In the next two years there will be some significant tax changes you should anticipate. While there are too many to list here, I’ll highlight a few which are pertinent to physicians and some strategies you should consider to take advantage of them.
Income and Social Security Tax
Whether you call it a rollback of the 2001 tax cuts or a tax increase, it’s almost certain your income tax bracket is going up. As it stands now, in 2011 tax rates for all income tax brackets will revert to 2000 levels, when the top federal tax bracket was 39.6%. At that time the lowest current tax bracket (10%) did not exist so not only will you be in a higher tax bracket on the last dollar of your income but your first dollars of income will be taxed at higher rates. If you’re like me and your pay has stayed flat or declined over the past decade, there is some hope here. The federal income tax brackets are indexed for inflation, so that every year it takes progressively higher income levels to fall into the same tax bracket. At this rate with my pay staying flat, I might actually one day fall to a lower tax bracket! If you just can’t get enough of the ED and are itching to do more shifts, now may be a good time to stack up before income tax rates go up. With stock prices down to levels not seen in a decade, you’ll get a dual benefit: keep more of your income and buy more stocks at a 50% discount from the highs.
Similarly, Social Security taxes are also indexed for inflation, but for most physicians this hurts since our pay usually does not keep up with inflation. When I finished residency in 2001, the first $80,400 of income was included in calculating the Social Security tax, but in 2009 it’s the first $106,800. Basically I’m paying over $3,000 more dollars this year in Social Security tax than I was in 2001. Want more pain? There is no cap on the Medicare tax and there is preliminary talk about eliminating the cap on the Social Security tax as well. So let’s do some math: if you’re in the highest income tax bracket in 2011 and there is no cap on Medicare taxes and assuming a state income tax rate of 5%, your last dollar of income would be taxed at almost 48%. How do those extra shifts sound now?
The problem, as I see it, is that while EPs incomes may look “high” to outsiders, our income falls in a range where the tax brackets start going up rather quickly so that a significant portion of our income is taxed at the higher rates. Further, we usually don’t have too many large legitimate business tax deductions, and we can’t deduct all of the bad debt we are forced to inherit because of EMTALA. Throw in malpractice insurance premiums, student loans, and some personal expenses, and suddenly you start feeling a little insecure. It would be another story if we made millions, but with most EPs making between $175,000 and $250,000, the tax burden really has a big impact on us.
Let’s take an example of three EPs (one making $300k, another making $400k, and the third making $500k) to estimate the potential additional amount of federal income tax each might pay in two years. Let’s assume each one is married and has two minor children. In addition each one is an independent contractor and pays $30,000 in malpractice insurance premiums and has $10,000 in additional business related expenses (license fees, CME, etc.). Each EP also contributes the current maximum ($46,000) to a tax deferred retirement plan (SEP IRA, Keogh, etc.) and pays health insurance premiums for his family in the amount of $5,000. Each EP also just purchased a new house with a 30 year fixed mortgage loan of $500,000 at 5% interest. The property generates $5,000 in annual property taxes. For simplicity, I’ll assume all other assumptions stay the same (in reality there will probably be an increase in the SEP IRA contribution, an increase in the self employment tax, and other uncertain changes) between now and 2011. As you’ll see in next month’s column, each EP should be prepared to pay about 10% more in federal income tax starting in 2 years.
Capital Gains and Dividend Tax
Since 2003, the tax on qualified dividends dropped to 15% for people in high tax brackets, the lowest it’s ever been. Consequently, there was a flood of activity in dividend paying stocks and new mutual funds which targeted high dividend stocks. In 2011, this tax rate will end, and any dividends in taxable accounts will be taxed at your highest tax bracket—as much as 39.6%. Also, the tax on capital gains will be increased from the current 15% to 20%. With the depressed stock market, now may be a good time to switch out of high dividend paying stocks into ones which pay lower dividends. If you’ve been in the market for a long time and have capital gains (you’re probably thinking I’m crazy after last year’s annihilation), another strategy is to sell your current winners and pay the relatively lower capital gains rate now and “reset your basis.” This strategy is probably more effective for physicians who are closer to retirement. Further, if you own mutual funds in taxable accounts, look at the capital gains distributions they’ve been making over the years. If a mutual fund has been distributing more than a few percent in capital gains distributions, you may want to switch out of the fund into a more tax efficient investment.
Read more about how the tax man taketh – and how to keep him at bay – in next month’s issue.
Setu Mazumdar M.D. practices EM in Atlanta, GA and has passed the CFP® Certification Examination