12 Financial Planning Steps for Surgeons Before Bush Tax Cuts Expire
Ending the Bush Era tax cuts and approaching the fiscal cliff is worrisome for many surgeons, especially those who own their own practice or real estate. However, there are steps high-income surgeons can take to limit the burden.
"You can reduce future taxes with good planning and decisive action," says Shomari Hearn, a certified planner and vice president of Palisades Hudson Financial Group in Fort Lauderdale, Fla. "The new 0.9 percent increase in Medicare payroll taxes applies to employees and self-employed individuals earning more than $200,000, and married couples earning more than $250,000 a year. Only earned income above the threshold is subject to extra tax."
Surgeons are also worried about the Medicare rates, which have been updated every year with the resolution of the "Doc Fix," but this year Medicare rates are wrapped into a bigger financial package, so it isn't certain the fix will occur in the same way.
"Each of these physicians has worked hard and invested in themselves, and they hope to have a good financial situation in the future," says Mike PeQueen, managing director and partner at HighTower Las Vegas. "They are as uncertain and as angst-ridden as any other group. Many of the smaller practices are considering massive changes and some want to retire early, if possible, because they are so dispirited by the lack of control over their environment."
Here, six financial planners and professional managers discuss the steps surgeons should take to sustain themselves in this new financial era.
1. Reallocate investment portfolios. Shuffle your investments to make sure they are in the most advantageous place within your portfolio. Tax efficient investments — such as index funds, non-dividend paying stocks and bonds — should go in taxable accounts; investments that pay out large dividends and interest should be placed in retirement and other tax-deferred accounts.
"Rates are going up and tax rate on qualified dividends is limited this year," says Andrew Schwartz, a CPA specializing in healthcare professionals with Schwartz & Schwartz PC. "People want their more tax-efficient investment in their taxable accounts and others in their retirement accounts."
Surgeons who don't depend on investment income can hold most income-producing securities in retirement accounts and think about selling some of the interest and dividend-paying securities in taxable accounts to repurchase them in an IRA or 401(k), says Mr. Hearn.
"You can reinvest the proceeds in growth investments that pay little or not dividends and in tax-exempt municipal bonds," says Mr. Hearn. "This will reduce net investment income, MAGI and taxes."
2. Max out retirement contributions. Maxing out retirement contributions is a smart move for practices with 401(k) plans where there is a matching component on a percentage of contributions based on the first $250,000 of salary. Contributions to employer-sponsored plans reduce taxable income and can help cut the net investment income tax. However, surgeons must include their staff and whatever they do for themselves as a whole.
"There is flexibility in how this contribution is allocated to skew the contributions toward physician owners," says Mr. Schwartz. "They need to work with a competent retirement planner to take advantage of that."
For example, if surgeons make $250,000 in salary, the salary deferral is $17,500 and the match is another $10,000. If they are over 50 years old, they can contribute more. Contributions to a Simplified Employee Pension, SIMPLE IRA and other qualified plans are also subtracted from taxable income, says Mr. Hearn.
3. Upgrade to a defined benefits plan. People continue to look seriously at defined benefit plans and the most popular is a cash balance. In this situation, the ultimate benefit defines the annual contribution so surgeons can put away a greater sum of money than with other plans.
"Medical groups are seriously looking at implementing the cash balance plans," says Mr. Schwartz. "Tax rates are going up, so whatever you can do to shield taxes is smart. Someone within the practice — either the business manager or managing physician — needs to revisit their retirement plans and make sure they have the best plan in place."
All this planning creates a more stable financial future.
"When surgeons retire, they will need a plan to pay for their high lifestyle costs," says Thomas Balcom, CFP®, CAIA, MBA, Founder of 1650 Wealth Management in Lauderdale-by-the-Sea, Fla. "Taxes are important but cash flow is more important. Figure out what their cash flow will be during retirement and that guides their decisions. It's just thoughtful planning on behalf of the surgeon and his or her advisors. Thinking about it now as opposed to in the future is critical."
4. Convert traditional IRAs to Roth IRAs. Distributions from traditional IRAs are excluded in calculating net investment income but they are included when calculating MAGI, which could increase your exposure to a new tax. However, the Roth IRA has income-tax free distributions and is excluded from both equations.
"The conversion amount counts as taxable income," says Mr. Hearn. "But it's often worth paying a one-time tax in 2012 to get future Roth tax benefits if your income tax rates will stay the same or be higher in the future."
When surgeons retire, their income will be substantially lower, yet many want to maintain the same lifestyle. It's important to have enough money to live on after retirement, and with traditional IRAs surgeons will be paying taxes on the money they retrieve.
