With less than 2 months left in 2022 and the busy holiday season coming up quickly, it'll be New Year's Day before you know it. Planning now with your tax professional can help reduce your tax bite in 2022 or put you in a better tax position in the long run. Here are several strategies to consider before year-end.
1. Max Out the Deferral Contribution to Your Employer's Retirement Plan
The first step is to review your pay stub to ensure you max out the deferral to your employer's 401(k) or 403(b) retirement plan. The maximum is $20,500, and for those age 50 or older, the max is $27,000 in 2022. Taking lower than the maximum deferral may have seemed like the proper course at a younger age, when you had student debts or a new mortgage. If that's no longer the case, it's best to increase your deferral to the maximum allowed to save on taxes and build the assets you'll need to retire.
While revisiting your deferral amount, consider making a Roth deferral — which many retirement plans now allow. This Roth money will allow your withdrawals in retirement to be tax-free. Although this strategy doesn't make sense for mid-to-late career physicians in higher tax brackets, we usually recommend Roth deferrals to clients under 40 as they have a long window for their retirement money to compound and grow.
2. Strategies for 1099 Independent Contractors
A solo 401(k) is often the best option for 1099 earners, whether these earnings are their sole income source or in addition to their W-2 income.
For example, we have a 50-year-old client who has retired from her medical practice and still earns $100,000 per year in 1099 income from consulting. In this case, she wears two hats: employee and employer. Anyone age 50 or older can contribute as much as $67,500 to a solo 401(k) in 2022. Note that you must establish a solo 401(k) by December 31 of this year if you plan to make contributions for the 2022 tax year.
My client could choose from among several mega backdoor Roth tax strategies, which will be covered in more depth below.
She could choose a $27,000 pre-tax or Roth elective deferral, plus $18,587 (20% of net income) in profit-sharing contributions. A mega backdoor Roth 401(k) would allow her to contribute an additional $21,913 after-tax, which can then be converted to the plan's Roth 401(k) bucket. No tax will be due on this Roth conversion.
A second option is to contribute $27,000 as a Roth deferral, and instead of making a profit-sharing contribution, which is always pre-tax, the client could make $40,500 of after-tax contributions. The after-tax money can be converted into the Roth 401(k), resulting in all $67,500 going into the Roth bucket.
Cash Balance Plan
A one-person cash balance plan (CBP) can be opened as late as September 15, 2023, for the 2022 tax year. The contribution amount varies by age and the amount of 1099 income. For example, a 55-year-old physician with a net income of $75,000 might be able to contribute $80,000 or $90,000 pre-tax into a CBP. At higher incomes and more advanced ages, the amount going into a CBP can be over $200,000 per year.
One thing to keep in mind when opening a cash balance plan is that the IRS will probably disqualify the deduction if it doesn't view it as a way to fund your retirement, but rather a one-time attempt to lower your tax bill in a year when you had a spike in income. Another consideration is that CBPs are expensive to open and administer — roughly $1500-$2000 per year.
In some circumstances, it makes sense to combine a 401(k) and CBP to defer even more money, in which case the annual cost will be nominally higher.
3. Strategies for W-2 Employee With Supplemental 1099 Income
Although we see some physicians who receive all their income as 1099 independent contractors, it's more common for us to have clients who are W-2 employees in their clinical practice and have 1099 income from a side gig.
Regular 401(k) and Solo 401(k)
A physician age 50 or older can defer $27,000 in their employer's 401(k) plan. Assuming the same $100,000 of 1099 income as above, $61,000 can be contributed into the solo 401(k). This is a combination of a profit-sharing contribution and after-tax contributions, which is immediately converted to Roth.
4. Mega Backdoor Roth 401(k) for Group Practices
The mega backdoor Roth 401(k), a permutation of the solo 401(k), can be a powerful strategy for group practices. If you're a partner in a small practice, you and your colleagues control the plan document that governs the retirement plan. Allowing for after-tax contributions and in-plan Roth conversions, or in-service withdrawals, rolling your after-tax contribution into a Roth IRA, you can build a large Roth bucket during your years of practice.
Physicians who are employed by large hospitals and health systems rarely have these plan provisions available, but it's always a good idea to check because in the rare instance that these provisions are present, the mega backdoor Roth 401(k) is a great planning vehicle.
