Dec 25

The Effects of Tax Law Reform on Physicians and Other High Income Individuals

tax law

Tax Law and Weekend Call

I sit down to write this a day after finishing a week of call. Honestly it wasn’t so bad. I’ve had many which were far more stressful and disruptive to my sleep patterns. But no matter how smooth my call weeks are, there is never a time I would rather be on call than not. I have never once thought to myself on a free weekend:

 

“you know, I really wish I was in the hospital working right now!”

 

And as I reflected upon this, I thought a bit deeper about working part-time and the implications of the new tax law.

 

Wait, what?

 

I know, not intuitive, but I spent many hours this week reading analysis of the new tax bill and it is stuck in my brain (as now it is something that will actually affect me, and I wanted to know if there were any actionable steps I could take to minimize my tax liability). After all, we all know that MONEY = HAPPINESS, and it will solve all our problems!

 

Well maybe not…but that doesn’t mean we should just hand it over without thoughtful consideration. After all, money may not solve all of our problems, but it does have a tendency to solve our money problems, and I’m pretty sure I can find more fulfilling ways to spend my money than our federal government.

 

These last few months I almost completely avoided thinking much about tax law.  Occasionally I would be tricked into reading a ‘news’ article about the subject, most of which devolved into some biased political rant about how awesome/terrible or just/unfair each proposal was and how changing the tax code would either massively grow the economy or devolve us into a third world cesspool of hyperinflation and deficits. In other words 99.9% of it was completely useless information that wasted my time and mental energy. I wasn’t going to influence this law, so I would put my time and energy into analysis after the fact.

 

Unlike News, Laws Actually Matter

Now that the bill is law it is worth learning about.

I’m assuming TurboTax will make me comply with it, so I thought I would learn about it and help you navigate the inner workings. Before we go on though, I need to give you a few warnings: I’m going to be talking about the high end of the tax spectrum here – this article is focused on physicians and other high income W2 earners (like me). Physicians make a lot of money relative to many others in society and I recognize that some people will take offense when they perceive people are whining about taxes when they make 500k/yr. Just to be clear – I’m not whining (and I don’t make 500k/yr either). These are just my observations. I like thinking about finance and optimizing. I would do it if I was making 30k, 300k or 3 million dollars a year.

Also, I am not a tax professional and I don’t know if this information is 100% accurate. I didn’t read the actual bill, just summaries of it. Don’t quit your job or move to another state based on my blog post – do your own research.

 

Incentivize This

With that out of the way I am going to summarize this new tax bill for you in terms of incentives. Often laws are used to incentivize us to do (or not do) certain things and this law is no different. If you give a tax break for mortgages, more people will have them. The same will be true for llama farms or light trucks or…whatever.  My interpretation of the new law is that congress does not want you to:

 

  • Be an employee
  • Have more than about 400k of taxable income
  • Live in a “blue state” (high state and local taxes)
  • Own an expensive house
  • Get divorced

 

If you are a highly paid spine surgeon with a huge mortgage on your $3 million house in San Francisco you just got royally screwed by this tax bill. Sorry about that, but someone needed to take the bullet. But what congress is really telling you is you are working too hard! In California if you are making 700k a year, each additional dollar is exposed to 11.3% state tax, 37% federal tax, 1.45% Medicare tax for a grand total of 49.75%. If that is not incentive to cut back on hours and not work I don’t know what is – unless you love your job of course. Maybe you should move to Nevada.

 

Pain is an Excellent Teacher

Below 250k this bill really shines. It’s beautiful really. But as your income level increases so does the tax burden. Here are all the bad things that happen to you as you climb up the income levels (note: these numbers are for married filing jointly, the numbers are different for single and head of household status).

 

250k: This is when the additional 3.8% Medicare tax kicks in for investment income.

315k: The 32% marginal tax bracket starts (up from 24%).

400k: Child tax credit of 2k/year starts to phase out. 35% tax bracket starts.

440k: Child tax credit completely phased out.

479k: Capital gains rate goes from 15% to 20% (really 18.8 to 23.8 with Medicare tax)

600k: Marriage penalty kicks in. 37% tax bracket starts.

 

Here are a couple of good summary articles for you to read if you are interested. (Thanks to my buddy Physician on Fire for alerting me to that awesome Michael Kitces article!):

https://www.kitces.com/blog/final-gop-tax-plan-summary-tcja-2017-individual-tax-brackets-pass-through-strategies/

https://www.physicianonfire.com/tax-reform-physicians/

 

Additionally something super bad happens at 315k if you are not an employee, but instead a pass-through entity such as an LLC or S corporation (like if you are an independent contractor). Pass through entities get a 20% tax reduction, but because physicians are a “specified service” business, the 20% tax deduction starts phasing out, and is completely eliminated at 415k of taxable income. If you are a physician (or other pass through entity) making less than 315k of taxable income this is a massive tax savings and you should probably look into it.

 

Tax Code Sweet Spot

As I look at the charts and numbers, you are best served to get taxable income below 315k so you stay in the 24% tax bracket or at least under 400k if you have children to get the full child tax credit (and stay out of the 35% tax bracket). The easiest way to do this is to fully fund employee sponsored retirement plans such as a 401(k) and 403(b), health savings accounts and health insurance premiums, etc. It may also be a smart move to look into starting a cash balance plan to lower taxable income.

 

The average physician salary in 2017 was 316k for specialists and 217k for primary care. Averages are of course meaningless because there are some physicians making over a million and some less than 150k, but it is pretty easy for a 2 physician household (or any two high earning professions) to get above 500-600k. This is an obscene amount of money to most, but when combined with a very high cost of living area (San Francisco, Manhattan, etc.), having limited free time and being forced to outsource many parts of your life, having high state and local taxes, and now the inability to deduct most of them from federal taxes, at the end of the day it can feel like much less income that it is on paper.

