WCI #53: Tax Cut and Jobs Act Pass Through Deduction

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 back to the White Coat Investor Podcast and videocast. That's right, this is on YouTube too. We're down here in the White Coat Investor Studio audio video studio in my basement recording this. And today I'm going to wear my most comfortable hoodie sweatshirt. And if my wife finds out I'm putting YouTube clips up wearing this, I'm going to be in trouble. So don't tell her. Today we're going to talk about the Tax Cut and Jobs act pass through deduction as well as answer a whole bunch of questions from readers.

At some point in our financial lives, it will be time to buy a home. A physician mortgage can be a good vehicle for a young doctor who's just out of school and has a more effective place to use their money than on a big down payment. These loans allow doctors to secure a mortgage with fewer restrictions and a lower down payment than a conventional mortgage. But if you're further advanced in your career or deeper into your journey to financial freedom, buying a home with a conventional mortgage and then later on potentially refinancing that loan to a better rate with a shorter time frame could be a great move. Wherever you are in your financial journey, make sure you use the mortgage that will be most financially beneficial for you. Hop over to our recommended tab to learn more about all of your mortgage and refinancing options@whitecoatinvestor.com mortgage. You can do this and the White Coat Investor can help.

Our quote of the day today comes from Ayn Rand who said, money is only a tool. It will take you wherever you wish, but it will not replace you as the driver. I like that one. It's a little bit like that quote that money just makes you more of what you are. It doesn't actually change you. So today we're going to talk, first of all, just for a few minutes, about the pass through income deduction. I recently ran a blog post on this subject and just wanted to get some of this information into the hands of podcast listeners who haven't seen that blog post. The Tax Cut and Jobs Act 2018 established a brand new deduction that's never been in the tax code before. In some ways, it replaces the exemptions that you previously had. Your personal exemptions. You know, one for you, one for your spouse, one for each of your kids. That's where it plugs in on the 1040, basically below your itemized deductions. So it's a below the line deduction, but it's not an itemized deduction. So you can take both it and the standard deduction. It's really a business deduction. And it turns out that the most drastic changes in the Tax Cuts and Jobs act are was really these changes to the business tax code. There are significant changes to the personal tax code as well, but the biggest changes are to the business tax code. And one of those was cutting the corporate income tax. For C corporations, the maximum went from 35% to 21%. And the problem with doing that is it tilts the playing field. What do I mean by that? Well, there's a lot of businesses, even very big businesses that, that are structured as pass through entities. These are sole proprietorships and partnerships and s corporations or LLCs that are taxed as sole proprietorships, partnerships or S corporations. And so when you just cut the taxes for the C corporations, that's not really fair to the other businesses. And so this pass through deduction is to try to make up for some of that and to keep people on a relatively even playing field. So what is the deduction? The deduction is basically 20% of your qualified business income. However, there's a lot of caveats. And all the caveats, instead of making the tax code simpler, have made it more complicated. And the reason why is because whether you get to take that full 20% deduction comes down to 4 the nature of the business, the taxable income of the business owner, how much the business pays its employees, how much property the business owns, at least in a few situations. And so let's start with the first one of those, the nature of the business. There's basically two categories here. You're either a personal service business or you're a non personal service business. What is a personal service business? Well, you probably are a personal service business if you're a physician, an attorney, a veterinarian, a dentist, a podiatrist, an optometrist, a chiropractor, an accountant, a financial advisor, even a professional athlete. Those are all considered personal services businesses. Interestingly, engineers and architects are excluded specifically from that list, presumably because they create some sort of a final product that comes out of the process. But the problem is if you're one of those personal service businesses, you are limited. If you make too much money from getting this deduction, we'll talk More about that in a moment because this brings us to the second factor, the income of the business owner. And if you own a personal service business and your taxable income, remember that's not your total income, nor is it your adjusted gross income, it's your taxable income. What's left after all your deductions, if that is below $157,500 or if you're married, twice that, then you can qualify for the deduction between 157,500 and 207,500. Or if you're married, between 