Tax planning for physicians

Tax planning is a crucial aspect of wealth management, particularly for high-income professionals such as physicians. Many physicians, whether they are transitioning from residency or have been attending physicians for decades, must navigate complex decisions related to benefits, retirement contributions, and tax strategies. Given physicians’ significant income levels, with many in or near the highest federal tax brackets, these decisions can have a substantial impact on their long-term financial success.

As new physicians finish their residencies or fellowships and become attending physicians, they receive benefits information and must make choices about tax withholding and contributions to retirement plans.

This column covers two often-asked-about tax planning topics that new or veteran attending physicians raise in financial planning meetings: (1) which employer-sponsored retirement plans to participate in and (2) how to reduce their tax burden. This second question is most relevant to physicians who are self-employed, so this column also discusses an effective tax planning strategy for them.

Employer-offered retirement plans

Hospital attending physicians typically receive a benefits packet that goes through all the employer-provided financial benefits — from health insurance to short- and long-term disability and retirement plans. It is often difficult for them to know which benefits to choose. Many hospitals offer physicians multiple retirement plans, including Sec. 401(k), 403(b), or 457(b) accounts as well as Sec. 401(a) and state-sponsored plans. It is not uncommon for physicians to be eligible to contribute to multiple plans, thereby allowing them to make tax-deductible contributions of nearly $100,000 annually.

When considering which plans to participate in, first, it is important to know about the employer’s matching contributions, which typically range from 4% to 6% of wages. The participant should contribute enough to the plan to get the full match. Many physicians likely will max out at least one defined contribution plan (e.g., a 401(k) or 403(b)). Since most physicians are in a higher tax bracket, it is best for them to make these contributions pretax, thus reducing their taxable income, instead of to a Roth individual retirement account (IRA). Some may consider designating a portion of their contribution as a Roth IRA if they are not in the highest tax bracket.

After making sure that they get the full employer match, the next question is should they contribute to the other plans offered to them — such as a Sec. 457(b) plan?

If the Sec. 457(b) plan is nongovernmental, the employee tells the employer how much they want to contribute. The employer owns the account, so it is subject to the employer’s creditors, although this would rarely be an issue. Additionally, a nongovernmental Sec. 457(b) account cannot be rolled over into an IRA when the employee stops working for that employer. For many new attending physicians who just finished their training, this is a downside worth considering. They want maximum flexibility, and they are unsure whether they will stay at their current hospital for their entire career. It may make sense for them to wait a few years to participate in the Sec. 457(b) plan and instead focus on paying off student loans and building up a nonretirement account, which gives them more flexibility.

A governmental Sec. 457(b) plan’s assets cannot be claimed by the employer’s creditors, and it is eligible to be rolled over into another retirement plan such as an IRA or Sec. 401(k) plan. Because of this increased flexibility, most high-earning physicians will choose to participate if eligible. Since many physicians work for not-for-profit hospitals and not directly for a governmental organization, they are more likely to be offered a nongovernmental Sec. 457(b) plan rather than a governmental one.

As already mentioned, flexibility is a consideration when choosing which retirement plans to participate in and how much to contribute. New attending physicians who just finished their training may have student loans or may have a goal to buy a house in the near future. If those goals will require a large cash outlay, building up reserves outside a retirement plan may better suit them.

For example, a new attending physician may choose to max out a Sec. 403(b) plan but choose not to participate in a Sec. 457(b) plan because they want to save up for a home down payment. Of course, there are some exceptions to the early-withdrawal penalty from retirement accounts, but raising cash is easier if individuals have some funds outside the retirement plan. Most physicians spend at least 10 years in college, medical school, and training, so once they become an attending physician, they want (and deserve) to have some flexibility. Getting excited about contributing nearly $100,000 to retirement plans is hard if it does not leave much disposable cash — even if those contributions are tax-deductible and reduce their tax burden.

Benefits of a backdoor Roth IRA

The highest-earning physicians, or households with two physicians, are looking for every opportunity to invest in a tax-advantaged manner. In those situations, they are likely maxing out every employer-provided retirement plan available to them, and they still have leftover discretionary income. In this case, they should consider making “backdoor” Roth IRA contributions (see Mollberg, “Making a ‘Backdoor’ Roth IRA Contribution,” 215-4 Journal of Accountancy 72 (April 2013)). Most physicians are over the modified adjusted gross income limit for Roth IRA contributions (for 2024, $161,000 for single taxpayers and heads of household and $240,000 for joint filers).