The progressive nature of our tax code and the fact that most employers eat the costs of health insurance, malpractice insurance and other benefits, there is a non-linear relationship between salary and net value of total compensation packages amongst physicians.

 

 

What You Can do About It

  1. Move to a low tax state: The biggest reason high income physicians will see their taxes the same, or even a little worse is due to the severe reduction of SALT (state and local taxes) deductions. These are now limited to 10k. Let’s say you were paying 60k/yr in state income tax and 10k/yr in property tax. That 70k deduction is now down to 10k, or a loss of 60k in deductions. At the 37% marginal tax bracket that is worth about 22k. Poof. Gone. This offsets the lowering of tax brackets. Living in a state with no income tax is now more beneficial. High income physicians and other professionals in low income tax states will do better with this tax bill.
  2. Work less: It is obvious to me that congress doesn’t want high income employees to work, especially if you make a lot of money and live in a high tax state, and I’m happy to oblige. Obviously if you like work and it makes you happy, you should do it as much as you can because physicians are highly compensated for trading their time for money. But if you are burned out or want more free time in your life cutting back on work is a good option for many. I am not a big fan of working for 50 cents on the dollar.
  3. Start your own business: If you can turn yourself into a pass through entity and make less than 315k/year of taxable income you get a 20% reduction on your tax bill. Boom!
  4. Fully fund retirement accounts like your 401(k) or 403(b): You should already be doing this.
  5. Get a health savings account if you have a qualifying insurance plan: HSA is another great way to shelter a bit more money from the IRS.
  6. Downsize your house or rent: Probably more trouble than it’s worth, but may make sense for some individuals in some housing markets.
  7. Get divorced before December 31, 2018 so you can deduct your alimony payments (this is sarcasm, but seriously, this tax break arbitrage will end).
  8. Start watching news so you can be fully informed at all times (just kidding).

 

Summary

There is a lot of other stuff in the new tax code so reading the articles I linked above is probably a good idea. Most physicians will benefit from the new tax law. A few will not see much change, and a few will pay a little more.  Those with high SALT deductions will be hurt most. In the grand scheme of things none of this really matters all that much. A 1% change to your income shouldn’t matter or even be noticeable. If it is, you have bigger problems. Go figure out how to get a 1% raise or stop buying avocado toast and lattes.

 

The biggest impact on your financial life will actually be invisible and unmeasurable. Cutting the corporate tax rate is the meat of this bill. If this boosts corporate profits and increases the value of your investment portfolio, this may dwarf any small changes in the amount of federal income taxes you pay each year. We won’t be able to measure this because we don’t have a control universe without tax reform to compare it to (bummer).

 

Anyways, don’t lose too much sleep over it. Shelter what you can, work less if it will make you happier and go worry about more important things.


Did I miss anything super cool? What changes do you plan to make in 2018 and beyond due to changes in the tax code?

9 comments

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  1. Thanks for the overview in simple terms. It’s easy to get lost in the details, but you’ve outlined the key points and listed some actionable items.

    I do live in a high-income tax state, but under the old tax code, I was paying the AMT, anyway, so I never got to deduct those state income taxes, anyway. The biggest benefit I expect to see is from the child tax credit, which will be new to me (even though my oldest turns 10 next year) and dropping from the 33% to the 24% marginal tax bracket. I’ll also be taking the standard deduction after years of itemizing. I wish I had more time to go through the house and find stuff to donate before the end of the year, but we’re visiting family out of state until the 31st.

    Thank you for mentioning my post, and Merry Christmas and your Happy family!
    -PoF

    1. Sounds like we are in similar tax environments. Most of my tax savings will be from child tax credit, AMT going away and the 24% bracket as well.

  2. Great outline. I’ve weighed the pros/cons of moving to a LCOL area, the implications of finding a similar/better job, and ease of access to airports. It’s not an easy decision, as the more frequently you change jobs, the more frequently you and your family has to restart your lives. The toughest part is to figure out whether a financial gain would translate easier to a better quality of life.

    Merry Christmas!

    1. The ironic thing about physician jobs is that in the LCOL areas the salaries tend to be the highest. It’s crazy economics.

    • hatton1 on December 26, 2017 at 7:07 am
    • Reply

    I agree with you that the biggest benefit that I see is the lowering of the corporate tax to 11%. I think this will continue to fuel the stock market rally at least I hope so.

    1. This has been a pretty long bull market. I can’t imagine it going on much longer…but maybe this time is different 😉

    • Ryan on December 27, 2017 at 12:17 pm
    • Reply

    I was excited about the possibility of PSCs but have recently learned that “health” industry is excluded from these. What other private business or corporate loopholes are there for physicians?

  3. Thanks for your thoughts on this tough subject! The bill is a tough read, but you have written it in a digestible form. I think one other big benefit is that that AMT is likely to hit less high income earners and, even if it does, to less of an extent than it used to.

    With three kids, it’s going to be important to try and stay under that 400k number unless I am going to make well above that and make the loss of the child credit worth it. Saves me 6k in taxes (2k per kid).

    • DadsDollarsDebts on January 6, 2018 at 7:23 am
    • Reply

    How did I miss this article. Nicely said.

    As for me, my home burned and we are now renting with no plans to buy. When we buy we will downsize (problem solved). If we rebuild we will sell the new home.

    As for taxes, California does get screwed and I am not sure a work around on this one except to move elsewhere…we will see what happens. Not out of the possibilities in life.

    Otherwise, I doubt I will form a passthrough entity making that much money, but I have debated locums as a work around to my desire to have time off and travel with my family.

    So life will see. For now, I am trying to make the right moves with the insurance money to maximize my freedom going forward.

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