315 and $415,000. That is gradually phased out. And if you're above the upper limit of that range, you simply don't get this deduction. So a doctor with pass through income from his practice that has a taxable income of over 207,500 or over 415,000 if you're married, basically doesn't get this deduction at all. So that's going to exclude a fair number of physicians. Obviously. It also excludes all the employee physicians. You have to be a business owner to get this deduction. This deduction can also be limited by how much the business pays its employees because it's basically capped at 50% of the wages paid to the employees. So if you don't have any employees, you're not paying any wages. There is no deduction. This is one reason why it may be good to have an S corporation. Aside from the fact that you can eliminate some of your payroll taxes, usually just Medicare for physicians, you also pay yourself a salary as an S corp owner, and that salary, those wages can actually increase how much of this deduction you can get. The downside, of course, is every bit that you pay in salary is less you get in qualified business income. And so it's actually a fairly complicated calculation determining how much to pay yourself as an employee to minimize how much you you have to pay in Medicare taxes while maximizing this deduction. And then in a few situations, particularly with real estate related businesses, it also depends on how much property the business owns, because this deduction can also be limited by a factor of 25% of the salaries paid plus 2.5% of the basis of the property the business owned. So if the business owns lots of property, that can also help them to maximize their deduction. Also, the deduction is maximized at 20% of your taxable income. So if your only source of income is this pass through income, you almost surely aren't going to get 20% of your qualified business income for the deduction. And so there's lots of examples of doctors who are going to get this and doctors who aren't going to get this, but those are the main basic rules. So what are some general guidelines and what you can do to maximize this deduction? Well, well, some people may consider changing from employees to independent contractors. Remember when you do that, however, that you need to make sure you get paid more because an independent contractor has to pay for their own benefits and has to pay both halves of the Social Security and Medicare taxes. So as long as you're getting paid more for that fact, and you should be able to negotiate that, then you're likely to come out ahead being an independent contractor. Now, because of this deduction, you can also hire employees in a lot of situations. That's going to increase the wage factor so that that isn't limiting how large this deduction is going to be for you. You can also lower your taxable income if your taxable income is too high in order to get this deduction. If you're phased out of it, lowering your taxable income can get you to a point where you could actually take this deduction. Now how do you lower your taxable income? Well, remember, taxable income is almost at the very end of your 1040. So any deduction you take is going to help there. And the biggest one for most doctors is maxing out your retirement accounts. So by using tax deferred retirement accounts and health savings accounts, you might be able to lower your taxable income enough to get this deduction. Conversely, there are even a few situations where raising your taxable income can increase the size of this deduction. Remember that it's limited to 20% of your taxable income. So if you can raise that taxable income, there's more of this deduction you can get. Also, obviously it doesn't look like the IRS likes doctors very much. And so moving from being a doctor to some sort of non service business can be helpful in getting this deduction and maximizing it. And of course, the tax code's always favored stay at home parents. That's not unusual at all in the tax code. You've heard of the marriage penalty before, but this is one situation where it's even more beneficial to have a stay at home parenthood. And so many two doctor couples will be phased out of the deduction where just one of them would have still gotten it. And of course, there are some situations where paying yourself more, particularly as an S corporation owner, can increase the size of this deduction due to that wage limiting factor. So if you're a business owner and you think this deduction might apply to you, you can look at it and calculate it and see about how much your deduction would be. But the truth of the matter is, unless you're willing to make significant changes in how much you pay yourself, how much your business makes and those sorts of things, there's probably not a lot you can do. You're either going to get this deduction or you're not. And you can just calculate it at the end of the year and be grateful for what you get. All right, let's move on to some questions I've been getting from readers and listeners. I get a lot of these and in fact, it makes it very easy to prepare these podcast episodes. Sometimes I just got to go look at my email box and go through the last five or six questions I got. This one comes from a new intern who just matched into a five year old orthopedic surgery