Tax diversification: Financial fundamental that proves to be even more important in 2025
Orthopedists, like all physicians, typically have tax reduction and long-term wealth accumulation at the top of their financial objectives.
The strategy of tax diversification is valuable to achieve both goals and is a concept that Carole C. Foos, CPA, and David B. Mandell, JD, MBA, have presented for more than 20 years to doctors across the United States. In early 2025, we want to revisit this tactic and highlight its importance for physicians and other high-income earners. Because Republicans control the White House and Congress and many have outlined proposals for tax reform, we can expect some changes in tax rules but do not know exactly what the legislative process will bring.
Regardless, the value of tax diversification is that it can — and should — be implemented in any tax environment, whether income and capital gains rates increase, decrease or remain at their current lower levels. Tax diversification can play an integral role in long-term planning in each of these environments.
Tax diversification defined
Tax diversification means building up wealth in the following three “buckets,” which are assets subject to ordinary income tax rates upon distribution in retirement, assets subject to capital gains tax rates and assets not subject to any tax upon distribution. While many physicians have heard of asset class diversification in the context of investing, it is important to direct additional attention to diversifying ones wealth according to tax rate exposure.
The figures may help show the value of having different tax buckets to draw from during retirement. As the retirement/wealth distribution phase may last for many years, or even multiple decades, being diversified across three tax buckets strengthens one’s position and provides options for withdrawing income depending on the tax rates in effect.
In these figures, we assume a marginal top tax bracket because many physicians will be in the top two or three tax brackets in retirement and the current rate of 37% is not close to an all-time high. We also assume a 6.6% state income tax, although many states, such as California and New York, have rates that far exceed this.
The benefit of being well-diversified from a tax perspective is that once in retirement, one can examine tax rates each year and pull from the appropriate bucket to maximize after-tax income. If, at the beginning of a physician’s retirement, income tax rates are high and capital gains taxes are relatively low, then it may be best to draw from bucket number two (Figure 2). If the opposite is true, bucket number one (Figure 1) may be targeted for “overweight” distributions. Bucket number three (Figure 3) provides the highest level of flexibility, as it can be accessed in any tax environment. An ideal retirement plan calls for physicians to have a significant percentage of their wealth in each bucket. Yet, in our experience, most physicians have too little wealth in bucket number three.
Case study
In an example of orthopedists Olivia and Oscar, the two physicians and their spouses are all aged 45 years and plan to retire at age 65 years. At this point, both couples have a joint life expectancy of 91 years, meaning that, according to the actuaries, at least one spouse in each couple should live until age 91 years. With a planned retirement age of 65 years, these couples will need to rely on their assets and other sources of income (eg, social security) to provide them with income for 26 years.
While numerous financial, investment and planning factors are essential for Olivia and Oscar, let us concentrate on the tax issue here. Both couples will begin drawing down assets in 20 years and stop doing so 46 years from now. During that period, tax rates may differ from today and change several times.
Let us assume that Olivia and Oscar have the same overall net worth, but their asset mix is different. Olivia has her net worth in all three buckets — some in a qualified retirement plan (QRP), some in after-tax brokerage accounts and real estate, and some in a Roth IRA and a permanent life insurance policy. Oscar has nearly all his net worth in his home and 401(k) QRP. They both qualify for social security.
Olivia is better positioned than Oscar to maximize her post-tax retirement income. Most of Oscar’s retirement income will come from his QRP and social security, both of which are subject to ordinary federal and state income taxes. If income tax rates are high, Oscar has little flexibility to take income from other sources unless he is willing to sell his home, which he may be reluctant to do. (Also, he cannot sell only part of his home, like Olivia can do with her brokerage accounts, and it may be difficult for him to get favorable loans against his home equity in retirement when he will have no income.)
On the other hand, Olivia is well positioned if income tax rates are high. She can draw down her brokerage account if capital gains taxes have remained lower than income taxes. Moreover, she can take income from her Roth IRA or access life insurance cash values, both of which are completely tax free.
Olivia is better positioned to alter her income plan if tax rates change during retirement, while Oscar does not have this flexibility. It is not difficult to understand that, despite their equal net worth, Olivia may net out significantly more after-tax retirement income than Oscar. Because of tax diversification in her long-term planning, Olivia is in a more secure position in retirement.
Flexibility in long-term planning
Regardless of the planning tools an orthopedist employs to save for retirement, one of the fundamental pillars of any retirement plan should be flexibility to withstand changes in tax rates, income, market performance and personal health.
Here, we focused only on flexibility regarding taxes and the importance of tax diversification. While always an important concept, tax diversification is especially relevant today, as many physicians are seeking ways to minimize the negative impact of potential tax increases in 2025 and beyond.
- Reference:
- Mandell and OJM Group partners are pleased to announce the 2024 publication of our newest book, Wealth Strategies for Today’s Physician: A Multi-Media Playbook. The playbook’s innovative format features more than 90 links to videos and podcast episodes to enhance important financial topics for physicians. To receive a free print copy or ebook download, text HEALIO to 844-418-1212, or visit www.ojmbookstore.com and enter code HEALIO at checkout.
- For more information:
- Sanjeev Bhatia, MD, is an orthopedic sports medicine surgeon practicing at Northwestern Medicine in Warrenville, Illinois. He can be reached at sanjeevbhatia1@gmail.com or @DrBhatiaOrtho.
- David B. Mandell, JD, MBA, is an attorney and founder of the wealth management firm OJM Group, where Carole C. Foos, CPA, is a partner and tax consultant. They can be reached at 877-656-4362 or mandell@ojmgroup.com.
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