"Instead of having the higher tax rate in the future, bite the bullet and pay the taxes right now," says Mr. Balcom. "They might be paying higher taxes today, but over time they can use Roth IRAs to invest in REITs, high yield bonds and other dividend paying strategies and the withdrawals are all tax free. It allows you to have tax-free income later. Nobody wants to pay higher taxes now, but in the future if you have the high yielding investments in the Roth IRA accounts it's the gift that keeps on giving."
Making your Roth IRA conversion now can beat the tax hike beginning in 2013. "The amount you convert from a traditional IRA to Roth counts as taxable income," says Anna K. Pfaehler, a certified financial planner with Palisades Hudson Financial Group in Scarsdale, N.Y. "With tax rates scheduled to jump in the next year, converting in 2012 can provide significant savings compared to waiting a few months."
However, you will need to pay an extra tax by April 15, so consider whether this conversion still makes sense. If so, decide the amount; some covert their entire IRA at once and that could bump surgeons up into a higher tax bracket.
"Instead, convert the portion you can without sparking a higher rate assuming you have the money to pay the tax on it," Ms. Pfaehler says. "If you are in the highest bracket already, converting now will not cause you to have a higher tax rate. But the top rate may be higher in 2013."
5. Shift income to family members. Surgeons can shift some of their income to family members in gifts at various levels. For college-aged children who don't qualify for financial aid, an allocation can be made for the child to claim tuition tax credits.
"In this case, shifting income from the parent to the child saves taxes no matter what, but during college years they save extra," says Mr. Schwartz. "They can also shift income to family members or compensate a spouse and have the spouse max out their allowable retirement contributions."
Surgeons can create 529 plans for their children and grandchildren to benefit from the tax-free investment earnings. The current rates on investment are 43.4 percent, making this tax-free opportunity attractive.
"It's tied in with the gift system, so someone can put away $13,000 per child in 2012, and up to $14,000 next year," says Mr. Schwartz. "You can front load that up to five years, but if you do that you have to file a gift tax."
Making the gift sooner will also allow more time for assets to grow outside of the donor's estate. In some cases, they may want to use a more sophisticated estate tax-reduction technique, such as creating a trust for beneficiaries.
"Everything you give to an irrevocable trust is removed from your estate," says Benjamin C. Sullivan, a certified financial planner with Palisades Hudson Financial Group. "With an 'intentionally defective grantor trust,' there's an additional benefit: the grantor pays the trust's taxes, which allows the trust to grow quicker."
Intra-family loans are also an option, says Mr. Sullivan, and those interest rates are at historic lows. The surgeon can make a loan to a family member in the younger generation without consequences on the "gift" status as long as they charge interest at the minimal applicable federal rate, which sits at 0.89 percent for loans maturing in three to nine years.
6. Take capital gains this year and losses next year. It may be advantageous to sell appreciated investments before the end of the year because today's top rate of 15 percent on long-term capital gains will increase to 20 percent in 2013 if Congress doesn't extend the Bush Era tax cuts. Selling by the end of 2012 will save 8.8 percent in taxes.
"This may sound like a slam-dunk, but you need to take a close look at your portfolio and tax situation before you do anything," says Mr. Hearn. You may also want to sell losers and take investment losses next year, which can offset capital gains triggered in 2013. Additionally, it can save up to $3,000 in ordinary income if our losses exceed gains.
In this case, taking losses next year will help reduce your liability for new taxes, Mr. Hearn says. Charitable giving is another way to avoid the capital gains tax next year. There are low interest rates through the Charitable Lead Annuity Trust.
"Give income-producing investments to charity," says Mr. Hearn. "You'll get an income tax deduction for the fair market value of your security — as long as you owned it for more than a year, avoid capital gains tax and cut your future investment income."
One the other hand, surgeons may want to take advantage of capital gains rates through obtaining structured notes in a number of asset classes. This allows surgeons to avoid ordinary income and instead receive long-term capital gains for the growth of these positions.
"This is a sophisticated investment strategy that we use to address the tax issue that will face our clients upon the expiration of the Bush Era tax cuts," says Mr. Balcom. "By transferring taxes at the ordinary income level to the more favorable long term capital gains rates, we have essentially provided our clients with a nice tax benefit/savings."
This is a strategy used more commonly in Europe and Asia, and comes with credit risk. Make sure the banks are strong and you are comfortable with the credit risk before implementing this strategy. For example, you would be in trouble if you invested in Lehman Brothers notes because they have gone bankrupt.