residency. And really the question boils down to two things. The first is it's a five year residency, should I buy a house? And this comes down to that burning desire that residents, and especially their spouses have to buy a house. It's like you haven't made it in this world until you actually own your house. And the question is, well, is the advice different because it's a five year residency? Well, the truth is it's a little bit easier to break even if you're going to be there five years than if you're going to be there three years. And if you're going to be there seven years, it's even easier. And at 10 years it's easier. At 20 years, it's a no brainer to buy your house. So obviously the longer you're going to be in one place, the better off you are because you have more time for the home appreciation to make up for the fact that there are significant transaction costs that go into buying and selling a home. And so depending on who you ask, you know, if you ask the mortgage industry and the realtor industry, they'll say the break even period is two or three years. If you ask a bunch of homeowners who've actually been through this cycle, they're more likely to tell you the break even is about five years. And so you're taking a gamble by buying a house for a five year residency. It's not the craziest thing to do. Lots of people have done it and have come out ahead. But be aware that lots of people have done it and come out behind too. And so I think the general rule still applies of don't buy a house while you're in training or while you're in the military and you're going to be moving every three to five years. But if you want to, sure, it makes a little more sense in a five year residency than it does in a three year residency. He also asked about the physician mortgage lenders that I have on the website and asked if they are considered ethically responsible. Well, sure, they're all ethically responsible lenders, but they're also maybe not the person you go to and ask if you should buy a house. You know, going to ask a realtor or mortgage lender if you should buy a house is like going to ask a barber if you need a haircut. Don't be surprised when the answer is yes. But sure, if you've already decided to buy a house, they can certainly help you get a great mortgage. If you're interested in a physician mortgage, meaning one where you put down less than 20% but still don't have to pay private mortgage insurance, then they can help you with that. In fact, that list kept on the website under the recommendations tab is the Internet's most comprehensive list of physician mortgage lenders. Okay, here comes another question. This one asks, what about late starters or late realizers? My wife and I are Doctors. I'm a 1099 doc. She's employed in a practice. I'm emergency medicine. She's in family medicine. I finished in 2009, she finished in 2012. Well, that's not very late starters, I don't think. I mean, it's not quite someone who learned about all this stuff during residency, but it's not like they're 60 either. Initially I saved a little bit of money, but spent some as well. When she got out, we combined our lives. I make a little over 300,000, she makes a little under 300,000. We aren't very great at the financial thing. We got caught up in the whole life insurance game, but finally realized it isn't necessary. I owe about 108,000 and she has about 160,000 in medical school loans. I have a gift of preferred stock for my job of about 150,000 and some money in a SEP IRA. I hate that I lost some investing years, but I need to get focused. Where should I start? So this is someone that kind of just stumbled onto the whole white coat investor message and is overwhelmed. And I think there's a lot of people like that. And it's good to just get started, find something where you can make an improvement and change it. And so I gave this doc a few suggestions. The first one was to become financially literate. Just reading and learning, listening to the podcast, reading the blog, reading the newsletters, reading the book, reading some of the recommendations books and becoming financially literate. All of a sudden you learn the message, or rather the language of finance. And then you can have rational conversations that you couldn't have before about it. And as you learn about it, you realize some things about your life where you can make improvements. I told them they probably need to refinance both of their student loans because it doesn't sound like they're going for public service loan forgiveness. That's easily done with my recommended student loan refinancing folks under the recommendations tab on the website. He needs to Open an individual 401k since he's a 1099 independent contractor and start funding it. That SEP IRA needs to be rolled into the Solo 401k SEP IRA is not the ideal retirement account for a single doc sole proprietor. That needs to be an individual 401 because it's easier to max it out and it allows you to continue to do backdoor Roth IRAs. They need to get some term life insurance in place and probably if they're like most, they need to cancel their whole life insurance. Sounds like it was sold to them, not something they specifically sought out and bought. Certainly it was a disservice to sell it to them while they owed. Let's see, what was it? Almost $300,000 in