While actively practicing, your number one or two cost category will be federal income taxes; maybe second only to staff costs as a category. In retirement, income tax could well be your number one expense without good planning.
Proactively arranging your affairs to mitigate or avoid taxes is perfectly legal and generally applauded in this country. But do draw a distinction between avoiding taxes and evading taxes—aside from the slightly different spelling and pronunciation—one will put money in your pocket and the other (evading) will put you in a federal facility for a few years.
Practice Integrated Income Tax Planning
Every practice is different as is each doctor. However, here are perhaps the most fruitful areas to consider in terms of managing and mitigating federal income taxes:
- Investing in your practice equipment and technology.
We have very generous expensing rules that were recently made permanent in the tax law. Plan the next five years of practice improvements and work with your team—which might include your equipment manager and IT expert, dental CPA, lender and perhaps office design specialist. Think about timing your investment and coordinating training to make the most out of new technology. Don’t be the doctor who makes knee-jerk purchasing decisions right before year-end—be deliberate. Think about the mission of your practice and increased productivity—then think about how the government will help you pay for it—not the other way around.
- Investing in your facility.
Likewise, investing in the facility from time to time is very influential on growth in the practice. Under current tax law, many improvements qualify for rapid write-off versus the default 39-year depreciation method. Cost segregation can further improve your deductions and can be applied retroactively to a prior remodel or build-out and garner you perhaps a very large deduction on this year’s tax return.
- Qualified retirement plans.
Do you have the right plan with the right features that maximizes your tax savings as opposed to staff costs? Have you explored adding your spouse to the plan? There are many different types of plans, and within these plans are different features that can be utilized to help optimize your funding. If you are running the same plan you had five years ago, you are probably missing out.
- Do you manufacture in your practice?
If you do, you can qualify for the 9% Domestic Production Activity Deduction (DPAD). This clearly applies to CAD/CAM activities such as CEREC and E4D, as well as making retainers and other appliances, and may well apply to other activities in the dental world including bonding braces.
- Getting the most out of things you already pay for.
You drive your car, you enjoy meals and perhaps certain entertainment activities. Perhaps you enjoy travel as well. These items can be deducted if there is a business element to the activity, it is documented, and certain other criteria are met depending on the activity. To keep more in your pocket, it is simply a matter of learning the rules and developing a simple method of creating and retaining the required documentation.
- Integrating your practice tax planning.
Integrate your practice tax planning into your overall tax planning process.
Planning for Your Investment Portfolio
Taxes often are the number one cost of investing and a cost sadly unquantified in your investment return. Here’s a question for you: Would you prefer to earn 10% or 8%? Most dentists could easily answer that—don’t you think? But consider this scenario: If you have a 10% return on an investment that generates ordinary income and you are in the 40% bracket—your after-tax return is just 6%. Compare that, for example, to the investment that generates a 9% return that is mostly appreciation and generates a small qualified or capital gain dividend taxed at 20%—perhaps leaving you with an after-tax return of say 8.6%. Now who is crazy and who is smart?
Managing Taxes in Your Portfolio: A Few Techniques
- The Right Funds: Choose passively managed funds that are tax efficient by their nature. For taxable accounts, utilize “tax-managed” funds where available.
- The Right Location: Determine your asset allocation (hopefully a result of documenting your goals and concerns and developing a comprehensive financial plan around them). Then place tax-inefficient assets, such as bonds, CD’s, commodities and real estate, in your tax-deferred accounts where taxable income is not an issue. Then place tax-efficient assets, like passively managed (ideally tax-managed) equity funds, in your taxable accounts. The accounts won’t look or act the same, but if you think of them together as a single portfolio you get the best of your well thought out allocation with a higher, perhaps significantly higher, after-tax return.
- Tax Loss Harvesting: This should be done throughout the year, anytime there is a loss position in a taxable account large enough to justify the activity. At a minimum, harvested losses will provide you a $3,000 per year deduction against your other income—saving several hundred dollars or more. Accumulating harvested losses through down markets comes in handy when you eventually take a gain; for example, when you sell your practice or in retirement as you eventually tap your appreciated portfolio.
- Minimizing Short-Term Gains: Avoiding short-term gain taxed at ordinary income rates is also very helpful to the cause. Just another reason to avoid actively managed funds or portfolios.
- Specific Lot Identification: Eventually, if not from time to time, you will need to tap your appreciated equities. By taking the time and trouble to establish specific lot identification, you can pick and choose the lots that result in the best outcome tax-wise. For example, you might be able to generate a loss by specific lot even though the overall position carries a gain.
- Managing Tax-Qualified Distributions: Sooner or later, you will need to tap into your tax-deferred retirement accumulations. There is a lot of strategy that can be brought to bear on retirement income taxation. For example, during early retirement, you may find yourself in a very low tax bracket prior to age 70. These low, or in some cases zero percent tax brackets, could mop up some taxable IRA funds or Roth conversions. This could lower future tax rates that may begin to climb significantly once required minimum distributions take effect at age 70 ½ and social security benefits are claimed (not later than age 70).
The Only Return that Counts
The only return that counts, whether we are talking about the hard-earned profits of your dental practice or the return on your investment portfolio, is the return after tax. Yes, it takes a little knowledge and a little effort to arrange your affairs to optimize your after-tax returns—but given the level of taxation we have —the return on investment is strong. Keeping more of your hard-earned money in your pocket and out of the hands of the government, along with a strong cup of French roast is what gets me out of bed in the morning. How about you?
Written by Sam Martin, MBA (tax), CFP®, CPA
Sam Martin is Director of Wealth Management Services and Advanced Tax Planning for the Dental Group, LLC / Martin Boyle PLLC / Dental Wealth Advisors, LLC, a CPA, practice advisory, financial planning and wealth management services group exclusively serving dentists and their practices. Sam is a Certified Public Accountant (CPA), a Certified Financial Planner (CFP), and holds a master’s degree in federal income taxation. Located in Kirkland, Washington, Sam can be reached at 425.216.1612 or Sam@cpa4dds.com.
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