WCI #17: Understanding Tax Deductions and Credits

This is the White Coat Investor Podcast where we help those who wear the white coat get a fair shake on Wall Street. We've been helping doctors and other high income professionals stop doing dumb things with their money since 2011. Here's your host, Dr. Jim Dahli. Welcome to podcast 17. We're going to be talking about tax deductions with this podcast.

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Well, we're having a lot of fun here at the White Coat Investor. Actually, one of us, my wife is nowhere to be seen. She's halfway across the world in Finland right now. It seems that with our younger kids finishing school this week, we couldn't go on a vacation together. But we decided that, well, one of us still could. So off she went. But while the cat's away, the mice will play. And we're having lots of fun around here trying to fill in for her. It turns out she does a lot of stuff around the house that you never realize until she disappears. But today we're going to be talking about something that's incredibly boring. Tax deductions. I don't know why you guys even listen to this stuff. This can't possibly be the most interesting podcast available to you on your phone, but we'll try to make it as interesting as we can. Before we get into that, the quote of the day today is from Charles Farrell, who said all decisions you make should help move you from being a laborer to being a capitalist. All right, deductions. Everybody wants more deductions. A deduction is not necessarily a good thing though. Remember, a deduction is an expense, and even though you get to subtract it from your taxable income, you actually spend more on the the expense than you get to deduct from your taxes. So it's not always a good thing to have more deductions. It means you spent more. Spending a dollar to get 30 or 40 cents off on your taxes is not a winning formula. But if you're going to spend the money anyway, you might as well get the deduction. This is not quite the same as a credit. A credit is better than a deduction. You know, there's a few credits in the tax code that can really help you out. Doctors are phased out of a lot of them, but there's a few credits there. But a credit reduces your taxes dollar for dollar. So if you spend $1,000 on a deduction, that might only knock three or four hundred dollars off your tax bill. If you spend $1,000 ON A CREDIT, you get $1,000 off your tax bill. So a credit is far better than a deduction. Bear that in mind when looking at your taxes. The very best kind of deduction there is is a self employed business expense on something you would have spent the money on anyway. You know, it might be driving, it might be a trip, it might be your phone, it might be your Internet, stuff like that. And the reason why it is the best deduction is because not only do you not have to pay income tax on that money, but you don't have to pay payroll tax on that money. Bear in mind, of course, with these deductions that you're only supposed to deduct the portion of the expense you used for your business purposes. So if you're deducting your cell phone expenses and you're only using 10% of your minutes or whatever you want to divide it by for business purposes, you only get to take 10% of the cost of that expense as a deduction. Now, in practice, I think that's pretty hard for a lot of people to pin down and not something that gets audited terribly frequently. And so I think in practice, a lot of people tend to deduct a lot more than the percentage they're actually using for business purposes. But that is actually what the law says you're supposed to do. In general, you're looking for ordinary and necessary expenses incurred while carrying on your trade or business. That's in the words of the irs. And that's basically how they decide whether something is a legitimate business expense. If you're looking for more details on that, you can find that in IRS Publication 463. Bear in mind, one of the things that doctors ask about a lot is about whether they can deduct their mileage. And the general rule with deducting mileage is you can't deduct a commute. You can deduct business mileage, but not a commute. So if your daily travels involved you driving from your home to a hospital, then to a second hospital, or to A clinic, and then from that clinic home. The only deductible portion of that mileage is the distance between the hospital and the clinic. And so there's lots of ways that people try to maximize that mileage and minimize the commuting mileage. For example, they may choose to live close by one of the hospitals, so that portion isn't much of the mileage. Or they may choose to locate one of their offices in their house. And that way, if their commute is their walk downstairs from their bedroom to their office, and then driving from that home office to the hospital becomes a business mileage rather than a commuting mileage. You know, there's lots of little tricks people use to try to maximize those miles, because business miles are a pretty darn good deduction. I think it's 56 or 57 cents a mile you get. So if you drive 10 miles, you get a deduction of 560 over the course of the year. Those miles can really add up depending on your business and how much you have to drive. You could have thousands of miles that are deductible. But the typical doc who wakes up, drives into the hospital or drives into the clinic and at the end of the day drives home from the clinic isn't getting any deductible miles. While we're talking about the home office, bear in mind that IRS regulations on home offices. You have to use this space regularly for your business. You and exclusively for your business. So if the kids are in there doing their homework too, that's not exclusive use. It basically has to be a portion of your home that you don't use for any home stuff. Now, do