Tax-Advantaged Savings for Doctors
Doctors and other high-earning professionals can be some of the most challenging clients to find tax savings for. Their incomes are too high for them to claim a lot of common deductions and credits, but because that income comes in the form of wages, they don’t have access to all of the the tax planning opportunities that are available to business clients. Retirement plans offer some of the easiest opportunities for tax savings, and doctors do have many of the same options as other taxpayers.
Despite what some would consider to be a very good income, doctors often don’t have the cash flow, especially early in their careers, to maximize all of their available savings options. Because some plans offer more tax savings than others, the best tax savings can often be had for the fewest dollars by maximizing contributions in the following order:
- 401(k) to the company match
- HSA if enrolled in a compatible health plan
- IRA or Spousal IRA
- 401(k) with no match
- Non-deductible IRA with Roth rollover
- Other Options
401(k) with Company Match
Contributing enough to a 401(k) ( or similar plan) to get the company match will almost always get the best possible tax savings for a doctor’s retirement dollars. Employers will often match 50% to 100% of the first 3% an eligible employee saves in an employer-sponsored plan. The employee contribution comes out after payroll taxes but before income tax. The employer contribution goes in with no tax at all. With the new top Federal tax rate of 39.6% and the top Maine state income tax rate of 7.95%, the very highest earners could find themselves saving about 44 cents on every dollar that they contribute to the plan. Once you factor in the tax that they save on the employer contribution, high-earning doctors stand to save about 92 cents in tax for every dollar they contribute, up to the company match. The income tax piece of this savings is a deferral, but most doctors can expect to be in a lower tax bracket during retirement, making some of the savings permanent.
HSA (Health Savings Account) Contributions
HSAs are one of this author’s favorite forms of retirement savings because they can be kept for retirement or used to pay current medical expenses. An HSA is an account, similar to an IRA, that taxpayers can contribute to if they have certain high- deductible health insurance plans. Unlike an IRA, there are no income limites on HSA eligibility, making HSAs a great way for doctors to defer tax on additional income. Contributions made to an HSA go in before income tax and payroll taxes, but they come out tax free if used to pay for medical expenses. If there’s money in an HSA when the taxpayer reaches retirement age, it can be withdrawn. Money taken from an HSA in retirement is subject to income tax, but not to early withdrawal penalties. A word of caution, however – HSA funds withdrawn early for non-medical expenses are subject to a 20% penalty, in addition to being fully taxable.
IRAs and Spousal IRAs
IRAs and Spousal IRAs are only occasionally an option for doctors because most doctors have an employer-sponsored retirement plan available. A taxpayer who is not eligible to participate in an employer-sponsored can conttibute to an IRA and claim a tax deduction no matter how high their income, but when an employer plan is available, the deduction passes out at certain income levels. Single taxpayers earning more than $59,000 and married taxpayers who earn more than $95,000 begin to lose their IRA deductions if they are able to participate in an employer plan
The idea behind a spousal IRA is that a homemaker married to a higher earning tax payer ought to be able to save for retirement based on his or her spouse’s earned income, even if they have no earned income of their own. Married couples with only one wage earner have a higher income cap on IRA deductions than couples where both workwork and are eligible. The spousal IRA is available to married couples with adjusted gross incomes under $188,000 in 2013 and $191,000 in 2014 if the working spouse is covered by another retirement plan. There is no income limit on the IRA deduction if neither spouse is covered by a company plan.
The reason why a deductible IRA can be better than an unmatched 401(k) contribution is that the fees in an IRA trend to be lower than on a 401(k), and with a wider range of investments available, there are more low cost investment options. Asset allocation and cost control are among the most important factors in building wealth over time.
Unmatched 401(k) Contributions
Additional retirement savings after the spousal IRA has been funded (or is not available) should go into a 401(k) or similar plan, even if no match is available. The primary advantage to continuing to fund the 401(k) comes from being in a different tax bracket in retirement – it allows money to be put aside now with a net tax rate around 44% and later withdrawn with a marginal rate that’s likely to be below 30%.
Nondeductible IRA with Roth rollover
Roth IRAs were created as a vehicle to help people who expected to be in a higher tax bracket during retirement. Money goes into a Roth IRA after taxes, and comes out tax-free during retirement. The principal of a Roth can also be withdrawn tax and penalty free at any time. This makes it an ideal investment vehicle for a lower wage-earner who may need some of the money before retirement. Its main advantage to a doctor or other high-earning professional is the growth each year is not taxed. This means that its still usually a better option than a taxable account.
Technically, high-income taxpayers are not allowed to contribute to a Roth IRA. The income limit to contribute prohibits Roth contributions for taxpayer with an AGI at or above $188,000 in 2013 for a married couple, but there’s a catch. Taxpayers can contribute to a traditional IRA at any income level, they just lose the deduction if their incomes are too high.
There has been a substantial loophole surrounding Roth IRA conversions since 2010. Previously, higher-earners were barred from contributing to a Roth or converting a traditional IRA to a Roth. This means that a doctor or other high-earner who doesn’t have other balances in a traditional IRA can fund one with a non-deductible contribution, and immediately convert it to a Roth IRA, tax-free.
Other Tax Advantaged Savings Options
Once contributions to retirement accounts have been maximized, there are many other options that provide some tax advantages, each with their own rules and benefits. Some options include:
- College savings plans for children and other relatives
- Municipal bonds or municipal bond funds
- Annuities and similar products
Investors should not let tax consideration rule their investment decisions, but when the amount of money as available to invest is less than the available limits on tax advantaged around, choosing the right account types to invest in can yield significant savings.