student loans. And that's years after they bought this whole life insurance, after they paid it down a little bit. They need to learn about her retirement account options at her job since she's employed. You can do that by getting the plan document, by talking to human resources and and get a little more information about that and start funding it. They also need to open up backdoor Roth IRAs and start funding those. An investing plan needs to be put into place. If they want to read and learn how to do that themselves, they can. If they need a little bit more help, there's the fire your financial advisor online course that I've put together that is ideal for someone trying to put together their investing plan for the first time. If that's not quite enough help, they can hire a financial advisor both at an hourly rate or they could hire for a flat annual fee or even for an asset under management fee to help them put together an investing plan that preferred stock is probably not something they want to hold on to that probably needs to be sold and moved into a diversified portfolio. More than likely that's in a taxable account and needs to be used to fund these retirement accounts they now have. I also told them they should calculate their savings rate and make sure it's 20% of their gross income, which will probably lead them to the realization that they spend too much and save too little, which honestly may be the biggest and most difficult change they have to make. Then I give them six or seven blog posts that hopefully will help lead them to the right place and referred them to my list of recommended financial advisors if they want to get a little bit of help. But the truth is it seems overwhelming at first, but honestly, there's thousands of doctors who have figured this out before you. You can do it. If you want to learn how to be a do it yourself investor, you certainly can do it. Take control of your financial life. Alright, next question. I'm interested what you would suggest for advice or books talking about physicians starting a side non medical business. I understand this site provides income for you, that's certainly true. However, I mean something like car washes, an automated business to both reduce taxes and have an additional income. Well, chances are good if you buy a successful car wash, you're not going to reduce your taxes and the reason why is you're going to increase your income. When you make more money, you pay more in taxes. But each of these businesses is an individual deal and has to be evaluated on its own merits. If you are not capable of evaluating the business merits of buying a business, you probably shouldn't buy it. And so get some help. See your accountant, see an attorney. And you know, if you need a financial advisor to help you evaluate the merits, hire a financial advisor to help you with it. But the truth is I can't say all car washes are good businesses to buy. They're not all good investments. But I'll bet there's lots of car washes that do very well. A lot of it probably comes down to the price you pay and so you've got to look into all the details of the business just like any other business you're looking at buying. Here's another question I got this one comes from a pediatric dentist earning $270,000 whose wife is my hygienist. He's an employee doc and there are owners of the practice who work elsewhere and I'm wondering where I can put money besides a backdoor Roth option It's interesting that he says my wife is eligible for the 401k. Remember they're both employed by the same practice. But I am not because I'm a highly compensated employee. Have you heard of this? And if you do, do you have any recommendations? Well, first of all, I would double check that information because usually when you're a highly compensated employee, it limits how much you can put in the 401k. It doesn't keep you from contributing to it at all. And so I would get the plan document, I would talk to the partners, I would talk to, you know, a human resources person, if there is one, and I would actually find out if that's true. It's probably not true. You probably can put something in the 401k even if you can't put $55,000 in there. So I'd knock on that door a little bit more and learn about it. But no, you can't go to an individual 401k or a SEP IRA. You're not self employed, you're an employee. And so if you truly can't use the 401k and you need to save more money than your wife can put into the 401k and you can both put into backdoor Roth IRAs more money for retirement, then you're going to have to do it in a taxable account. That's what happens when you run out of retirement account space is you go to a taxable account. But I think I'd push back a little bit about what I'm being told about not being able to contribute to the 401, because I don't think that's true. All right, here's another question. This one comes from a doc who's interested in learning more about IBR and repay and basically asking should I apply for IBR and then puts repay in parentheses as soon as possible so that upon graduation from medical school I can begin making payments and capture as much of these government payments on the unpaid interest as possible? Or should I take advantage of the six month grace period and allow my loan to accrue interest without the repay in