people bend that all the time? I'm sure they do, but that's what the the way the laws are written, if you look at Schedule C, they give you all kinds of suggested business expenses. But those are just suggestions. The only rules are that your expenses be both ordinary and and necessary for your trade or business. But Schedule C lists advertising, car and truck expenses, and there's all kinds of rules about those. Commissions and fees, contractors that you pay, depletion and depreciation, employee benefit programs, insurance interest you may pay, legal and professional services, office expenses like printing and paper and all kinds of office supplies, pension and profit sharing plans, rent, vehicles, machinery and other equipment, repairs and maintenance supplies, taxes and licenses, travel, meals and entertainment. And that has its own set of rules. Of course, you need to be familiar with that. For example, in general, your business meals are only 50% deductible. Utilities, wages for your Employees. Those are all listed there on schedule C. But you can add all kinds of other stuff. They have an other category. So anything that is a reasonable business expense, meaning it's ordinary and necessary for your business, you can deduct. And those deductions are the best because no income tax and no payroll taxes are paid on them. No tax at all. Basically all that stuff that you can justify as a business expense are bought with pre tax dollars. The next best kind of deduction after business expenses for the self employed are above the line deductions. And you may have heard that phrase before above the line, but not know what they're talking about. Well, the line is line 37 on your 1040. It's the one at the very bottom of the first page and it's recreated on line 38, the very first line on the top page of on the top of page two. So the line is lines 37 and 38. And that line is titled adjusted gross income. Any deduction above that line is better than any deduction below that line. And there's a few reasons for that. The first is that your adjusted gross income is used to calculate lots of stuff in the tax code. For example, whether you can contribute directly to a Roth ira. But there are lots of sections where it comes down to whether you have a higher or lower adjusted gross income. As to whether you can take a deduction or whether you're subject to a phase out. It's a really important number in the tax code. In fact, most of the time when an accountant is talking about your income, that's what they're talking about is your adjusted gross income. Above the line deductions are also better because of the P's limitations. These are the ones I'll talk about a little more later. But basically Donald Pease, one of the congressmen I believe came up with this idea to tax high earners a little bit higher. And the way he did that was by limiting your below the line deductions. Once you start making over a certain amount of money, and that doesn't apply to above the line deductions, you also can take all the above the line deductions you qualify for and still take the standard deduction. So that's another benefit of above the line deductions. It's not itemized. You also get. So the other problem with below the line deductions is that you don't necessarily really get the whole thing. Since the standard deduction is free, only the portion of your itemized deductions above and beyond the Standard deduction is really a true deduction for you. But there are a number of these above the line deductions that are worth looking at and seeing if you qualify for. These are probably my largest tax deductions every year. One of those is educator expenses. There are also certain business expenses of reservists, performing artists and fee basis government officials. Now you're unlikely to be a performing artist or a fee basis government official, but there's plenty of docs out there who are reservists. Your HSA contribution is also an above the line deduction. Moving expenses are an above the line deduction. Your self employment tax, at least the employer portion of it, is an above the line deduction. Unlike your state income taxes for example, which are not an above the line deduction. They're below the line deduction, but those self employment taxes are above self employed. Health insurance is an above the line deduction. Alimony is an above the line deduction. Which is nice that it's not a below the line deduction, but you wish it would come off your income a little bit higher. I mean that basically means all the alimony you pay. So you've got to pay the payroll taxes on it. Your ex spouse does not. IRA deductions also come off above the line. And the student loan interest deduction also comes off above the line. Although bear in mind that most attendings can't deduct that because they make too much money. Same thing with tuition and fees. Deduction also an above the line deduction that most attendings can't take. But these are the major deductions for most self employed docs. You've got your retirement plans, you've got your HSAs, you've got your health insurance premiums. I mean that might be, you know, a six figure amount depending on how you've got things structured. It's a significant deduction. Once you pass line 37 and 38, you are now looking at your itemized deductions or below the line deductions. And this is schedule A territory. You know when people ask do you itemize or take the standard deduction? This is what they're talking about. They're talking about whether or not you fill out a schedule A. You never get all of your itemized deductions because the standard deduction is free. So if you total up all your itemized deductions and you come up with $15,000 worth of deductions, but your standard deduction is 12,000 in reality, you're only getting 3,000 extra in deductions for itemizing and as a high earner, you may be