Avoid the $500,000 mistake

Nov. 1, 2011
With many doctors in the highest tax brackets, tax-efficient investing is extremely important.

John K. McGill, MBA, CPA, JD, and Jeff Harrell, CFA

For more on this topic, go to www.dentaleconomics.com and search using the following key words: $500,000 mistake, Jeff Harrell, CFA, John K. McGill, MBA, CPA, JD.

With many doctors in the highest tax brackets, tax-efficient investing is extremely important. Unfortunately, the majority of doctors (as well as their advisors) routinely misallocate their investments, which results in excessive taxes.

What we are referring to here is the simple concept of what type of investments should be placed in which accounts. Most doctors have a combination of accounts that typically include both retirement and taxable accounts.

When it comes to selecting investments, the two most common mistakes are allocating all accounts using the same stock to bond ratio, and investing retirement accounts in aggressive investments such as individual stocks and equity mutual funds, while at the same time purchasing conservative municipal bonds in taxable accounts.

Maximize tax efficiency

Many doctors may be surprised by our suggestion that these are mistakes, since many financial advisors recommend this approach. Unfortunately, most investment advisors overlook the importance of investing the doctor’s funds in a manner that maximizes tax efficiency. This is done by favoring income producing investments in retirement accounts and capital appreciation investments within taxable accounts.

By doing so, you will be able to take advantage of lower long-term capital gains rates (15% maximum) when you sell appreciated stocks within a taxable account, while deferring ordinary income taxes when the doctor is in higher tax brackets through retirement plan/IRA investing. According to a study in the Journal of Finance, this strategy can generate as much as 15% to 20% more after-tax wealth over time.

Most doctors do not recognize the benefits of proper security allocation between registrations due to their extreme focus on tax avoidance. After all, allocating most stocks to a qualified plan and purchasing municipal bonds in taxable accounts creates no immediate tax liability.

Unfortunately, when it comes time to begin retirement plan withdrawals, capital gains have been converted into ordinary income, while at the same time they are generating below average income on lower yielding municipal bonds.

Still not convinced?

Suppose two doctors purchased 1,000 shares of Apple Computer 25 years ago at a cost of $1,000. This investment is now worth $2.6 million, so needless to say both doctors are very happy. However, one doctor purchased the shares through his IRA, while the other purchased shares through his taxable account.

They are both now ready to retire. The doctor with the shares in his IRA will pay ordinary income tax (35% maximum rate) on every dollar he withdraws from the plan, while the other doctor will only pay capital gains tax (15% maximum rate) on the shares he sells. The difference is more than $500,000!

Tax-efficient investment strategy

So how can a doctor implement this tax-efficient investment strategy? Let’s assume a doctor has $400,000 in her profit sharing plan, $100,000 in an IRA, and $200,000 in her taxable account. This doctor believes she should be invested in 50% stocks and 50% bonds based on her risk tolerance.

So, how should her accounts be invested to achieve a total of $350,000 in stocks and $350,000 in bonds?

First, the $200,000 taxable account should be invested 100% in stocks to take advantage of the aforementioned long-term capital gains tax rate.

Second, the doctor should recognize that she has fiduciary liability in her profit sharing plan; so making her IRA more aggressive would be the next best option. She should allocate 60% of the IRA assets to stocks and 40% to bonds. This would bring her total stock allocation to $260,000, or $90,000 short of her desired 50% stock and 50% bond goal.

Finally, she should allocate $90,000 of the profit sharing plan to stocks and invest the remaining amount in fixed income. This creates the overall 50% stock and 50% bond allocation desired.

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 (www.mcgillhillgroup.com). Jeff Harrell 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.

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