effect? My loan servicer told me to take advantage of the grace period. Well, the truth of the matter is loan servicers don't always, maybe don't even usually give good loan advice. That's like asking the bank how long you should carry your mortgage. Well, they want you to carry it for the whole time because they make money with it. And so that's not where I would go for student loan Management advice. It's generally bad advice to wait and use that grace period. It's certainly bad advice for most docs to go into deferment or forbearance during their residency. You want to be in one of these income driven repayment programs. Most of the time the right program is the repay program or the revised pay as you earn program. And the reason why is the government subsidizes your interest rate. And so unless you have a very high earning spouse, the government's going to cover some of the interest on your student loans. The other advantage is those programs are associated with forgiveness programs which you may or may not use. You probably won't use the IBR or the PAY or the repay forgiveness because you have to make payments for 20 to 25 years to get that. And most docs are going to have their loans paid off before then. But you might use the public Service loan forgiveness program, especially if you become an academic physician or otherwise employed by a non profit after you finish your residency. And so the sooner you start making those payments, the more money you're going to have to get forgiven under the public Service loan forgiveness program. But even if you think you're going to end up paying your loans off yourself, you might as well get started, number one. And number two, the sooner you enroll and repay, the sooner you will start getting that subsidy from the government and they're going to help cover some of the interest. As that loan grows, it'll basically grow at a slower rate during residency than it would otherwise. But bear in mind that IBR is not repay. They are two separate programs. They're both income driven repayment programs, but they're entirely different programs. And you want to figure out which one's right for you. The answer is usually repay. Okay, here's another question. I'm interested in hiring my kids. Should I hire them as W2 employees or 1099 employees? Also, if they make, and I love this phrase, cash money doing babysitting, can they put that money in a Roth ira? And also can I establish a UGMA or UTMA account through Vanguard? Well, these are all easy questions. You should hire them as W2 employees. And the reason why is if your children work for your business and the only owners of the business are the parents, then they basically don't pay payroll taxes up to a certain amount of income, which is about $12,000 this year. They don't pay any income taxes and it's a business tax deduction for your business. So it's great to hire your kids but hire them as employees. Don't contract with their business as 1099 employees. You certainly don't want to have to pay them. To have to pay not only the employee half of the payroll taxes, but the employer half of the payroll taxes when you could avoid paying those altogether if you just employed them. Bear in mind you cannot do that if you are an S corporation. It can't be a corporation. It's got to be a sole proprietorship or a partnership or an llc. Filing is one of those two things in order to avoid those taxes. So if they make cash money doing babysitting, that can go in a Roth ira. Roth IRA just requires earned income. So if they have earned income, whether that comes from babysitting the neighbor's kids, or whether that comes from mowing the neighbor's lawn, or whether that comes from working in your business, your real estate business, maybe to flip houses, all that can go into a Roth IRA because it's earned income. But don't try to pay them to do their chores. Don't try to pay them to babysit their little brother, don't try to pay them for mowing your lawn and then try to call that some sort of income for them. This needs to be for legitimate businesses, whether they're doing it for somebody outside of your family or whether they're working in your legitimate business as an employee. And you need to pay them the going rate. They can't be paid, you know, some ridiculous rate, $1,000 an hour in order to, you know, babysit. And of course, UGMA or UTMA or Uniform Transfer for Minors accounts can be open at Vanguard. Those are basically just taxable accounts for your kids. And there's still a custodial count, if you will. And so the parents have control over it until they turn 18. And at that point, if they want, they can blow it all on cocaine and hookers. All right, let's talk about a dumb investing idea. This was sent to me by somebody in my email box and said, well, here's a way to buy Bitcoin without the risk of losing money. Sounds intriguing, right? Everyone's interested in Bitcoin these days. And so here was the scheme. First, you buy a bond. You buy a bond to protect your original investment. You don't spend all the money you're planning to invest to buy the bond, but you spend most of it to buy the bond. For example, you might buy a five year bond for $8,500 that will grow over those five years to $10,000. And so that's your original investment amount, so you won't lose that money because the bond