phased out of those deductions as well. I mentioned earlier the P's limitations. These kick in at an adjusted gross income. There's that line 37 and 38 again of $259,000 if you're single, or $311,000 if you're married. And once you make more than that, you start having your itemized deductions be limited by this provision of the tax code. In reality, the way it works out is it just adds 1% to your marginal tax rate. So it's like a 1% surtax on high earners. It's like a stealth tax, really. It's not necessarily something that you should limit your charitable contributions or something for. Just realize that the tax brackets are a little bit higher than you thought they were. Once you're making more than $259,000 single or $311,000 married. But your below the line deductions are pretty easy to see. You just work your way down schedule A. The first thing you see is your medical expenses, but only the portion that's more than 10% of your income. So if you're a doctor, chances are you're not going to get any of those. If your adjusted GROSS Income is $200,000, you know you got to have $20,000 in medical expenses before any of them are deductible. So that's not a very common one. What is common, however, are your state income taxes. If you're in an income tax free state, you may be better off taking the sales tax provision. But for most doctors who are in a state where they're paying income taxes, they're better off deducting their income taxes. It's interesting that they don't let you deduct both. You actually have to choose between the two, which is kind of an interesting provision of the tax code. Your property taxes on your house are deductible on schedule A, as is your mortgage interest. Your charitable contributions are also deductions on schedule A. This includes money or goods that you give to Goodwill or another charity, as well as any mileage you spend on that charity. But you cannot deduct the value of your time, nor can you deduct, you know, professional fees. You didn't charge them if you worked for Doctors Without Borders or something like that. You know, these really. Your time can't be deducted when it comes to charity. You can also deduct thefts or other losses. Although, you know, any Significant losses really are going to have to be, you know, some uninsured loss that's of a significant size. So a lot of times, you know, if you can claim it on your homeowner's insurance or something, you're not going to be able to deduct it too. It's one or the other. But starting with thefts and other losses on the form, as well as unreimbursed employee expenses, tax prep fees and investing fees, these are all subject to the 2% of your income floor. So unless you have enough of those that add up to more than 2% of your income, you don't get any bit of a deduction there. And this can be really helpful in simplifying your taxes. If you've only got a few hundred dollars worth of those sorts of expenses, it's not even worth keeping track of. But if for some reason you're paying a lot of money toward, you know, investment management or financial advising, well, you may be able to get above that 2% of income floor. Bear in mind that in general, if it's at all possible, you're probably better off having your investing fees that you're paying to a financial advisor subtracted from your tax deferred accounts rather than having them try to deduct them on schedule A. That way you're paying them completely with pre tax dollars. But if you talk to, you know, the tax gurus about this, the way they say you're supposed to do it is you're only supposed to take the portion that is applicable to the pre tax account out of the pre tax account. So for example, if your portfolio is 50% pre tax and 50% taxable, you're only supposed to take half of the financial advisory fee out of the pre tax account. But I can't say for sure that that's what all financial advisors are doing. I suspect a lot of them are bending that rule a little bit. But that's kind of a basic overview of what tax deductions are. Anything that is a legitimate business expense can be deducted, but it's far easier to deduct it if you're self employed than if you're an employee. Because if you're an employee, not only does it end up on schedule A where it may not be that much more than your standard deduction, and it may have the peas limitations applied to it, but it's also subject to 2% of income floor. Whereas you can just deduct the whole thing if you're self employed. So you're Far better off getting your employer to institute some sort of slush fund account or CME account or whatever that you can pay for that sort of stuff pre tax if you're an employee than it is trying to take it as a deduction as an employee. All right, let's get into some questions. This one comes via Twitter. Is it really possible to have just a 20 year career? This was in response to something I tweeted out about how much you had to save if you wanted to retire in 20 years. But I found it kind of funny because there's all kinds of, you know, personal finance fire bloggers out there who reached financial independence in much less than 20 years. Physician on Fire, our partner site, he reached it in less than 10 years. Mr. Money Mustache was seven years from the start of his career until he retired. And I suppose even our family reached it about 11 years out of residency. So 20, when you compare to those seems downright easy. Although the truth is most people don't reach financial independence and in just 20 years, but mostly just because they spend too much. Financial independence is really just a function of your savings rate. I think one of the better posts on the Internet about this is by Mr. Money Mustache entitled the Shockingly Simple Math Behind Early Retirement. And he basically makes a graph that shows what percentage you need to save if you want to retire in what time period. And