Navigating IRS deductions: a tax guide for residents
New—and old—rules may save you money, but only if you understand all of the ins and outs
From the February 1999 ACP-ASIM Observer, copyright © 1999 by the American College of Physicians-American Society of Internal Medicine.
By Phyllis Maguire
With April 15 just around the corner and new rules taking effect for deducting interest paid on student loans, it's time to start thinking about your taxes.
It's no surprise if you haven't—what with small stipends, walloping debt and brutal hours, most residents haven't thought much about, much less mastered, the tax-code maze. But it's worth the effort: You may be able to significantly lower your taxes, but only if you know where to look.
For the first time in recent years, for example, housestaff can deduct interest paid on student loans—under certain conditions. You can also write off a number of work-related expenses, but only if you meet certain criteria.
So how can you minimize your taxes, steer clear of trouble with the IRS and keep an eye on your financial future? While you should always consult a qualified tax adviser before filing your return, here are some tax strategies to make the most of student loan interest, individual retirement accounts, business expenses and moonlighting income.
Probably the biggest tax question residents have this year concerns the deduction of interest on their student loans. The Taxpayer Relief Act of 1997 allows you to deduct interest paid on student loans on or after Jan. 1, 1998. The maximum deduction you can take for the 1998 tax year is $1,000; that deduction will increase annually by $500 increments until the year 2001, when it will peak at $2,500.
But there are several restrictions, all of which apply. First, you can deduct only interest paid under a formal repayment plan. If you have deferred your loans but make voluntary payments to chip away at your debt, for instance, you cannot deduct the interest portion of those payments.
There is also a time restriction: You can deduct interest paid only during the first 60 months of a loan's repayment period. And there are income restrictions. To take the maximum deduction, you can earn no more than $40,000 if you are single and $60,000 if you are married and filing a joint return. (You cannot claim the deduction if you are married and filing a separate return.)
If you exceed those income limits, however, you may claim a partial deduction if you are single and make between $40,000 and $55,000 or are married and earn between $60,000 and $75,000 (and file jointly). For instance, a single resident with an adjusted gross income of $47,500—the midpoint of the range—can deduct 50% of the maximum deduction ($500).
Unfortunately, many residents can't meet all of these requirements. With PGY-1 housestaff stipends averaging less than $34,000 per year, residency is the one time physicians will qualify under the income restrictions. But doctors' educational debt is typically so large—topping $80,000 on average for the class of 1997, according to the Association of American Medical Colleges (AAMC)—that residents often defer paying off their loans until they finish their residencies. By then, their higher incomes knock them out of the deduction ballpark.
"The folks who are going to qualify are those who have debt in the $30,000 to $40,000 range," explained Paul S. Garrard, an AAMC senior staff associate. "It's a twisted kind of logic that will help people with less debt."
Mr. Garrard suggested talking to a financial planner about paying off your student loans over a longer period of time, a strategy that would lower your monthly payments enough so you could make them as a resident and take the deduction.
If you have to defer your loan payments and can't take advantage of the interest deduction, don't despair. Analysts say there can be tax advantages to deferring loans and attacking them more aggressively once you're in practice. Brian H. Fenn, a certified financial planner with Carolina Capital Consulting Inc. in Charlotte, N.C., said that when physicians finish their training and buy a house, they can roll their student loans into a mortgage or other type of equity loan, making all their loan interest tax-deductible.
Are IRAs worth it?
One way to reduce your taxable income—and perhaps qualify for the student loan deduction—is through a 401(k) or 403(b) contribution plan. These types of retirement plans allow you to make annual pre-tax contributions of up to 20% (with a 1998 cap of $10,000) of your income. They are a particularly attractive option if the medical center where you work will match your contribution, putting away a certain amount for every dollar you contribute.
But if you're establishing a traditional individual retirement account (IRA) on your own just to get a tax deduction, experts suggest a Roth IRA instead. With conventional IRAs, you don't pay taxes on your contributions until you withdraw the money after retirement. You will pay taxes on those withdrawals, however, according to the tax bracket you're in when you retire.
With a Roth IRA, on the other hand, you pay taxes up front on the money you contribute, but the money grows tax-free. And unlike a traditional IRA, your funds can be withdrawn tax-free at retirement. (You can contribute up to $2,000 a year to a Roth IRA.)
Because doctors typically find themselves in a much more bruising tax bracket when they retire than while they're residents, analysts say it is a good idea to pay taxes on your retirement money now, not in the future.
"Doctors want to save taxes today at all costs, which may not necessarily be the best thing to do," said Mr. Fenn. "When you're in a 15% or 28% tax bracket, a tax deduction is not that big of a help. Residents should be more concerned about their tax situation down the road."
What to deduct
Many residents get confused about deductions. Start with moving expenses. You may be able to deduct moving expenses if you've moved more than 50 miles from your medical school to the teaching hospital. (As usual, restrictions apply.)
You can also itemize a long list of unreimbursed business expenses such as professional society dues, work-related books, journal subscriptions, job search expenses and required work clothes on Schedule A (consult the IRS for a full list of what you can deduct), but there are some major strings attached. First, you can only take those miscellaneous deductions if they total more than 2% of your adjusted gross income. If your adjusted gross income is $40,000, in other words, you cannot deduct the first 2%—or $800—of unreimbursed business expenses.