5. Deferred Compensation 457(b) Retirement Plan
In addition to the 401(k) or 403(b) plan, some nonprofit employers offer a 457 deferred compensation retirement plan, which allows you to defer an additional $20,500 pre-tax. If you work for a governmental institution, the 457 is not subject to creditors. However, money that an employee defers to a non-governmental hospital or health plan is subject to the creditors of your hospital or health system if they go bankrupt. In this case, consider the financial health of your employer before deferring your money to the 457.
6. Backdoor Roth IRA
In a backdoor Roth IRA, you make a nondeductible IRA contribution and then do a Roth conversion, avoiding the income limits on direct Roth IRA contributions. If you have a traditional IRA, this will usually negate the benefit of the backdoor Roth IRA strategy because the conversion will not be fully tax-free. An option for those with a traditional IRA is to roll their IRA to their employer retirement plan, opening the way for annual backdoor Roth IRA funding. Something else to consider is that spouses — gainfully employed or not — are eligible to fund a backdoor Roth IRA, giving a couple a combined contribution of somewhere between $12,000 and $14,000 annually, depending on whether one or both are age 50 or older.
7. Health Savings Account (HSA)
If a high-deductible health plan suits your situation, consider enrolling and fully funding an HSA. In 2022, the maximum contribution into an HSA is $3650 for individuals and $7300 for family plans, with an additional $1000 allowed for those age 55 or older. The benefit is that money you defer to the HSA is tax-free, and you can withdraw it tax-free for qualified medical expenses. We recommend to our clients that they not spend from their HSA account so that it grows and becomes an ideal vehicle to pay for health expenses in retirement.
8. Roth Conversions
Roth conversions are usually best for late-career practitioners whose incomes have decreased significantly, or those who are retired and have no earned income. Given the significant market declines in 2022, this could be an auspicious year for Roth conversions.
Earlier-stage physicians are often poor candidates for Roth conversions because converting from a traditional IRA to a Roth IRA counts as income. Consider that if someone earning $350,000 does a $100,000 Roth conversion, they will pay taxes as if they had earned $450,000, pushing them from the 32% marginal federal tax bracket to the 35% bracket.
9. Tax-Smart Charitable Giving With a Donor-Advised Fund (DAF)
The tax benefit for charitable giving has changed. The Tax Cuts and Jobs Act (TCJA) of 2017 doubled the standard deduction ($12,950 for individuals and $25,900 for couples). As a result, many physicians who formerly itemized deductions no longer have the opportunity to deduct charitable gifts, except for up to a $600 deduction on their federal income taxes.
Opening a DAF can remedy this situation. For this scenario, fund your DAF with more than the standard deduction. For instance, instead of giving $10,000 a year in charitable contributions 5 years in a row, fund your DAF with $50,000 in the first year. Your annual charitable donations can then be made from this account. This provides a $50,000 deduction on top of your miscellaneous deductions such as from state taxes, local taxes, and mortgage interest in the first year. In subsequent years, you will take the standard deduction rather than itemizing.
A related tax savings strategy is to fund your DAF with appreciated assets. For instance, if you have a stock worth $50,000 that you purchased for $10,000, consider using that stock as your contribution to the DAF to avoid capital gains taxes, usually 20%. Instead of owing $8000 on the $40,000 gain, donating the $50,000 of stock lets you entirely avoid the capital gains tax.
10. Qualified Charitable Distributions (QCDs)
A DAF is a great vehicle we strongly recommend for charitably inclined clients under 70.5 years old. Beyond that age, the best charitable gifting method is to take advantage of QCDs) and gift directly from your IRA accounts to charities.
At 72, the QCD can act as a tax-free portion of the required minimum distributions from retirement accounts. In other words, if a 72-year-old with a required minimum distribution of $80,000 chooses to give $20,000 to charities via QCD, only $60,000 of the required minimum distribution will count as taxable income.
Strategies like these can go a long way to reducing taxes while properly positioning money to draw from in retirement.
Whether you're a young doctor or are approaching retirement, there are creative ways to reduce your tax bill and thereby save more to fund retirement. Remember that whatever strategy you're considering, always consult with your tax professional on the specific rules and benefits of the various scenarios available to you.
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Cite this: Joel S. Greenwald. 10 Best End-of-Year Tax Strategies - Medscape - Nov 04, 2022.