Published 6/1/2014

Reducing the Tax Bite on Retirement Wealth

Tax diversification is the key

Carole C. Foos, CPA, and David B. Mandell, JD, MBA

Nearly all orthopaedic surgeons are focused on reducing their income taxes. This is understandable, because income taxes are generally the highest-rate tax AAOS members will pay during their lifetimes. Compared to other taxes, the raw amount of income tax paid is also typically the largest, and income taxes must be paid annually.

However, comprehensive tax planning must also consider the tax impact on assets a client will rely on in retirement. Without such planning, the tax bite on long-term investments can be brutal. In fact, a study by mutual fund tracker Lipper showed that from 1997 to 2007, the typical equity fund investor lost 16 percent to 44 percent of total gains to taxes. Left unchecked, this tax cost can be ruinous to a physician’s long-term financial plan. This is why reducing retirement asset taxes through proper tax diversification is so crucial.

Taxation ground rules
Most orthopaedic surgeons will rely on the following asset types in retirement:

  • qualified retirement plans (QRPs), which include defined benefit plans, 401(k)s, 403(b)s, profit-sharing plans, rollover or SEP-IRAs (taxed as QRPs, even if they are not QRPs technically)
  • securities and investment funds
  • real estate and other personally owned assets

QRPs are subject to income taxes when they are distributed. Due to the high marginal tax rates (more than 60 percent) in the past, many retired surgeons may be losing 40 percent to 50 percent of their QRP funds to taxes (state and federal).

A personally or jointly owned investment portfolio may be subject to a host of tax treatments as it grows or when it is converted to cash. Long-term capital gains taxes will be assessed on the appreciation of portfolio assets. Qualifying dividends earned in the portfolio will also be taxed at the long-term capital gains tax rate. Short-term gains, interest income, and foreign dividends will be taxed at ordinary income tax rates.

Most real estate and other investments are subject to federal capital gains taxes and state income taxes when they are turned into retirement cash. Depending on the state of residence, today’s long-term rates may range from 20 percent to 33 percent and have been higher in the past. In addition, a portion of the gain may be subject to ordinary income tax rates due to depreciation recapture.

Focusing on fees rather than taxes
Many physician-investors spend little time on tax planning, instead focusing on investment-related fees rather than investment-related taxes. Although it is important to ask about fee schedules, other issues should also be considered when selecting a financial advisor.

For example, the firm should avoid conflicts of interest such as the following:

  • utilizing internal positions against those of their clients
  • conflicts regarding securities that the advisors underwrite
  • in-house investment products

Physicians seeking investment advice should research firm choices thoroughly online and review their disclosures through the Securities and Exchange Commission (www.sec.gov) or the Financial Industry Regulatory Authority (www.finra.org) websites.

No one wants to overpay for investment advice, but focusing solely on the fee to the exclusion of tax considerations is also not recommended. If one assumes an 8 percent average gain (not unrealistic for stock market returns during the past 80 years), taxes could be an expense of up to 4 percent. Focusing on a 1 percent or 2 percent investment fee expense and ignoring a 1.5 percent to 4 percent potential tax liability expense simply does not make sense.

Be proactive and diversify
Tax planning for retirement, including a focus on the tax treatment of retirement assets, is crucial. One approach is to pursue a goal of diversification through asset allocation. Diversification and asset allocation are based on a Nobel Prize-winning theory on investments and can be applied to the taxation of investments as well.

Quite simply, tax diversification means using multiple “buckets” for one’s investment portfolios and retirement wealth that are taxed differently in the funding, growth, and access phases. Some, such as QRPs, may be tax-advantaged in the funding phase but have onerous taxation during the access phase. Others—such as a Roth IRA or a cash value life insurance policy—have beneficial taxation in the growth and access phases, but no tax benefit for funding.

The goal should be to diversify wealth with regard to taxation so that the following aims are met:

  • Investments should minimize tax drag under current law.
  • Retirement plans should not be derailed by any potential increase in future tax rates–whether income, capital gains, dividends, or other taxes on a federal or state level.

Among the tactics that can be implemented to achieve these aims are the following:

  • using the right “buckets” for the right assets—QRPs for assets that spin off taxable income; taxable buckets for growth assets
  • managing taxation of transactions—loss and/or gain harvesting in a given year, depending on the client’s current and upcoming tax situation
  • diversifying against the QRP with additional retirement planning to make sure funds grow in various “buckets”
  • using tax-advantaged investments (such as oil and gas or municipal bonds) to limit current taxable income
  • employing cash-value life insurance and annuities, asset classes that are given beneficial tax treatment under the tax code
  • incorporating charitable planning with foundations and trusts for current and future deductions and income streams

Orthopaedic surgeons should want their investments to be more tax efficient, especially if their retirement planning depends on those investments. Taxes on investments can be detrimental to long-term wealth building, if proper planning is not adopted.

David B. Mandell, JD, MBA, is an attorney, author, and principal of the financial consulting firm OJM Group (www.ojmgroup.com). Carole C. Foos, CPA, works as a tax consultant for OJM Group. They can be reached at mandell@ojmgroup.com

Editor’s Note: This article is for general information purposes and should not be construed as providing financial advice. Individuals who need tax or legal advice should contact a duly licensed professional.


Additional Information:
Disclosure: OJM Group, LLC. (“OJM”) is an SEC registered investment adviser with its principal place of business in the State of Ohio. OJM and its representatives are in compliance with the current notice filing and registration requirements imposed upon registered investment advisers by those states in which OJM maintains clients. OJM may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration requirements. For information pertaining to the registration status of OJM, please contact OJM or refer to the Investment Adviser Public Disclosure web site (

Special offer for AAOS members: Download Wealth Protection Planning for Orthopaedic Surgeons and Sports Medicine Specialists, co-written by David Mandell, JD, MBA and Peter Millett, MD, for free at www.guardpub.com/orthopaedicwealthprotection/ by using code AAOS123.