One important question to ask those who are considering making a backdoor Roth IRA contribution is: Do they have any pretax (traditional) IRAs? If they do have a pretax IRA, then the backdoor Roth IRA contribution could be partially taxable, which is not what they would be intending.

Many physicians contributed to a retirement plan during residency or fellowship, and they may have rolled those over to a traditional IRA. In that case, they could either convert the traditional IRA to a Roth IRA — and pay ordinary income taxes on the amount of the conversion — or do a reverse rollover into their new employer’s plan. Either action will set them up for backdoor Roth IRA contributions in the future.

Although the backdoor Roth IRA contribution limits are relatively modest compared to defined contribution plans, this is a great way to build up the tax-free bucket of investments. Physicians who are making backdoor Roth IRA contributions should consult with their tax preparer to make sure that the nondeductible IRA contribution and conversion to a Roth IRA are reflected correctly on their tax return.

Example: Dr. S is a newly minted attending surgeon who has just completed her training and secured a position at a large hospital. As she transitions from her residency to her attending role, her salary has increased significantly from $65,000 to $300,000 annually. With this new income, Dr. S is faced with several financial decisions, particularly regarding retirement savings.

Dr. S’s employer offers multiple retirement plans, including a Sec. 403(b) and nongovernmental Sec. 457(b) plan. Since she is now in a higher tax bracket, she opts to make her contributions on a pretax basis to reduce her taxable income. After consulting with her financial adviser, Dr. S decides to contribute the maximum allowable amount to a Sec. 403(b) account to take full advantage of the employer’s 5% match.

Although the Sec. 457(b) plan is available, Dr. S decides to hold off on contributing to it because she is uncertain about her long-term career plans at this hospital and values the flexibility of having accessible funds outside retirement accounts. Instead, she focuses on paying down her student loans and building a savings account for a down payment on a house.

Given Dr. S’s high income, she is above the income threshold for direct Roth IRA contributions. However, she is interested in building tax-free retirement savings. She decides to use the backdoor Roth IRA strategy. Dr. S first contributes $7,000 to a nondeductible traditional IRA. Since she has no other pretax IRA accounts, she can convert the entire amount to a Roth IRA without any tax consequences, thus adding to her tax-free retirement savings.

With this plan in place, Dr. S is saving for the future with tax-deferred dollars, building a Roth IRA account, and tackling her short-term priorities of paying off her student loans and saving for a down payment.

S corporation election for self-employed physicians

The retirement plan decisions discussed above relate to physicians and other high earners who are employees earning wages reported on Form W-2, Wage and Tax Statement (W-2 employees). Many physicians are not W-2 employees; they are self-employed, with compensation reported on Form 1099-NEC, Nonemployee Compensation, by one or more entities. In this case, there are multiple tax planning opportunities, including maximizing their deductions and entity selection.

Self-employed physicians may be high earners, in the 32% federal tax bracket or higher. Often, they are still figuring out how to structure their business entity, which is a great time to discuss forming an S corporation to reduce self-employment taxes.

If a self-employed physician has not yet planned to reduce their tax burden, they should consider an S corporation election. This election could greatly reduce their self-employment taxes. Even when including the cost of administering a payroll, along with CPA and attorney fees, the tax savings can be significant for a self-employed physician earning $300,000 or more.

Of course, they still need to be prudent and receive a reasonable salary, determined by consulting with their CPA (see Hemani, “Advising S Corporation Clients on Reasonable Compensation,” 55-10 The Tax Adviser 54 (October 2024)). The self-employed physician can further reduce their tax burden by setting up a retirement plan for themselves, such as a solo Sec. 401(k) plan with profit sharing.

Prescription: Tax planning

Proactive tax planning is vital for physicians at every stage of their careers. By carefully selecting retirement plans and considering strategic tax-reduction methods, physicians can maximize their financial well-being and ensure long-term stability. For employed physicians, understanding the nuances of various retirement plans, such as Sec. 401(k), 403(b), and 457(b) accounts, is crucial in making informed decisions that align with their short-term needs and long-term goals. Meanwhile, self-employed physicians can benefit significantly from the tax advantages offered by an S corporation election alongside a well-structured retirement plan.

Whether a physician is just beginning their career or is a seasoned professional, these strategies provide a foundation for effective financial planning and the potential to significantly reduce tax burdens, thereby enhancing overall financial security.

Contributor

Wesley Botto, CPA/PFS, CFP, is a financial planner with Hillcrest Financial Group in Cincinnati. For more information about this column, contact thetaxadviser@aicpa.org.