3 Reasons You Should Pay More Taxes

Welcome to tax season!

Suppose you are a married physician and your taxable income is $250,000. You’ll pay about $60,000 in federal income tax + $12,000 in state income tax (assuming 5% rate) + $10,000 in Social Security/Medicare taxes (if you are an employee, more if you are an independent contractor) for a total of $82,000. As your income rises not only do you pay more of most of those taxes, but you might get whacked with other taxes also, such as the net investment income tax, an extra Medicare tax, and a higher capital gains tax....and don’t forget your property taxes! How’s that for not paying your “fair share”!

As much as I hate to say this, sometimes it’s actually in your best interests to pay more taxes. Here are 3 reasons why you might want to up your already lofty tax bill:

Reason #1: Selling Individual Stocks for Gains

One of the best ways to build wealth is to own a broadly diversified investment portfolio of mutual funds across multiple investment classes, yet I continue to meet physicians who own just a handful of individual stocks. In the past few years those stocks probably have gains as the global stock market has performed well. If you own these stocks in a taxable account, you face a dilemma: do you sell, pay the capital gains tax now, and diversify, or do you hold on to them?

The answer is painful but simple. You need to hold hundreds or thousands of individual stocks for effective diversification. Owning just a handful is usually much riskier, and when the risk shows up on the downside, you’ll get pummeled with hefty losses. Those losses can easily exceed the extra tax bill for selling them now.

For example let’s say you bought a stock in a taxable account for $10,000, hit a home run, and a few years later it’s worth $50,000 for a total long term gain of $40,000. If you sell then you’ll likely pay somewhere between $8,000 to $12,000 in capital gains tax for a net after-tax gain of between $28,000 to $32,000. On the other hand you risk losing all $50,000 if the company goes belly up or losing far more than the tax you would pay if the stock drops.

Sell now and move on. Plus, even if you picked some winning stocks, you’re really just gambling with your money and it’s likely just luck.

Reason #2: Skipping High-cost Insurance Policies

Many financial advisors love selling permanent life insurance policies to doctors. The sales pitch goes something like this:

“Wouldn’t it be great to stuff as much money as you can in a tax-free investment vehicle instead of a taxable account and pay no tax when you withdraw the money?”

Pretty tempting isn’t it? You may even start salivating like a rabid dog as you daydream over the buckets of money you would save by not paying any taxes on the investment gains.

Wait a minute. Here’s a particularly egregious example of a physician I met who fell for that sales pitch. This physician is in his 50s and bought a whole life insurance policy 5 years ago as a way to invest his money. The whole life policy “guaranteed” an annual rate of return of a few percent per year. In a whole life policy you build up a cash value which can be used as an investment vehicle.

The physician pumped $50,000 dollars annually into the whole life policy for the past 5 years for a total outlay of $250,000. What is the cash value today? About $125,000. That’s right — a 50% loss in the first few years. It gets worse. Had he invested that money over the past 5 years in a taxable account and gotten a measly 5% annual after tax rate of return, then his investment would have grown to about $275,000. So his actual loss was $150,000. The problem with many whole life insurance policies is that the fees are so high that the breakeven point on the cash value is many years down the road. I’d rather just pay taxes along the way and skip the tax-free investment.

Reason #3: Saving More Money

This might sound a little odd but if you need to save more money into your retirement portfolio you might have to pay more taxes to do so. If you are already maxing out your tax-deferred accounts, such as your employer-sponsored 401k, a SEP IRA, or an individual 401k account, then you should strongly consider investing additional dollars in a taxable account. You’ll be taxed on dividends annually but you’ll most likely pay a 15% federal dividend tax rate on qualified dividends. That’s more palatable than the regular income tax rates on your income. Plus, if you sell an investment in a taxable account, you pay tax only on the gain and not the initial investment.

If you are in the later part of your medical career and you’re behind on your savings, another option is to work more for the next few years and generate more taxable income so that you can save more money into your investment portfolio. Of course this will subject you to more income taxes and might even push you into a higher income tax bracket, but that might be the only option you have if you want to build up your investment portfolio more quickly. For example let’s say you are married and your taxable income is exactly $226,850. That’s the threshold for the 28% federal income tax bracket. If you absolutely cannot cut any expenses and you want to save more money, you’ve got to generate more income. Let’s say you work just one extra day per month and make $1,600 per month gross income for a total of about $20,000 more taxable income over the next year. Because you’ve already “maxed out” the 28% federal tax bracket, that next $20,000 will be taxed at 33% or $6,600 — that’s about $1,000 more in federal taxes than if the extra income were taxed at the 28% rate. But there’s a huge benefit for you to work more and pay the tax. You can now invest an additional $10,000 to $13,000 annually (remember you have to factor in state income tax and Medicare taxes) and shore up your investment portfolio. If you did that for just 5 years and generated a 5% after tax return, you’d have an additional $55,000 in your investment portfolio.

Now go and pay your fair share!

Setu Mazumdar, MD, CFP® is board certified in EM and he is the president of Physician Wealth Solutions.