7. Limit illiquid investments. Many surgeons enjoy investing in different projects, especially high-risk, high-reward ventures or other unique pet projects. However, in today's financial market, it's smarter to make liquid investments.
"Limit illiquid investments like private equity, real estate and venture capital," says Mr. PeQueen. "These things that have been off the beaten path are very illiquid and right now surgeons need to focus on liquidity — things they can turn into cash if they retire early or need more cash flow in the future."
This also means curbing risk-taking tendencies. "Surgeons like to take risks, especially if they stand to make a lot of money, but these investments could also be a complete loss," says Mr. PeQueen. "Surgeons need to reevaluate their attitude toward risk and dial that down because they might not have as much income later."
8. Switch to a high-deductible health insurance plan. Switching to a high deductible health insurance plan and fully funding a Health Savings Account each year can make a big impact on the surgeon's ability to pay for healthcare expenses. HSAs offer tax deductible contributions, tax-deferred growth and tax-free distributions to pay for the surgeon's family healthcare expenses.
"The practice can put in money for the owner and self because the HSA is like an IRA account," says Mr. Schwartz. "It was set up during the Bush era when money became more portable. The beauty is that you can put in an amount that is higher than the deductible so you don't lose much and your premiums go down. Your out-of-pocket exposures go up, but that isn't dollar-for-dollar so the exposure is covered."
The contributions are also tax-deductible by the individual group so the money that comes out of the account that pays for family medical expenses is tax free. Additionally, any money still sitting in the account when the surgeon turns 65 years old can supplement their other accounts.
"Surgeons can fund an HSA and not use it for medical expenses right now, and they will have money built up in the tax advantage account," says Mr. Schwartz. "For surgeons who are making good income, they don't need to take money out of an HSA for a $25 copay."
9. Take advantage of Medicare free S-corp distributions. Surgeons can set up an S-corp and retrieve profits by taking salary — or the S-corp distribution — which avoids Medicare tax of up to 3.8 percent next year. Surgeons can look up reasonable salary rates online at websites like salary.com to figure out what other surgeons are being paid in their area.
"The key is they need to take reasonable salary," says Mr. Schwartz. "Some physicians that own real estate may pay themselves generous rent and that will backfire once unearned income is taxed at 3.8 percent Medicare tax. The only way to avoid that is with the S-corp."
If the real estate or practice has more than one owner, the rate is based on ownership percentage on the day of distribution.
10. Make estate tax moves now. Estates of $1 million or smaller haven't been taxed since 2003, but that could all change at the end of this year. People who have no estate or gift tax liability now could face liability next year.
"The new certainty is uncertain," says Mr. Sullivan. "Don't wait for Congress to act. Make your estate-tax planning moves now."
The strategies don't have to be complex, and surgeons should also think about portability after their death. Married couples who are worth significantly more than $1 million should have a "credit-shelter trust" provision in their wills so each person's $1 million estate tax exemption will be fully preserved, says Sullivan.
"Whether the estate and gift tax is a new challenge for you or an ongoing part of your financial planning, it's important to create a plan that works for you no matter what," says Mr. Sullivan. "Build in flexibility to deal with any future changes Congress may throw your way."
11. Look at cross-tested profit sharing plans. If surgeons aren't already using cross tested profit sharing plans for their retirement fund, they could consider putting money away in these types of accounts, which are tax free. They are also flexible to fit the individual surgeon's needs.
"Cross tested profit sharing plans are good for small practice owners," says Mr. PeQueen. "They are prime candidates for these types of plans. Depending on the age of the physician and staff, they could put away far more before taxes than the standard off-the-shelf plan."
Surgeons can hire a good CPA with experience in healthcare to help them make these decisions. Knowledge about other changes, such as electronic medical record implementation and the ICD-10 conversion, will help these professionals understand the surgeon's and practice's needs.
"It's a lot to ask of a physician who is technically proficient in medicine to be proficient in business process decisions," says Mr. PeQueen. "A good CPA should know the problems surgeons are facing to run their own practices."
12. Accelerate income and defer expenses. Whenever possible, accelerate your income by moving up compensation you would normally receive in 2013 so you collect it before the end of the year. This includes bonuses or other compensation you were planning to receive in early 2013.
"Affected self-employed individuals can request that clients pay year-end invoices in 2012," says Mr. Hearn. "They also can put off large purchases of equipment and other expenses until 2013 to reduce income and exposure to the new taxes next year."
To defer expenses wait until 2013 to purchase new imaging equipment or instrumentation to make sure you capture the appropriate rates.
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