Wender Hwang, MD Chief Resident Department of Emergency Medicine Loma Linda University Medical Center Loma Linda, Calif Erik W. Thurnher, MD, CFP Emergency Physician Kaiser Permanente Medical Group Lakewood, Calif Certified Financial Planner Physicians' Financial Advisors Newport Beach, Calif

In the first 2 articles of this series (June and July/August 2006), you learned basic investment strategies and how to begin investing. This month’s article teaches you how to use the tax code to your advantage, keeping Uncle Sam’s fingers out of your meager paycheck.

Financial Disclaimer
Please consult your tax advisor or employer if a particular topic is right for you. Side effects of learning about or using the tools outlined here may include increased wealth, early retirement, thicker wallet, or sounding educated at a cocktail party.

Reduce Your Tax Burden and W-4 Withholdings
The first pay stub Dr Hwang received during his internship year had the following amounts:

Income earnings	$1539.20
Federal income tax withholding	—$148.38
Federal Medicare tax (1.45%)	—$22.32
Federal Social Security tax (6.2%)	—$95.43
State (Calif) income tax withholding	—$50.09
State (Calif) disability insurance (1.18%)	—$18.16
Before-tax deductions	—
After-tax deductions	—
Net pay distribution	$1204.82

This was his first real paycheck. Looking at his salary earnings, he thought, “Wow, I get that much every 2 weeks. I’m rich.” Then he saw that $334.38 was deducted in taxes in this paycheck alone, which amounted to 20% of his salary. Where did all that money go? What could he do to reduce these deductions as much as possible?

Unfortunately, unless the government changes the tax laws, Medicare tax will remain 1.45%; Social Security tax, 6.2% (up to $94,000 income); and state disability insurance (in California), 1.18% of your total income. Be thankful, though, that you are actually only paying half of the total taxes; your employer pays the other half. That is, the total tax amount is double these 3 percentages. If you decide to become a private contractor or a partner in your medical group after residency, you will have to pay for the employee’s and the employer’s portions of these 3 taxes.

Taxes are significant deductions from your paycheck, and you stand to gain the most by reducing your tax burden. The 4 methods to reduce your tax burden and tax withholdings are, in order of priority:

1. Reducing your taxable income and tax burden with pretax deductions (ie, 401k/403b accounts as discussed in the July/August 2006 issue)
2. Using strategies to maximize your itemized deductions
3. Spending pretax money on medical and child care expenses using a flexible-spending account (FSA)
4. Reducing the federal/state tax withholdings by changing your W-4 exemptions

Tax Exemptions
Although it may be satisfying to receive a tax refund in April, you are essentially giving the US government a free loan for many months. Federal/state taxes are collected in a pay-as-you-go plan each pay cycle. The amount withheld is based on the W-4 form you filled out when you were first hired. Many people claim too few allowances and thus have too much money withheld from each paycheck, leading to a tax refund in April.

To correct this, fill out a W-4 form at the payroll office either to claim exempt (have no money withheld each paycheck) or to increase the number of allowances (Table 1), which will decrease the amount withheld in taxes each paycheck. With less money withheld, you can invest that money (in the bank or the stock market) instead of giving the government a free loan. You still have to file a tax return in April (even if you claim exempt), and you may end up owing some tax. You can claim exempt status only if you expect your annual taxes to be less than $1000 or if you had no tax liability in the previous year (ie, if you did not work in the past year). Otherwise, simply increase the number of allowances on the W-4 worksheet.

The difference between regular withholdings and claiming exempt status is:

Biweekly pay stub	Regular withholdings	Exempt status
Income earnings	$1539.20	$1539.20
Federal income tax withholding	$148.38	$0.00
Federal Medicare tax(1.45%)	$22.32	$22.32
Federal Social Security tax(6.2%)	$95.43	$95.43
State (Calif) income tax withholding	$50.09	$0.00
State (Calif) disability insurance (1.18%)	$18.16	$18.16
Net pay distribution	$1204.82	$1403.29
Total deductions/ withholdings	$334.38	$135.91

Remember the following 2 caveats if you want to claim exempt status or increase your allowances:
1. You need discipline to save money in case you have a tax due in April.

2. Uncle Sam will penalize you if you hold back too much tax money. Generally, no penalty is incurred if you meet any of the following requirements (you will still have to pay the tax you owe in April, just without penalty):

• You have already paid at least 90% of your tax burden for the year as paycheck withholdings. This is for people who increase their allowances, not for those who claim exempt. You must pay at least 90% of your total annual tax or else the Internal Revenue Service (IRS) penalizes you. No penalty is incurred if any of the remaining requirements are met:
• Your unpaid tax due is less than $1000
• You had no tax liability for the previous tax year
• You had no taxes withheld, and your current-year tax, less any household employment taxes, is less than $1000
• You have paid as much tax this year as you owed the previous tax year.

If you decide to claim exempt status or to increase your number of allowances, you will want to do everything you can to decrease your taxable income so that you qualify for one of the no-penalty requirements. Generally, most interns will fall under the “no tax liability the previous year” exception. For ideas on how to reduce your taxable income see the sections on tax-deferred 401k/403b accounts (in the July/August 2006 issue), FSAs, and tax deductions.