it goes from, you know, 100% of your income to retire right now to, you know, if you're saving 0% of your income, you'll never retire and everything else is somewhere in between. But if you go down the chart, you see that 20 years works out to be saving just over 40% of your take home pay. So maybe for a doc, 30% of gross. Now, most doctors won't do that, but it's hardly impossible as a doctor to save 30% of your gross income. It's not that hard to do and that'll get you to financial independence within 20 years. But if you've never actually looked at that math and never thought about what it'd be like to not have to work, I think that's worth spending some time looking at those numbers and figuring it out because it's certainly possible to have just a 20 year career, even for a doctor. Another question I got was I am starting med school this fall at the local university. Tuition is now $39,000 per year. I am trying to reliably calculate my expected debt, which will be unsubsidized, of course. Would you take a look at this Calculator and see if it is trustworthy. And he left me the link to a calculator from a government website, which I'm sure is probably perfectly fine. It's not that hard to set up a calculator that can figure out what your total debt's going to be. But really all you need is round numbers. Anyway. You can do this process by hand. Take $39,000, set, see what your interest rate is, perhaps 6 or 7%, and multiply that by $39,000. So at the end of year one, that's your total. At the end of year two, add on another $39,000 and multiply it all by 6 or 7% and that's the total. At the end of year 2, you can repeat that for year 3 and year 4, and that'll get you into the ballpark of about what you're going to owe at the end of medical school. Of course, expect that to increase by perhaps as much as 50% during residency, so depending on how long your residency is and how big of payments you make at that time. But that's basically how it works out. So for this doc who's paying $39,000 a year in tuition, if that's all the money he's borrowing, I would expect to come out of med school owing about $200,000. You can also use your own calculator. In fact, it's a great thing to be able to use a spreadsheet. And Excel has about 5 financial calculations that are worth knowing. Future value is probably the relevant one in this case. But basically, if you put in the functions of $39,000 a year and you put in your interest rate and you put in four years of med school, it'll spit out the exact answer for you to the dime of what you're going to owe when you walk out of med school. And so that can be useful to learn, not only because you'll see what you're going to owe, and maybe you'll spend a little bit less money in med school on your lifestyle, but also those skills you learn to calculate. That is the exact same skills you use to figure out how much you need to retire and how much you need for college tuition and that kind of stuff. Alright, our next question. Why does the rule of 25 seem to assume that you get to spend the entire 4%? It seems like a big chunk of the 4% will go to taxes in retirement unless you have massive Roth accounts. Well, that's absolutely true. The 4% does have to include your taxes not only that, it has to include any financial advisory fees you pay. That's why a 1% of assets under management fee is so large. I mean that's a quarter, a quarter of the money you have to spend in retirement that's going toward that financial advisor that first year. And so it can really add up. But a lot of people don't realize that most people, including docs, pay dramatically less in taxes in retirement than they did during their peak earnings years. Not only are you not paying payroll taxes, but you are paying much less in income taxes due to the progressive nature of our tax code. Now if you're some super saver and you retire with 10 million bucks, that might not be the case. But if you're a typical doc, you know your only taxable income is going to be part of your Social Security. And the money you take out of tax deferred retirement accounts, you know, the amounts that come from your taxable account are generally pretty tax favored. Be taxed at maybe 15% as capital gains and qualified dividends and anything taken out of your Roth accounts, of course, or any basis from your taxable accounts is totally tax free. So it's not unusual for a doc to have a tax rate on his income of less than 10% in retirement just because a lot of that money has frankly already been taxed. But yeah, when you're running your numbers, you need to include that, both your taxes and your advisory fees in that 4%. Appreciate you listening to our podcast today. A word from our sponsor.

Do you ever find yourself wishing there was somewhere to go to ask your finance, insurance or investing questions? The White Coat investor community is a great place to turn. We have a thriving community across all of our social, Facebook, Twitter, Instagram, Reddit and our WCI forum. We have been discussing solutions to your money problems since 2011. Join the Conversation with thousands of other White Coat investors on your favorite social media platform for financial resources, tips and strategies. Just head to your platform of choice and search for the White Coat investor. You can do this and the White Coat investor can help.

Thanks for listening today. Head up, shoulders back. And thanks for what you do out there. Your work matters and that's why I try to support you. Because I'm sick of docs being taken advantage of because they spent their time trying to help others rather than learning how the business world works. But this stuff isn't that complicated. You can learn it in addition to medicine and you know, be able to live the good life you expected you would be able to by going into medicine. Thanks for listening. See you next time.