PracticalDermatology

With many dermatologists concerned about possible tax increases during the current administration in Washington, it is a good time to re-visit the concept of tax diversification.

Before defining this term, consider the question: What tax rates will be in place during your retirement, which may last 10 to 30 years or more? Obviously, you do not know, even if you are already retired, and neither do we. Because nobody knows what the tax rates, rules on deductions, and other tax-related laws will be in the future, it is essential for holistic wealth management to include a tax diversification strategy.

Tax Diversification Defined

Tax diversification means building up wealth in three “buckets”:

1. Assets subject to ordinary income tax rates upon distribution in retirement

2. Assets subject to capital gains rates

3. Assets not subject to any tax upon distribution

While many physicians have heard of asset class diversification in the context of investing, we believe it is fundamental to direct additional attention to diversifying your wealth according to tax rate exposure.

The visual at right may help you to see the value of having differently taxed buckets to draw on when you reach retirement. As the retirement/wealth distribution phase may last for many years—or even multiple decades—being diversified across three tax buckets puts you in a position of strength and gives you options for withdrawing income depending on the tax rates then in effect.

In this diagram, we assume a marginal top tax bracket, since many physicians will be in the top two or three tax brackets in retirement, and the current rate of 37.6 percent is not close to an all-time high. We also assume a 6.6 percent state income tax, although many states have rates far exceeding this, such as California and New York.

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 but capital gains taxes are relatively low, then it may be best to draw from Bucket #2. If the opposite is true, Bucket #1 may be targeted for “overweight” distributions. Bucket #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 #3.

Case Study: Dermatologist Diane & Gastroenterologist Gary

Let’s look at the examples of dermatologist Diane and gastroenterologist Gary. Diane, Gary, and their spouses are all 45 years old and plan on retiring at age 65. At this point, both couples have a joint life expectancy of age 91, meaning that, according to the actuaries, at least one spouse in each couple should live until age 91. With a planned retirement age of 65, these couples will need to rely on their assets and other sources of income (for example, social security) to provide them with income for 26 years.

While numerous financial, investment and planning factors are essential for Diane and Gary, let’s concentrate on just the tax planning issue here. Both couples will begin drawing down assets in 20 years and stop doing so 46 years from now. During that period of time, tax rates may be very different than they are today and may change several times.

Let’s assume that Diane and Gary have the same overall net worth, but their asset mix is very different. Diane 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. Gary has nearly all his net worth in his home and 401(k) QRP. They both qualify for social security.

Diane is much better positioned than Gary to maximize her post-tax retirement income. Most of Gary’s retirement income will come from his QRP and social security, both of which are subject to ordinary federal and state income tax. If income tax rates are high, Gary 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 can’t sell only part of his home, like Diane 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.)

Diane, on the other hand, 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 completely tax-free.

Diane is much better positioned to alter her income plan if tax rates change during her retirement, while Gary does not have this flexibility. It is not difficult to understand that, despite their equal net worth, Diane may net out significantly more after-tax retirement income than Gary. Because of tax diversification in her long-term planning, Diane is in a more secure position in her retirement.

Long-Term Planning Requires Flexibility

Regardless of the planning tools a physician 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 with regard to taxes and the importance of tax diversification. While always an important concept, tax diversification is especially relevant today, as many dermatologists are seeking ways to minimize the negative impact of potential tax increases in 2021 and beyond.

The authors have recently completed Wealth Planning for the Modern Physician. To receive free print copies or ebook downloads of this book or Wealth Management Made Simple, text PRDERM to 844-418-1212, or visit www.ojmbookstore.com and enter promotional code PRDERM at checkout.

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This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized legal or tax advice, or as a recommendation of any particular security or strategy. There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circumstances. Tax law changes frequently, accordingly information presented herein is subject to change without notice. You should seek professional tax and legal advice before implementing any strategy discussed herein.