will be worth $10,000 in five years. And then they say, put the remaining money or the last 1500 bucks into Bitcoin and then wait five years. Well, this is a bizarre thing to recommend to somebody. And the reason why is it starts from this idea of how can I invest in bitcoin without losing money? Which is really not the place you should start with an investing plan. Where you should start with your investing plan is your goals and what you want to fund with your investments. For example, if your goal is to have $2 million in 20 years in retirement funds, then you start from a very different place than if your goal is how can I invest in bitcoin without losing money? And so you come up with these nonsensical portfolio ideas when you start from the wrong place. And that's why you've got to begin with the end in mind. In general, this sort of an investment scheme is not a good idea. And so I actually replied back to the author of this post that sent it to me, and I said, this is. This is stupid. Basically, you know, you want to focus on your goals. You want to, you know, invest with a reasonable amount of risk that's likely to lead you to reach your goals. And a portfolio that's almost completely bonds is not going to do that. And you want to avoid speculative instruments like bitcoin anyway. I mean, if you really want to invest in bitcoin, why not limit it to 5% of your portfolio or something like that? Something where you can participate in some upside, but it's not going to sink you if the whole thing goes to zero. And the author actually agreed with that criticism, but his defense was, well, it's better than what this guy's doing. And he pointed to somebody who is basically taking all the equity out of his home and buying bitcoin with it. Well, I guess it's better than that. But the bottom line is you just got to avoid doing stupid stuff with your money. And putting a portfolio like this together counts as a stupid investing plan. So I got a letter from Capital One this week. We've got quite a few expenses to pay up at the conference hotel for the white Coat investor conference. And so I said, well, let's put it on the credit card. We get a little bit of cash back if we do that. And it was pointed out to me that our expenses were more than our credit card limit. The credit card limit was only $20,000. So I said, well, we'll just apply and get a higher limit. So I applied with Capital One and asked him, hey, will you give us a higher limit? Bear in mind, Katie and I have no personal debt. We basically don't carry any debt month to month on this business. The business makes over seven figures a year and the credit limit on this card is just $20,000. So here's the letter they sent me. You recently requested a credit line increase for your Capital One account. Unfortunately, your account isn't eligible right now. We know this isn't the answer you were hoping for and we want to help you understand why. So here's the reason why. Your financial obligations reported to us by the credit reporting agency are too high. Really? This is one reason why it's good not to have to depend on your credit. I have a great credit score. It's over 800. I owe very little money, my debt to income ratio is tiny, and yet they won't raise my credit limit. It just goes to show you that you don't want to be in a situation where you need to be dependent on credit for anything. Because sometimes surprises like this come up. A lot of times doctors find no one will loan them money for a mortgage or whatever it might be, or a car loan, who knows? And sometimes it doesn't make any sense whatsoever. I mean, whoever's working in their underwriting department is clearly just looking at some, some sort of bizarre ratio or something somewhere and making the decision based on that. Because obviously this would be an incredibly no brainer, incredible no brainer as a credit risk. But I encourage you to get yourself in a position where you don't need credit like that. We don't, we just wrote them a check. But bear in mind, it's kind of stupid the way the banking industry works sometimes when it comes to offering credit. And so the less you can interact with them, the better off you're going to be and the less hassle you'll have in your life.

At some point in our financial lives, it will be time to buy a home. A physician mortgage can be a good vehicle for a young doctor who's just out of school and has a more effective place to use their money than on a big down payment. These loans allow doctors to secure a mortgage with fewer restrictions and a lower down payment than a conventional mortgage. But if you're further advanced in your career or deeper into your journey to financial freedom, buying a home with a conventional mortgage and then later on potentially refinancing that loan to a better rate with a shorter timeframe could be a great move. Wherever you are in your financial journey, make sure you use the mortgage that will be most financially beneficial for you. Hop over to our recommended tab to learn more about all of your mortgage and refinancing options@whitecoatinvestor.com mortgage. You can do this and the white coat investor can help.

Be sure to follow us on social media, Twitter or Facebook, and keep your head up, your shoulders back. You've got this. We're here to help you. See you next time.