As physicians, we find ourselves in higher tax brackets than the majority of Americans. With the graduated tax system here in the US, the more we make, the higher the percentage of taxes we owe. That is not just because of the tax brackets, but also because many tax write offs are phased out as income climbs creating a compounding effect.
There are things we can do to decrease our tax burden. I am very disappointed that our tax code favors those in the know. It should be fair to all. Everyone who qualifies for write offs should get them, without having to hire accountants or attorneys or having to ask for them. But that is not the way it works. This is the tax for being uniformed. If you know what to do, you can pay less taxes. I’d like you to be better informed so here are five ways you can decrease your tax bill before the year ends.
1: Rough out your taxes during Thanksgiving weekend.
You are going to have to spend time gathering up all your documentation and putting it together for your taxes. You will spend the same time doing this whether you do it now or procrastinate until next October, but doing it now means you still have a month to make adjustments in the outcome.
By taking a look at your taxes before the year ends, you can determine if there are any deductions that can only be taken if completed before December 31st. If you consistently procrastinate until after April 15th and file an extension every year, you might miss some great opportunities to lower your taxes.
When I gather up my tax information and do a rough estimate of my taxes before the end of the year I usually see a few holes that I can plug or opportunities I can take. Many times they wouldn’t have been noticed without doing a quick estimate. It also allows me to calculate the amount I need to adjust my taxes paid for the year so I can avoid penalties.
The year I retired, I skipped this step. I figured my income dropped so much that year that I wasn’t going to bother with this calculation in advance. That was the year I missed some great opportunities. Turns out, I owed zero taxes that year. I wrote about this in tax surprises my retirement year. With zero taxes owed, I should have made some Roth conversions and took advantage of the lower tax brackets. It was also a great time to spend on health care and deduct it (see #2 below). I missed these great opportunities that could only be deducted if they were completed by December 31st.
Whenever there is a significant change in your income or deductions, that is the most important year to estimate your taxes before year end to see what will be different with these changes. Get in the habit of roughing out your taxes around Thanksgiving every year so you don’t miss out on opportunities.
If you have an accountant who does all your taxes, then get the information to them before Thanksgiving and they will give you some rough estimates and will have suggestions for moves you can make before the year ends.
2: Manipulate your Schedule A deductions.
When you rough out your taxes early, look for numbers that are at break points so that by making a small change, your tax bill will be significantly reduced. For example, if this year’s deductions will be over the $24,000 standard deduction, this is the time to pre-pay property taxes or increase charitable giving.
The entire property tax bill doesn’t have to be paid in the same year. Since the property tax deduction has an upper limit of $10,000, you can bunch the bills up. For example, if you pay property taxes in November and are not going to hit the $24,000 mark for itemized deductions this year, pay the minimum property tax payment now and pay the rest in January 2020. Then in November 2020 pay the entire next bill, as long as the total amount of property taxes paid in 2020 doesn’t exceed the $10,000 upper limit that is deductible. (In that case I would pay the amount that would take my property tax payments for 2020 to $10,000.)
This will create a bigger deduction every other year instead of an unused deduction each year. This works especially well in states with no income taxes since income taxes count towards the $10,000 SALT limit (State And Local Taxes) on line 5 of Schedule A.
Charitable giving can be timed as well. If you are over the $24,000 threshold, then now is the time to make any additional donations you have been thinking about. You will get the full deduction on those gifts that way. If you are way short of the $24,000 threshold this year, make your year-end donations in January in hopes of doubling up next year and getting a deduction on line 11 on Schedule A
Medical expenses are limited to 7.5% of adjusted gross income. For most physicians, we will not have enough medical expense to exceed this number with our high income. But sometimes we will. If big medical expenses happened this year and you are over the 7.5% threshold, then December is a good time to do some elective medical spending. Get your physical, pay for braces for your kids in a lump sum, or have that colonoscopy you have been putting off. Paying attention to your medical deductions could net you a nice figure on lines 1-4 on Schedule A
3: Fill your retirement accounts.
This is a good time to take a look at what you have contributed to tax protected accounts for the year. These accounts include 401(k), 403(b), 529, HSA, IRA and whatever other savings account you have available to you.
At the very least, put enough money in your company retirement account to get the employer match if you are entitled. That is equivalent to 100% tax free interest in just one single day. There is no investment you can make that has a higher return than an employer match.
If you have extra money in your checking account that is not spoken for in your budget, move it into a tax protected account if there is still space available.
Most doctors don’t qualify to deduct traditional IRA contributions. If this is you, and you don’t have any money in a traditional IRA account, then consider a backdoor Roth IRA. First make a deposit to a non-deductible traditional IRA account and the next day, convert that money to a Roth IRA. That money and its interest will never be taxed again.
Max out your tax deferred accounts and don’t take any money out of these accounts until after you retire, or your kids are in college (529). That includes the health savings account. Even though you can take out money each year to pay for health-related issues, let it grow tax free and use it after you have retired.
Do not let the year end with space left in these tax protected accounts unless you are financially struggling. If you are struggling, get out of that hole before filling your retirement accounts. There is no reason for you to continue to struggle financially.
4: Harvest tax losses if you can
There are two scenarios where you might consider tax loss harvesting. Each must be done with money invested in a standard brokerage account, not in a tax protected account.
The first case is to use some losses to offset $3,000 of income, the maximum allowed. This will only amount to about $1,000 in tax savings but that will be enough to buy a few days at Disney World. To do this you will sell off your stock for at least a $3,000 loss. Then buy a similar stock with that money so your overall investment strategy is unchanged. That loss will be written off against your ordinary income.
The second case is when you realized a large capital gain this year. If you have a gain and do nothing, you will owe capital gains taxes on the profits you made. If you have a stock, outside your retirement funds, that took a big loss recently, you can sell it and lock in those loses. You will then be able to write off those loses against the gains you made and reduce or eliminate the capital gains tax.
One of the reasons I owed no taxes in my retirement year was I had a large capital loss in a company I owned that went out of business. Those losses were used against that year’s gains which contributed to bringing my taxes to zero.
5: Convert your taxable IRA or 401(k) accounts to Roth Accounts
The sticky point about Roth conversions is that they must be done before December 31st. If you don’t look at your taxes until after that date, you will never be able to do Roth conversions to fill a tax bracket, which is the most efficient way to do this.
When you convert to Roth accounts, the conversion is taken as a distribution from your traditional account and is therefore considered part of your taxable income for the year. You can select the amount to convert so that your income doesn’t go over the limit for your current tax bracket. The year I owed zero taxes, I could have made some conversions at 0% tax and some more at 10% tax. It would have been a great move had I looked over my taxes before year end. I didn’t find out until April that I could have done this and by then it was too late. Don’t repeat my mistake.
If you can take advantage of any of these items before December 31st, you will be able to save some money with very little effort. It’s almost like bending over to pick up a $100 bill. Not much effort for such a reward. Have you taken advantage of any of these ways to reduce your taxes? How did it turn out for you?
Thanks for reminding me about the roth conversion. I already wrote down for next month actions to be taken. I use TaxCaster to make a rough estimate, but is pretty close.
Seems like there is very little to do during the earning years. Max out tax favored accounts. Most will take the standard deduction. Roth conversion make no sense. And finally, fortunately there are few options to tax loss harvest this year.
When you retire, there is a golden Tax Planning Window where you can control your income and thus control your taxes. Years of transition and years of low or no income are perfect for tax planning and making a difference!
I’m going to use your blog as a basis for Tuesday Tax Tips on the Financial Literacy Project FB page. Thanks!