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Investment strategies for the impending tax law changes
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As of this writing, our federal government has committed over $11 trillion in bailouts designed to help the U.S. economy. Some commentators have argued that this dramatic infusion of liquidity has saved our economy from a freefall into a financial abyss. Of the bailout funds announced so far, only about $3 trillion has been spent. Reasonable persons will recognize that this money has to come from somewhere; here we examine some facts about the tax obligations of higher-income Americans and corporations, to see how much of this burden will fall on doctors and similar earning taxpayers.
According to the Internal Revenue Service (IRS), over 140 million tax returns were filed in 2009; 70 million of these taxpayers pay over 97% of the total income tax in the United States. This means that the above bailouts will cost each taxpayer (of the 70 million who pay taxes) an average of $157,143.
According to www.taxfoundation.org, the tax burden of the top 1% of earners exceeds that of the bottom 95% of earners. Most physicians can expect to be in the top 1% if their adjusted gross income is over $410,000, and in the top 5% if their income is over $160,000, according to 2007 data. If tax changes that benefit the wealthy are not enacted, the top 5% of U.S. taxpayers (1.4 million people) will be expected to pay 60.63% of this bailout, or an average of $952,757 per taxpayer. These numbers are not alarmist propaganda; they are easily authenticated by any interested party by using readily available government data.
Corporations to the rescue?
In 2009, Exxon reported $45 billion in profits, and the company commented that it had $0 U.S. income tax liability. During the same time period, General Electric filed more than 7,000 tax returns in various jurisdictions, with a declared global profit of $10.8 billion, and a net U.S. income tax liability of $0. The financial collapse and need for bailouts has not affected the executive incomes at top U.S. financial institutions either; Citigroup’s CEO, John Havens, received total compensation of $11,276,454, even while his company had to rely on $5 billion of government bailout funds. Because of the close nexus between the government and big business, it is unlikely that the latter will step up to pay for the bailouts that were supposedly necessary to save them in the first place.
According to the Tax Foundation, the average adjusted gross income of a member of the top 0.1% of taxpayers is $7.4 million. To claim a seat in this rarefied group of high-income earners, one needs a minimum income of $2,155,365 per year. In comparison, the top 1% of taxpayers, as a group, has an average adjusted gross income of between $410,000 and $2.155 million.
The tax distribution between the above two groups is uneven; the top 1% of earners pay an average income tax rate of 22.56%, while the top 0.1% pay a lower average tax rate of 21.46%. In other words, the group with income between $410,000 and $2.1 million pays more tax as a percentage of income than the group with average income of $7.4 million. Better advice, resources, careful tax, retirement and investment planning probably account for this difference.
The source of additional tax revenue
Legislation has been passed to mandate a Medicare surtax of 3.8% on all investment income for taxpayers who earn more than $250,000. The cost of this tax increase is going to vary based on the amount of investment income you have. If you consider that long-term gains on investments currently are only 15%, this tax represents an increase of 25.3%. There could also be a tax rate increase on capital gains and dividends that could be as high as 33% of the existing tax rate, from 15% to 20%.
These two taxes could represent an increase in taxes on investments of over 58%. The dollar impact of this increase will depend on the value of one’s appreciated assets and income-producing assets, such as real estate, equipment, etc. In the case of surgeons who utilize smart asset protection strategies and separate assets from the operating practice, this tax may not be overly painful.
The Medicare tax on investments is in addition to the Medicare tax rate hike from 2.9% to 3.8%. This is on all earnings above $250,000 for taxpayers filing jointly. In addition, Social Security is a 12.4% tax for the self-employed, but has been applied only to the first $106,800 of income. What would happen if Congress successfully legislates away all benefits of S-Corporations and every dollar of income is subject to the new 3.8% Medicare tax? What happens if Social Security is no longer limited to the first $106,800 and it picks up again on all income over $250,000?
The answer is that for doctors making $500,000 to $1,000,000 per year, this could represent up to $110,000 of additional taxes. The Medicare payment increase alone for a $1,000,000-earner who currently takes half of his income in salary and half in S-distribution could be as high as $23,500 per year.
U.S. taxpayers could possibly see an increase in the highest marginal income tax rate back to 39.6%, from the current rate of 35%. For a professional earning $600,000, this could cost another $9,200. Also, the estate tax repeal that was enacted under President Bush is going to expire on December 31, 2010. This means that, unless one dies this year, the large estate taxes — up to 55% or so — are back on the table.
In light of the above changes that could affect your tax liability and financial position some suggestions are offered below:
Pay what you can now
If one assumes that tax rates are going to increase substantially to pay for the bailouts and other social programs that are on the public agenda, then it makes sense to move funds from taxable environments into tax-free environments. Examples of ways to accomplish this goal include:
- If you have the liquid cash available to pay the tax, convert all IRAs to Roth IRAs in 2010.
- If you have property with capital gains, especially those that are the result of a number of 1031 tax-free exchanges, sell it and pay the taxes now.
- If you have appreciated stock of public or private companies, explore ways to sell so you can pay taxes now, and
- Increase the amount of money you invest into tax-free vehicles like cash value life insurance. Under the current tax regime, the benefits of tax-saving outweigh the costs of the insurance. In a higher tax environment, the benefits will only be enhanced.
Pay no more than necessary
On items that must pay tax at some point, it may be prudent to pay tax now and get it out of the way. As for future income, one should plan to maximize tax deductions in any way possible. If Congress passes the bill to eliminate all benefits of S-Corporations, one strategy is to take advantage of all the benefits C-Corporations offer including:
- 100% deductible health insurance expenses (individuals cannot deduct health related expenses until they exceed 7.5% of AGI – another bill suggests this be raised to 10% of AGI- unless the individual is eligible to take a self-employed health insurance deduction). For a doctor earning $600,000, the first $45,000 to $60,000 of health expenses are not deductible individually, but are 100% deductible through a C- Corporation.
- Long-term care insurance is treated like health insurance. While you are in your key earning years, you can pay these premiums for a limited time (eg, 10 years), get a full income tax deduction while doing so, and pay 0% tax on benefits if and when you and your spouse need them. The deductible amounts for long-term care insurance are low for individuals.
- Take what the government gives you with life insurance. There are ways for a C-Corporation to tax-efficiently purchase life insurance. The attraction is in getting a partial deduction for putting money into a vehicle that grows tax free, allows you access to the funds in the policy tax free and provides some protection for your family, and
- Utilize larger and more powerful transactions, just as the very high earners do in order to pay fewer taxes. Some tax strategies exist that allow successful professionals to take annual deductions that can be substantial. A comprehensive discussion of advanced tools is beyond the scope of this article; feel free to contact the authors if this is of interest to you.
Not knowing exactly where the tax increases will fall should not discourage surgeons from planning their financial strategy. It is reasonably clear that tax rates are going to increase. They are going to increase in various ways we can anticipate and probably in ways that we cannot foresee. There is probably little downside in thinking about these issues that can affect income profoundly, and coming up with a sound financial strategy.
Christopher Jarvis, MBA, and Carole Foos, CPA, are accountants and financial consultants with the OJM Group. They can be reached at 877-656-4362 and www.ojmgroup.com.
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