Through tax diversification, you can optimize your taxable, tax-free, and tax-deferred accounts to maximize your portfolio.
In this article, we’ll explain what a good tax diversification strategy involves and a few other ways to reduce taxes today and in the future.
What is Tax Diversification?
Tax diversification is the foundation for building wealth and reducing taxes. This strategy considers unknown variables for the future, such as changes in tax rates.
Through tax diversification, the wealth you accumulate is separated into three asset “buckets:”
- Ones that would be subject to income tax rates when withdrawn
- Ones that would be subject to capital gains tax rates
- Ones that aren’t subject to any taxes when distributed
By spreading your wealth amongst these three buckets, you increase your options when you withdraw funds, choosing from the accounts with the best tax rules in effect at the time.
Once you’re in retirement, you can evaluate the tax rates yearly and determine which bucket of money to use to maximize your income. This is particularly helpful for newly retired physicians, as you may still have a higher tax rate from your previous year’s income but no longer have a regular salary in your accounts.
How much money you’ll need in each bucket when you retire depends on factors like your joint life expectancy (you and your spouse) and the sources of income you’ll receive after retirement, such as social security. You’ll also need to consider how long before your ordinary income stops and you begin to draw down on your assets (how long until retirement), understanding that tax rates will likely change multiple times before then.
Your mix of assets within these three buckets determines your position upon retirement. You have more flexibility to avoid negative changes in tax rates with a diversified portfolio and comparable assets in each bucket.
Other Tax Strategies: Business Deductions
Physicians who own their own practice or work as independent contractors, freelancers, or locum tenens should be aware of the Tax Cuts and Jobs Act (TCJA) and how it changed business tax filing.
Deductions like Section 199A may reduce your taxable income enough to put you into a lower tax bracket, potentially saving you money. These deductions include (but are not limited to) the following:
- 199A permits a deduction of 20% or less of qualified business income for certain business owners of pass-through entities.
- Business meals can be deducted at 50% off the cost if the taxpayer or an employee is present and the food and drinks aren’t “extravagant.” However, entertainment expenses are no longer deductible.
- Deductions for business interest have changed based on average annual gross receipts.
For more specific deduction changes and how they’ll affect your tax filing status, check out the IRS information online or talk to your financial advisor. Depreciation, deductions, and other income tax variables impact your tax diversification wealth management strategy.
Using Tools That Provide Asset Protection
Physicians adjusting to higher incomes quickly realize the importance of tax planning and asset protection.
Depending on your position, you may be in a higher tax bracket, and you’re frequently exposed to liability, requiring more active asset protection.
Qualified Retirement Plans and IRAs
Two of the most effective asset protection methods against creditors are qualified retirement plans (QRPs) and Individual Retirement Accounts (IRAs). (Note that protection levels vary by state.)
QRPs are tax-advantaged accounts governed by ERISA (the Employee Retirement Income Security Act). ERISA established rules protecting workers’ retirement income and governing transparency on pension plans. QRPs cover defined benefit plans like cash balances and defined contribution plans like 401(k)s. These types of accounts offer tax deductions from income, making them a typical part of physician tax diversification.
Individual Retirement Accounts (IRAs) are treated differently tax-wise, depending on the type of IRA (traditional IRAs versus Roth IRAs). Your tax burden depends partly on whether you fund your accounts with pre-tax or after-tax dollars.
Non-Qualified Plans
Often overlooked by physicians, non-qualified plans provide fewer immediate tax deduction benefits but permit funds to grow in a tax-free account. The account is flexible, with no required minimum distributions, and is not governed by ERISA rules. Your employer can choose to offer this benefit at its discretion.
Primary Residence
Most states protect homes from creditor claims or lawsuits, but the level of protection can vary. Your advisor can help you better understand how well your primary residence is protected from lawsuits and how to use mortgage interest and capital gain exclusions to minimize your federal income tax.
Permanent Life Insurance
Permanent life insurance provides a death benefit to those you leave behind. Crucially, though, permanent policies accumulate cash value, which grows tax-free. In many states, such cash value is also exempt from creditor claims.
