by John K. McGill, JD, CPA, MBA, and K. Warren Poe Jr., CFP®
By now, most doctors have noticed the increasingly positive headlines regarding the recent successes of the stock market. Every day more market pundits find this an ideal time to make their future claim -- either that stocks have reached a market peak, or that this is the beginning of a new stock market breakout. Regardless of which outlook doctors believe, it is very important that they take the appropriate amount of risk given their own unique financial circumstances.
Unfortunately, most doctors tend to underestimate risk when the markets are booming and overestimate risk when the markets are sinking. During the U.S. stock market's 2007 high to its 2009 low, investors who were 100% allocated to stocks lost about half their portfolio value from top to bottom. During that same period, a balanced portfolio of equally weighted stocks and bonds lost only about 22%. Nearly retired dentists who had aggressively invested portfolios at the beginning of 2007 have many horror stories to tell. Many of these doctors had to either reduce their lifestyle or postpone their retirement dreams. While doctors cannot avoid losses altogether, they can definitely allocate their portfolios to cushion the fall.
Like a broken tooth, risk tolerance has a lot to do with withstanding pain. While those doctors with a high-risk tolerance are able to withstand that pain without much bother, others that are less risk-tolerant are deeply anguished. Recent studies show that the average investor dislikes losses almost twice as much as they enjoy gains.
In addition to the overall risk allocation, doctors should also pay attention to their asset allocation from a tax standpoint. Most doctors are aware of the higher tax rates they will face in 2013 as a result of the recent tax legislation. Many high-income doctors will pay significantly higher taxes on their income and investments. These new taxes are a result of higher tax rates, a newly enacted tax on net investment income to pay for health-care reform, and the loss of certain deductions. Now more than ever, doctors need to ensure they allocate their portfolios in the most tax-efficient manner to avoid losing thousands of dollars in unnecessary taxes.
Unfortunately, even under the discretion of investment professionals, many doctors adopt a pure tax avoidance philosophy when investing their portfolios. Doctors' tax-deferred accounts, such as 401ks and IRAs, are invested aggressively into stocks and other equity investments in order to reap the benefits of tax-deferred growth. Furthermore, many doctors position their taxable accounts conservatively in municipal bonds to receive tax-free interest income.
While tax avoidance may seem like a logical strategy, this often costs doctors in the long run. For example, a doctor receives a hot stock tip from a friend at a cocktail party that the friend hit the proverbial homerun in their IRA. While it's beneficial that the investment greatly appreciated, the doctor finds him- or herself in a situation where he or she will have to pay higher ordinary income taxes on the entire investment when the funds are withdrawn from the IRA. In contrast, if a doctor made this same investment in his or her taxable account, he or she would pay the lower long-term capital gains tax rate on the gain.
Moreover, assume the promising stock tip turned out to be a complete bust. By taking the risk in an IRA, the doctor would never be able to deduct the loss. If the stock was held in a taxable account, the doctor would be able to deduct a portion of the loss each year and use the remainder to offset future gains. While losses are not recommended investment outcomes, the benefit of proper tax allocation allows doctors to write off losses and become more scrupulous of any advice received at future cocktail parties.
As a result, when doctors examine both risk and tax efficiency in respect to their portfolios, they should position their most aggressive stock holdings in their taxable accounts. Not only are these accounts subject to lower tax rates, these accounts can also take advantage of tax loss harvesting and charitable gifting strategies. On the other hand, qualified retirement plans and IRAs should be invested more conservatively with tax-inefficient bonds and alternative investments.
In today's investment environment, doctors must keep a close eye on their investment portfolios. Determining the appropriate amount of risk is unique to every doctor, but ensuring that risk and tax exposure are diversified throughout different account registrations will inevitably have a significant impact on a dentist's future financial success.
John McGill provides tax and business planning services exclusively for the dental profession and publishes the McGill Advisory newsletter through John K. McGill & Company, Inc., a member of the McGill & Hill Group, LLC. Warren Poe provides investment advice through Select Consulting, Inc., a registered investment advisor and affiliate of the McGill & Hill Group, a one-stop resource for tax and business planning, practice transition, legal, retirement plan administration, CPA, and investment management services. For more information visit www.mcgillhillgroup.com.
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