Just about every physician I have met feels he pays too much in taxes, and many of them are right. A lack of understanding of your federal and state tax codes will cause you to miss out on tax breaks you have already earned and, more importantly, keep you from making minor changes in your financial life that may dramatically lower your taxes.
Refundable tax credits
The best breaks in the tax code are refundable tax credits. For a low earner who doesn’t owe taxes, a refundable tax credit is actually a negative income tax. The largest of these are the Earned Income Credit and the Additional Tax Credit, neither of which is available at typical physician income levels.
One refundable credit that is available to physicians with children in college is the American Opportunity Credit, for up to $2,500 per year.
Non-refundable tax credits
Non-refundable tax credits are also wonderful tax breaks, reducing your tax bill dollar for dollar down to zero, but no further. The most useful of these for physicians is the child care credit. This allows you to take up to 35% (limited to $3,000 per child, or $6,000 per family) of what you spend on child care, preschool, or even some housekeeping services.
The child tax credit is perhaps the most common refundable credit, but most physicians cannot claim it as it is phased out as income rises. Physicians can claim the residential energy credit, but it is quite low (lifetime maximum of $500). An adoption credit of up to $13,000 is not phased out until around $200,000 in income, allowing many physicians to qualify. Finally, physician investors who invest in international mutual funds in a taxable account can take a credit for the foreign taxes paid by the fund.
Tax credits vs. deductions
Deductions are not nearly as useful as a tax credit, but there are a lot more of them. A credit reduces your tax bill dollar for dollar, but a deduction just decreases your taxable income. For a physician with a marginal tax rate of 35%, a $1,000 deduction saves $350 in taxes where a $1,000 credit would save $1,000 in taxes.
Self-employed work expenses (Schedule C)
The best type of deduction is a work expense for a self-employed physician. These deductions are much more difficult for an employee physician to take, as the physician not only must itemize deductions, but he also loses the first 2% of his income worth of deductions.
A self-employed physician simply subtracts work expenses from his income. These include white coats, scrubs, work shoes, medical licenses, DEA licenses, CME costs, pager, cell phone, home office expenses, and work-related driving (not commuting). Tax, accounting, and retirement plan fees can often be deducted, also.
Your ideal strategy, generally, is to move as many deductions as possible from Schedule A (itemized deductions) to Schedule C (work expense deductions.)
After work-expenses, the next best type of deduction is an “above-the-line” deduction. The line in this case is line 38 on Form 1040—your adjusted gross income.
Below-the-line deductions are taken on Schedule A, and are useful only in the amount they exceed the standard deduction. But above-the-line deductions can be taken in addition to the standard deduction. These may include contributions to your Health Savings Account, moving expenses, payroll taxes, retirement plan contributions, health insurance premiums, and alimony payments.
However, most physicians won’t be able to take the student loan interest or the tuition and fees deductions. Another benefit of above-the-line deductions, unlike below-the-line deductions and exemptions, is they are not phased out via the “Pease limitations” beginning at an adjusted gross income of $254,050 ($305,200 married).
Finally, below-the-line deductions can help reduce your tax burden, also. These include the familiar itemized deductions taken on Schedule A, including state and local income taxes, property taxes, mortgage interest, casualty losses, and charitable contributions.
You may also be able to deduct some medical expenses, tax preparation fees, investment fees, and some unreimbursed employee expenses, but most physicians will not get much of a deduction for these.
Some people may find a benefit from bunching their deductions every other year, and then alternating between itemizing and taking the standard deduction. For example, if you regularly make charitable contributions, you can make your contribution for 2014 in January 2014 and your contribution for 2015 in December 2014. Then you would itemize your deductions in 2014 and take the standard deduction in 2015.
You may also be able to bunch medical expenses, property tax payments, mortgage interest, and even state income tax payments. This technique can also sometimes be used to reduce Alternative Minimum Tax.
Although exemptions are neither credits nor deductions, they function in a way as a type of above-the-line deduction. In 2014, your taxable income is reduced by $3,950 for yourself and each of your dependents.
In general, a high-income professional like a physician is better off keeping his children as dependents for as long as possible, even if he has to pay the difference in the tax bill of the adult child who cannot then claim himself.
The largest tax break for most physicians is offered by making contributions into retirement and educational savings accounts. These accounts, such as 401(k)s, Roth IRAs, and 529 Plans, all offer some combination of an upfront tax break, tax-free withdrawals, and tax-protected growth.
Maximizing these accounts may reduce your current and future tax bills by tens of thousands of dollars. The best part about these accounts, of course, is that you didn’t have to spend the money to get the break—you still have it!
Don’t pay more than you have to
Making an effort to understand the tax code and reduce your taxes can have a dramatic increase in your ability to grow your wealth and enjoy your income now and in the future.
Physicians are generally more than willing to pay their share of the expenses of running their country and state, but most of them would prefer not to leave a tip!
“This is a major change,” Washington says. “Even in a one- or two-physician practice, a month is too soon. Three months, maybe. And the bigger the practice, the longer it will take.”
James M. Dahle, MD, FACEP is not an accountant, attorney, insurance agent, or financial advisor and as such this article does not constitute legal, accounting, or tax advice and is for entertainment and education only. He blogs as The White Coat Investor at http:// whitecoatinvestor.com and is the author of the bestselling The White Coat Investor: A Doctor’s Guide to Personal Finance and Investing.