Reducing Taxes on Investments
Proactive investment tax planning won’t eliminate your tax liability but can help you reduce it. Here are five ways you may be able to lower your taxes on investments if you plan ahead.
1. Understand Your Asset Location
Asset allocation is one thing; asset location is something different.
Through an asset location methodology, you learn how your accounts are taxed, and then recognize how the investment products you use earn you income — and how that income is taxed.
As an example, income generated by securities held in qualified retirement plans and IRAs will not be taxed. Therefore, these accounts can be leveraged to own investments that spin off regular income – such as interest or dividends.
On the other hand, non-retirement accounts may be good places to own growth stocks that don’t distribute income or earn interest.
2. Pay Attention to Holding Periods
If you can hold out and take advantage of long-term capital gains rates, you’ll pay less tax than when you must incur short-term rates.
Depending on the initial investment, this could be a difference of thousands of dollars. While it may seem basic, it’s not always something that’s considered when trading mutual funds or handling managed accounts.
3. Diversify With Municipal Bonds
Municipal bonds are generally exempt from federal taxes, and some are also state and local tax-exempt. As a physician looking for accounts to allocate funds to reduce your tax burden, municipal bonds could be an attractive part of your portfolio.
4. Watch the Tax-Cost Ratio
High tax-cost ratio accounts are less tax-efficient and may be best left in retirement accounts. Lower tax-cost ratio funds can be accessed as needed with a smaller penalty. This aspect should be discussed with your financial advisor, as you may be able to find funds that better suit your unique needs.
5. Take Advantage of Charitable Donations
Finally, you’ve heard that it pays to be charitable, but altruism can also reduce your tax burden.
When you donate to qualified charitable organizations, you can maximize your tax savings. If you have highly-appreciated assets, you could consider gifting those assets to a charitable entity — perhaps even in a planned way to get some income stream from a charitable remainder trust.
Conclusion
Are you wondering if adding tax planning to your never-ending to-do list is necessary?
It’s understandable — you might think you have plenty of time to deal with it later. But before you know it, this year’s income taxes are due, and you may be unhappy with the results.
The good news is that although the initial consultation and discussion with a financial planner will take a little time out of your day, once you’ve worked out a plan, your advisor handles the time-consuming aspects.
The key is to find a financial advising company that understands physicians’ unique financial goals. Our specialists at OJM Group know the tax laws and can suggest ways for you to reduce your taxes in a number of ways. Contact us today to get started!
Our specialists at OJM Group know the tax laws and can suggest ways for you to reduce your taxes in a number of ways.
Disclosure:
OJM Group, LLC. (“OJM”) is an SEC registered investment adviser with its principal place of practice in the State of Ohio. SEC registration does not constitute an endorsement of OJM by the SEC nor does it indicate that OJM has attained a particular level of skill or ability. OJM and its representatives are in compliance with the current notice filing and registration requirements imposed upon registered investment advisers by those states in which OJM maintains clients. OJM may only transact practice in those states in which it is registered or qualifies for an exemption or exclusion from registration requirements. For information pertaining to the registration status of OJM, please contact OJM or refer to the Investment Adviser Public Disclosure web site www.adviserinfo.sec.gov.
For additional information about OJM, including fees and services, send for our disclosure brochure as set forth on Form ADV using the contact information herein. Please read the disclosure statement carefully before you invest or send money.
This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized legal or tax advice, or as a recommendation of any particular security or strategy. There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circumstances. Tax law changes frequently, accordingly information presented herein is subject to change without notice. You should seek professional tax and legal advice before implementing any strategy discussed herein.
Index Disclosure: An index is an unmanaged portfolio of specific securities, the performance of which is often used as a benchmark in judging the relative performance of certain asset classes. Investors cannot invest directly in an index. An index does not charge management fees or brokerage expenses, and no such fees or expenses were deducted from the performance shown. Index returns shown are price returns, which exclude dividends and other earnings.