file taxes either separately or jointly. In these situations, there tends to be a trade-off between taxes and loan payments, whereby if you file taxes jointly you might pay less tax but make higher student loan payments (since your spouse’s income is also considered when calculating your required payments). The situation also works in reverse. Therefore, you’ll want to consider the combination of both taxes and loan payments you would make under each filing status, in order to determine which is better for you.
While tax planning might not be top of mind for most residents and fellows, this period of a physician’s career presents a great opportunity to take advantage of the lowest income level of their working life. Most importantly, consider making Roth (after-tax) contributions to your retirement accounts to take advantage of your low tax bracket. Also, if you have student loans and are going for Public Service Loan Forgiveness, be sure to evaluate the combination of both taxes and loan payments when deciding your tax filing status. By focusing on the forest (your lifetime tax bill) rather than the trees (the taxes for a particular year), you can capitalize on the tax planning opportunities available during each phase of your career. While taxes are certain, such tax planning will help you maximize the amount of money that stays in your pocket and minimize the amount that goes to the IRS.
Disclaimer: 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 an Ann Arbor financial planner 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. As an Ann Arbor financial advisor, we enjoy working with clients both locally and remotely.