Question: I feel like I’m paying more in tax than most of the other doctors I know. What am I doing wrong?
Explore This IssueACEP Now: Vol 41 – No 11 – November 2022
Answer: As a general rule, paying more in tax is a good thing because it means you are making more money. While earning more does result in a higher tax bill, it also generally results in having more money even after paying taxes. Remember that only a relatively small portion of your earnings is taxed at your marginal tax rate (tax bracket), so being bumped into a higher bracket does not result in all of your earnings being taxed at that new higher rate.
Almost all doctors think they pay too much in tax and most of them are right. However, the way to significantly lower taxes is not to find some tricky, hard-to-find deduction or hire the right person to prepare your taxes. The main way is to live your financial life differently: save more, get married, have children, buy a house, start a business, give to charity, hold your investments longer, etc. There are three tax deductions that generally outpace the others for physicians. If you would like to pay less in tax, be aware of all of these and maximize them as much as possible.
#1: Tax-Deferred Retirement Accounts
The first deduction is using tax-deferred retirement accounts. These come in a wide variety of flavors including 401(k), 403(b), 457(b), 401(a), defined benefit/cash balance plans, solo 401(k), SIMPLE IRA, SEP-IRA, and even traditional IRA. All of them work similarly. Any money contributed into the plan by you or your employer this year is money deducted from your income before your tax bill is calculated on the remaining income. For example, if you earn $300,000 and put $20,000 into your 401(k), you will only pay tax on $280,000. If you are single with no other significant deductions, that $20,000 contribution will reduce your federal tax bill by $7,500 (and potentially your state tax bill as well). Imagine that you could put $50,000 or even $100,000 into tax-deferred retirement accounts. You could reduce your tax burden by tens of thousands of dollars this year, plus you would be in much better shape for retirement. The up-front tax deduction is not the only way a tax-deferred retirement contribution saves you tax money. That money also grows in a tax-protected way, meaning you do not have to pay any taxes on dividends or capital gains as you invest in the account between contribution and withdrawal. At withdrawal, all of the money in the account is taxed at ordinary income rates, but you use it to “fill the tax brackets” as you go. For most doctors, they will get a tax deduction of 24–37 percent on contributions and then pay 10–22 percent on withdrawals as they fill the various lower tax brackets with that income. That’s a winning combination. Maxing out your retirement accounts also provides significant asset protection and facilitates your estate planning.