What Physicians Need to Know About the Current State of Tax Reform

March 11, 2022

4 minute read


Disclosures: Foos does not report any relevant financial information.

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Passage of the Build Back Better Act by the Senate has been shelved. But it makes sense that high-income earners and those with large retirement account balances understand the provisions of the version of the bill passed by the U.S. House of Representatives in November 2021.

Provisions in the version of the bill passed by the House would limit the ability of some taxpayers to make Roth IRA conversions. It would also limit employer plan rollovers from after-tax accounts to Roth accounts, the so-called “mega backdoor Roths.” If these provisions were to remain in a version of the bill passed by the Senate, high-income taxpayers would have to look elsewhere for ways to fill their bucket of tax-free assets.

Source: Carole C. Foos, CPA

Tax diversification

The concept of tax diversification is important for high net worth individuals. Many physicians have placed a high concentration of retirement assets in their qualified retirement plans – both defined contribution plans (401k and 403b) and defined benefit plans such as cash balance plans. While these plans have provided a deductible contribution during the physician’s working years as well as tax-deferred growth, distributions from traditional qualified pension plans will be taxed at ordinary tax rates when the physician withdraws funds from the plans at retirement. Nobody knows what the future ordinary income tax rates will be. What we do know is that many retired physicians often remain in a higher tax bracket upon retirement, so distributions from qualifying plans may be subject to high ordinary income tax rates.

For this reason, it makes sense to also have assets that will be subject to lower long-term capital gains rates and some that will be tax exempt. Having assets in each of these compartments can serve as a tax hedge in years when tax rates are higher. One way to add assets to the tax-free bucket was the backdoor Roth conversion, which allowed doctors and their spouses to make non-deductible contributions to a traditional IRA each year and then convert the traditional IRA balance to a Roth IRA in a tax plan. free conversion. Even if the taxpayer had other existing IRA assets that had not been taxed, a prorated portion of the conversion was exempt from tax.

Home version

The House version of the Build Back Better (BBB) ​​Act would eliminate backdoor Roth contributions beginning January 1, 2022, for single taxpayers with modified AGI (MAGI) over $400,000 and joint filers with MAGI over $450,000. The threshold for heads of household would be $425,000. Transfers in the plan from after-tax accounts to Roth accounts would also be eliminated for these taxpayers. In addition, beginning in 2029, taxpayers whose combined IRA and defined contribution plan balances exceed $10 million would no longer be allowed to make further IRA contributions. Some contributions would still be allowed, such as SEP and SIMPLE contributions and rollovers from qualifying plans as well as assets received as a beneficiary or as part of a divorce or separation agreement. People whose combined IRA and defined contribution account balances exceed the $10 million limit should distribute the excess amount as a required minimum distribution, even if they are under age 72.

If the Senate passes a similar version of the BBB Act, high-income taxpayers will have to find other ways to fill their tax-free income basket to hedge against future tax rate increases. One of these options will be permanent life insurance policies to supplement traditional retirement income. Permanent (or cash value) life insurance policies come in many shapes and sizes. A well-designed policy can provide tax-free retirement income to physicians.

Life insurance with cash value

Using a permanent life insurance policy to supplement retirement income involves paying premiums with after-tax dollars. These premium payments serve two purposes: to cover the cost of the policy’s death benefit and to increase the cash value of the policy. The cash value of the contract can be invested in different types of investments, depending on the type of product. A popular product is investing cash value in index options, such as the S&P 500 stock index. Typically, investment options will include a floor so that if the index falls below the floor, the rate credited remains at the bottom (0% or even 1% or 2%). They also usually contain a cap. To the extent that the index exceeds the cap, only the amount up to the cap will be credited.

After letting the cash value grow for a number of years, the policy owner can borrow against the cash value to supplement their retirement income. Such a withdrawal, being a loan, is tax free as long as certain rules are followed and the policy is not a modified capitalization contract. On the death of the owner, policy loans will be repaid, reducing the death benefit payable to policy beneficiaries. Life insurance policies intended to provide supplemental retirement income should have contractually low interest rates on borrowed funds.

Next steps

While passage of a Senate version of the BBB Act remains to be seen, exploring options for increasing tax-free retirement income makes sense for those of you who think tax rates in the future might be higher than current rates. Physicians concerned about their continued ability to contribute to a tax-free retirement income vehicle should consider a permanent life insurance policy. When considering this option, make sure the policy is underwritten by a reputable life insurance company, the interest rate is low, and the cost of insurance is reasonable. A trusted advisor who compares and contrasts various insurance policies and companies can help in this endeavor.

For more information:

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Carole C. Foos, CPA, is a tax consultant and partner of the wealth management firm OJM Group www.ojmgroup.com. You should seek professional tax and legal advice before implementing any strategy described here. Foos can be reached at [email protected] or 877-656-4362.

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