A surprising number of the more than 1,500 physicians with whom we work, including those in aesthetic specialties, attempt to reduce their tax burden and accumulate retirement wealth without considering the fundamental long-term strategy of tax diversification. This article explains the potential benefits of tax diversification and how to implement the strategy.
TAX DIVERSIFICATION DEFINED
With tax diversification, three “buckets” of wealth are built up: (1) assets subject to ordinary income tax rates upon distribution in retirement, (2) assets subject to capital gains tax rates, and (3) assets not subject to any tax upon distribution. Many aesthetic physicians have heard of asset class diversification in the context of investing, but it is also important to diversify your wealth according to tax rate exposure.
The Figure illustrates the value of having differently taxed buckets to draw from when you reach retirement. The retirement/wealth distribution phase may last for years or even decades. Diversification 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.
Figure. An illustration of tax diversification.
For the purposes of this discussion, we assumed a marginal top tax bracket in the Figure because many physicians will be in the top two or three tax brackets when they retire and the current rate of 37% is not close to an all-time high. We also assumed a 6.6% state income tax, although states such as California and New York have rates far exceeding this.
The benefit of being well diversified from a tax perspective is that, once in retirement, you can examine tax rates each year and pull from the appropriate bucket to maximize after-tax income. If, at the beginning of your retirement, income tax rates are high and capital gains taxes are relatively low, then it may be best to draw from the second (orange) bucket. If the opposite is true, the first (green) bucket may be targeted for overweight distributions, drawing greater amounts from the ordinary income tax bucket when rates are lower. The third (blue) bucket provides the highest level of flexibility because it can be accessed in any tax environment.
With an ideal retirement plan, you will have a significant percentage of your wealth in each bucket. In our experience, however, most physicians have too little wealth in the third bucket.
CASE STUDY
A hypothetical case study using Pamela, a fictional aesthetic plastic surgeon, and Gary, a fictional gastroenterologist, demonstrates the potential benefits of tax diversification. Pamela, Gary, and their spouses are all 45 years old and plan on retiring at age 65. Both couples currently have a joint life expectancy of 91 years. In other words, according to the actuaries, at least one spouse in each couple should live until age 91. With a planned retirement age of 65, the couples will have to rely on their assets and other sources of income (eg, social security) to provide them with income for 26 years.
Numerous financial, investment, and planning factors are essential to success in these scenarios, but this discussion focuses on the tax issue. Both couples will begin drawing down assets in 20 years and stop doing so in 46 years. During that period, tax rates may be different than they are today and may change several times.
Let’s assume that Pamela and Gary have the same overall net worth but that their asset mix is different. Pamela 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. Both individuals qualify for social security.
Pamela is much better positioned than Gary to maximize her after-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 will have 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, whereas Pamela can sell part of her brokerage accounts. Furthermore, it may be difficult for Gary to secure favorable loans against his home equity in retirement when he no longer has practice income.
Pamela 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.
Pamela is also in a much better position to alter her income plan if tax rates change during her retirement, whereas Gary lacks this flexibility. It is not difficult to understand that, despite their equal net worth, Pamela may net out significantly more after-tax retirement income than Gary. Because of tax diversification in her long-term planning, Pamela will be in a more secure position in her retirement.
LONG-TERM PLANNING REQUIRES FLEXIBILITY
Regardless of the planning tools employed 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. Though always important concepts, flexibility regarding taxes and tax diversification are especially relevant today when many physicians are seeking ways to minimize the negative impact of potential tax increases in 2023 and beyond.
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This article contains general information that is not suitable for everyone. Information obtained from third-party sources is believed to be reliable but not guaranteed. OJM makes no representation regarding the accuracy or completeness of information provided herein. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice. The information contained herein should not be construed as personalized legal or tax advice. There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circ*mstances. Tax law changes frequently, so information presented herein is subject to change without notice. You should seek professional tax and legal advice before implementing any strategy discussed herein.
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