Physicians’ Most Costly Missed Opportunity in Tax Saving

February 25, 2011

Generally speaking, physicians make good money while in practice. Many of them are in the top tax brackets. Upon retirement, however, their earned income often drops to zero. If they can defer some of their compensation to the future, they can effectively move money from the top tax brackets to lower tax brackets.

Read part one of Michael Zhuang's series on tax issues here.For more from Michael and his colleague, David DeJong, listen to this podcast on tax tips for physicians.

Generally speaking, physicians make good money while in practice. Many of them are in the top tax brackets. Upon retirement, however, their earned income often drops to zero. If they can defer some of their compensation to the future, they can effectively move money from the top tax brackets to lower tax brackets. 

Take a physician couple who made $400,000 in adjusted gross income (AGI), for example. Their federal income tax would come to be $110,000 using 2010 tax rates. If they could defer $150,000 until after retirement, their federal income tax would be reduced to $60,000, an immediate tax saving of $50,000.

Of course, the tax on the $150,000 is only deferred until the money is taken out. When that happens, the tax on it will be $30,000 assuming tax rates stay the same. So by deferring $150,000 in compensation, they would realize a net tax saving of $20,000. If tax-free growth and time value of money are taken into account, the benefit would be far more. And that’s for only one year of income deferral. (If tax rates were to rise, the benefit will be less.)

While talking to CPAs and tax attorneys in my network of specialists, the common refrain I heard is that physicians are forgoing much of the benefit by being careless about their retirement plans.

For physicians in a solo or small group practice who are in their 50s and who have younger staff, a defined benefit plan could potentially enable them to defer $150,000 into the future, more than three times the SEP IRA limit.

Physician principals in large practices tend to use off-the-shelf 401k plans peddled by insurance companies. These plans have two major shortcomings:

1. They don’t have age-weighting or cross-testing features that optimize the principal's tax saving; and
2. They have huge hidden costs. A survey by Deloitte has found the average all-in fees for a 401k plan with less than 100 participants is 2.03 percent. A “large” physician practice that has 20 employees is likely to pay far more than that. Whatever money the physicians save in taxes they pay in fees and then some.

What should a physician do? Get an expert second opinion on your retirement plan. You owe it to yourself. If you don’t know any experts, schedule a no-cost discovery meeting with me. I may not be the right one, but I can always point you in the right direction.

Michael Zhuang is the founder and principal of MZ Capital Management, a Washington, D.C.-based investment advisor firm, offering financial planning, investment advisory and wealth management services. You can e-mail him here.