Tax Deductions
When starting our medical career, we are receiving a new steady source of income, and we are incurring several one-time and recurring professional expenses. These expenses are all tax deductible (Table 2) and can be itemized in your annual tax return (you only claim the total amount that exceeds 2% of your salary). In calculating year-end taxes, you can either itemize deductions or take a standard deduction (calculated by the IRS, based on marital status and a few other criteria).

Itemizing is better than taking the standard deduction only if the itemized expenses exceed your standard deduction. It is often difficult to find enough expenses to exceed the annual standard deduction. However, inherent in residency status are several large, required expenses. It would be prudent to plan all your major expenses (eg, licensure examinations, licensure fees, laptop computers, society memberships) to occur within the same tax filing year so that you can have a large itemized deduction and avoid making any business-related expenses during years when you will be claiming the standard deduction.

The following are a few examples of deductions you may be able to claim in your next tax return:

Moving expenses
• Airfare/car rental during your apartment search ($200-$400)
• Charitable donations of items you do not bring with you ($400-$800)
• Gasoline during your move (eg, $200, including the car/van you drive for your move)
• Interviewing expenses for your new job: airfare, hotels ($100-$400)
• Moving van ($400-$600, depending on distance)

Professional expenses
• Desktop/laptop computers ($500-$2000)
• Journal subscriptions
• Licensing examinations (eg, $600 fee for US Medical Licensing Examination, step 3)
• Licensing fees (eg, California state, $300; Drug Enforcement Administration, $395)
• Society memberships ($50-$200)
• Specialized medical equipment/clothing (eg, stethoscopes, white coats)

If you are a new intern, you may want to have all your residency expenses occur during that intern year, because you probably had large job-related expenses for that position (eg, moving, interview travel). You may, however, want to save the expenses for the next calendar/tax year, because you will have a full year’s salary during the next calendar year (you are only paid 6 months’ worth this year, from July to December). This approach is called “bunching deductions” and entails clustering deductible expenses in a single year so as to maximize any available tax savings.

Flexible-Spending Accounts
FSA participants make pretax contributions by payroll deduction into an FSA maintained by the employer. You pay your out-of-pocket healthcare and dependent care expenses as usual and submit receipts requesting a reimbursement check for these expenses. An FSA essentially increases take-home pay by setting aside untaxed money to pay for fixed expenses (Table 3). Two types of FSAs are available: the healthcare FSA and the dependent care FSA. The healthcare FSA reimburses eligible out-of-pocket healthcare expenses. The dependent care FSA reimburses eligible child care expenses and certain costs associated with the care of a dependent child, spouse, or parent.

You can benefit from an FSA even if you have no dependents. For example, a $20 monthly prescription (eg, birth control pills) will cost $240 per year. By contributing $10 pretax in each biweekly paycheck and using your healthcare FSA to reimburse you for the prescriptions, you will increase your take-home pay by approximately $30 (the amount of tax you would have paid to the government if that $240 was paid to you directly instead of the pretax FSA). This is money you would have spent anyway.

Some people argue that the FSA is too much hassle and that they would rather deduct healthcare expenses on their tax return. However, you can only legally deduct the portion of total health expenditures exceeding 7.5% of your annual income. No deductions are allowed if the total is less than 7.5%. Most of us are in this category. If your healthcare expenditures exceed 7.5% of your income, you stand to save a lot more money with an FSA anyway.

The main disincentive of having an FSA is that unused funds are forfeited every year on March 15. Money you accumulate in calendar year 2006 can be used for eligible expenses from January 1, 2006, through March 15, 2007.

The healthcare FSA annual limit is $2600. Eligible healthcare expenses include these items (partial list):
• Medical equipment
• Medical insurance copayments and premiums
• Over-the-counter medications for medical conditions
• Prescription medications.

Ineligible healthcare expenses include (partial list):
• Condoms, toothbrushes, toiletries, personal use items
• Federally controlled nonprescription drugs (eg, marijuana).

The dependent care FSA annual limit is $2500 for single people or married people who file separately and $5000 for married people who file jointly. Qualifying dependents for dependent care expenses are:
• A child under age 13 who is in your custody and whom you claim as a dependent
• A dependent (child older than 13, parent, sibling, or in-law) who lives with you whom you can claim as a dependent on your tax return and who is incapable of self-care
• A spouse who is incapable of self-care.

If care for a disabled spouse or dependent is provided outside the home, the dependent must live with you for at least 8 hours of each day.

Eligible dependent care expenses include (partial list):
• Care provided at a day-care center or other location outside your home
• Housekeeping services provided at least in part for the dependent
• In-home dependent care
• Nursery school
• Private preschool program
• Public or private before-school and after-school care
• Summer day camp, if the cost is reasonable compared with other alternatives, and if the main purpose is to provide for the well-being of the child.

Ineligible dependent care expenses are (partial list):
• Babysitting for social events
• Care provided by your spouse, your child under age 19, or someone you claim as a dependent for tax purposes
• Food or clothing provided for your dependent
• Overnight camp expenses
• School expenses for children in first grade or above
• Transportation expenses to and from the care location.

Conclusion
In the next article in this series we will discuss how to reduce your debt, specifically focusing on your existing debts and spending patterns. “Stop overspending” will not be found.

ACTION CHECKLIST For a reminder of the financial tasks you need to accomplish, refer to the Action Checklist that appears in Part 1 of this series. Access this online, in the Archives (June 2006, Vol 52, No 6).