Recently, Congress released proposed legislation to codify President Biden’s Tax Plan, also known as the American Families Plan. In its current form as the Build Back Better Act, the bill could be the most significant overhaul of the tax code in decades. For doctors, the proposed changes include higher tax rates, changes to retirement savings options, and new tax breaks for families.
We wrote this article to help doctors understand what the new legislation could mean for their finances if the bill becomes law. Once the bill is enacted we will update the article to reflect the actual law.
How does the American Families Plan impact your tax rates?
The American Families Plan would increase tax rates for higher income earners, specifically single individuals with income over $400,000 or married couples with income over $450,000.
The tax rates for families with income above these amounts would change in two ways:
- A new tax rate of 39.6% would be reintroduced for wages and salaries above $400,000 (Single) or $450,000 (Married). This is an increase to the current 35% and 37% tax rates.
- A new tax rate of 25% would be created for investment income from capital gains or dividends. This is a significant increase from the current 15% and 20% capital gains rates. The new rate would only affect investments held outside of retirement accounts such as brokerage accounts and trust accounts.
What can you do about it?
We need to start this discussion by talking about how the IRS determines what they consider taxable income, which is not the same as your total income. Understand that the proposed tax increases only apply to taxable income, not your total income.
Taxable income refers to the income that shows up on your tax return after taking all of your deductions into account, such as health insurance, retirement plan contributions, and the standard (or itemized) deduction.
How does this work?
Let’s look at how this might affect a married couple, Kristin and John, both of whom are doctors.
Kristin earns an annual salary of $300,000 before taxes working in a private hospital. However, she contributes the maximum of $19,500 into her 401(k), and pays $5,500 per year for health insurance premiums. Kristin’s salary after deductions is $300,000 – $19,500 – $5,500 = $275,000. This is the number that will show up on her W-2 at the end of the year.
Her husband, John, earns $200,000 annually before taxes working for a local non-profit, and puts $19,500 into his 403(b). He also has to pay $4,500 per year for his health insurance. John’s salary after deductions is $200,000 – $19,500 – $4,500 = $176,000. This will show up on his W-2 for the year.
Kristin and John’s combined taxable income is calculated as follows:
$275,000 (Kristin’s W-2 income)
$176,000 (John’s W-2 income)
$25,100 standard deduction
$425,900 taxable income
Even though Kristin and John earn a combined salary of $500,000, which is over the $450,000 cutoff for the new tax rates, their taxable income is only $425,900 after factoring in all deductions. This means that all of their income will still be taxed at the lower rates and they would not be impacted by this portion of the new law.
You may have more opportunities to reduce your taxable income, such as a 457(b) qualified deferred compensation plan, a non-qualified deferred compensation plan, or a health savings account (HSA). Any of these options would decrease your taxable income and help you to avoid the higher tax rates. You may also be able to save by itemizing your deductions.
As a bonus, contributing more of your salary to tax-deductible savings accounts will help reduce your student loan payments on any of the income-driven repayment plans, since the student loan payment calculation is based upon the income that shows up on your tax returns.
How does the American Families Plan impact your retirement savings?
As you can see, the American Families Plan can make contributing the maximum to tax-deductible savings accounts like 401(k)s, 403(b)s, and 457(b)s an even better option for doctors by preventing your income from being taxed at the new, higher tax rates.
Unfortunately, the changes don’t end there.
Another part of the proposed legislation would prevent so-called “Backdoor” Roth contributions. For a Backdoor Roth IRA contribution, money is first contributed to a conventional IRA or 401(k) on an after-tax basis and then converted to a Roth IRA. Until now, this has been an effective strategy for high-income earners who don’t qualify to contribute directly to a Roth IRA to still build Roth savings.
The American Families Plan would end the Backdoor Roth strategy by preventing after-tax IRA or 401(k) contributions from being converted to Roth — effectively closing the Back Door (yes, pun intended).
What can you do about the American Families Plan now?
First, understand that the proposed changes don’t take effect until after the end of 2021. If you’ve already been making Backdoor Roth IRA contributions, nothing in the proposed legislation would penalize you for previous Backdoor Roths. The bill would only prevent you from making future Backdoor Roth IRA contributions, beginning in 2022.
As a result, we are recommending that all of our doctor clients complete their 2021 Backdoor Roth IRA contributions and conversions now — before the end of 2021 when the proposed changes would take effect.
If the Backdoor Roth strategy is eliminated, this would also change the calculus for your savings waterfall. It may be time to think about other options for your money, such as focusing on your student loans, saving for a down payment, or investing in a taxable account.
What does the American Families Plan do for doctors with families?
For doctors with children, the American Families Plan could mean significant tax savings.
That’s because some of the changes from the American Rescue Plan could be made permanent, including higher child tax credits, an increased child and dependent care credit, and increased dependent care FSA contribution limits.
Increased Child Tax Credit
The increases to the child tax credit could save doctors with young children on their taxes. The credit is worth up to $3,600 per child for children under age 6, or up to $3,000 for children up to age 6 – 17.
NOTE: Be careful if your income has increased significantly: The advance payments of the credit could spell trouble for doctors with income that increases from one year to the next. By receiving advance payments, you run the risk of having to repay any child tax credit money you received that you are no longer entitled to receive based upon a higher income for this year.
This is why we generally recommend that our doctor clients unenroll from receiving advance payments of the child tax credit.
Dependent Care Savings
Our doctor clients typically find that childcare is not a small expense, whether you choose to hire a nanny or find a daycare center in your area. Thankfully, the proposed legislation would help with that.
The American Families Plan would expand two valuable tax savings opportunities for working parents: the Child and Dependent Care Credit and the Dependent Care Flexible Savings Account (FSA).
Child and Dependent Care Credit
Under the new rules, the Child and Dependent Care Credit can provide a credit for up to 50% of the cost of childcare. You can claim the credit on your tax return for up to $8,000 of qualifying expenses if you have 1 child, or up to $16,000 with 2 children.
What’s the catch? The Child and Dependent Care Credit has a phaseout, which means that at higher income levels the credit is capped at 20% of your childcare expenses, rather than the 50% maximum. That’s why we typically recommend contributing to a Child and Dependent Care FSA instead for doctors.
Child and Dependent Care FSA
Under the new rules, you can contribute up to $5,250 into a Child and Dependent Care FSA if you’re Single, or up to $10,500 if you’re Married and file jointly on your taxes, regardless of how much income you earn.
How much can contributing to a Child and Dependent Care FSA save you on your taxes?
Answer: It depends upon your tax rate.
Money you put into an FSA is deductible for federal, state, Social Security, and Medicare tax purposes. If you’re in the 32% federal income tax bracket, and your state has a 5% income tax rate, that means you could save 32% federal + 5% state + 6.2% Social Security + 1.45% Medicare tax = 44.65% total tax savings.
If you’re married and have 2 children, you can use both: contributing $10,500 into your Dependent Care FSA, then claiming the Child and Dependent Care Credit for any additional childcare expenses you pay out of pocket, up to the $16,000 maximum.
Keep in mind that all of this is only drafted legislation as of this writing, and things could change before the bill becomes law. Still, we hope you find this useful as a guide to the changes you might expect from the thousand-page American Families Plan that is currently making its way through Congress.
If you have any questions, please feel free to contact us or post in the comments