There is also a substantial "if" that governs all Schedule A itemized deductions. (Schedule A deductions include medical and dental expenses, taxes and home mortgage interest paid, gifts to charities and casualty and theft losses, as well as unreimbursed business expenses.) If those deductions do not exceed the IRS's standard deduction—which is $4,250 for single taxpayers and $7,100 for married people filing jointly—then none of them can be used. This rule makes it difficult to muster enough itemized deductions unless you pay mortgage interest and real estate taxes on a home you own.
Expenses like malpractice insurance are deductible, but most medical centers pay malpractice premiums for housestaff members. If you choose to moonlight, however, you will need additional malpractice insurance.
Moonlighting raises additional tax issues. For example, if you're considered a part-time employee at a moonlighting job, you'll receive a W-2 statement of wages. You can add unreimbursed business expenses incurred while moonlighting to your miscellaneous deductions on Schedule A.
For jobs where you work as an independent contractor, however, you'll receive a Form 1099 statement of miscellaneous income. To deduct expenses from income earned independently, you must file a Schedule C (Profit or Loss From Business). The advantage of filing a Schedule C is that you can deduct all expenses without having to meet the requirements for Schedule A deductions.
The problem is that knowing what to deduct on a Schedule C can get complicated. Financial analysts say that residents can deduct the standard mileage rate of 32.5 cents per mile when driving between jobs, such as going from the teaching hospital where you're employed to the clinic where you moonlight. You may not deduct mileage expenses, however, if you drive to your moonlighting job from your home-unless you qualify for having a home office, which brings up a whole other tier of tax-code complications. If you do deduct mileage, keep a detailed log of dates and miles driven to substantiate any claims you make.
There is another downside to income earned as an independent contractor: When you are self-employed, you are responsible for paying all of your social security and Medicare contributions, known as Federal Income Contributions Act (FICA) taxes. FICA contributions equal 15.3% of your net Schedule C income, after deductions, if your net income exceeds $400. If you can claim enough Schedule C deductions to bring your net income down to $399, you don't have to make pay taxes.
Many residents worry that filing a Schedule C makes them a more visible target for audits. Experts, however, say that the IRS sharply scrutinizes only those Schedule C returns that show profits of $100,000 or more. While that threshold certainly eliminates most residents, it is something to keep it in mind as you move into medical practice.
Finally, if you are an international medical graduate, your tax obligation will vary according to your home country and its tax treaty (or lack of one) with the United States. Different tax rules also apply depending on your status as nonresident or resident alien. Start with IRS Publication 901, entitled "U. S. Tax Treaties." (See box below for more information.)
Students vs. Employees: Should residents be taxed?
Next year, a few thousand past and present residents from the University of Minnesota in Minneapolis will have an unexpected item of income to report on their 1999 tax returns: interest earned on refunds from taxes they paid while they were residents.
After almost a decade of lawsuits, an appellate court last year upheld the university's position that its residents are students, not employees. As a result, they don't have to pay Medicare and Social Security taxes, also known as Federal Income Contributions Act (FICA) taxes.
Next month, the federal government is expected to refund the university "in excess of $40 million," according to William P. Donohue, JD, the university's deputy general counsel. That sum, which represents almost eight years of FICA tax contributions plus interest, will be divided between the university (which paid the "employer's" portion) and its residents.
While the payment represents a financial windfall for the university and its medical center, the court ruling has not sparked a groundswell of filings from other academic institutions for FICA tax refunds. Analysts say that's because residents at the University of Minnesota meet student criteria that don't apply at many other teaching hospitals.
The University of Minnesota's dispute began in 1989 when a disgruntled former resident complained to the Social Security Administration (SSA) that the university didn't withhold FICA taxes. The SSA assessed the university for FICA amounts not collected, plus interest, which ranged from $3 million to $4 million a year. While contesting the assessment, the university began withholding FICA taxes for residents in October 1990. (It has since stopped its FICA withholding and contributions.)
After trying unsuccessfully to settle the case, the university sued the SSA in U.S. District Court and won a decision that the Eighth Circuit Court of Appeals upheld in July 1998.
The university used two arguments to establish that its residents were students. First, it proved that an agreement from the 1950s between the federal government and the state of Minnesota regarding social security coverage was never modified to include medical residents. The more far-reaching argument, however, held that residents are excluded under FICA's statutory exception for students. University of Minnesota residents register for courses and pay tuition, key factors that helped the university win its case.
Because most residencies are not similarly structured, few teaching hospitals have jumped on the FICA-refund bandwagon. One that has followed the Minnesota decision closely, however, is Georgetown University Medical Center. According to Ted M. LeBlond, housestaff coordinator, Georgetown has filed for a refund of its 1994 resident FICA taxes and is planning to file for subsequent years as well.
Can Georgetown successfully argue that its residents are students? "Residents don't pay tuition here," admitted Mr. LeBlond, "but they do have a syllabus and they take classes." At stake for Georgetown and its residents is about $900,000 in annual FICA contributions.
Meanwhile, University of Minnesota residents can receive refunds only if they have authorized the university to file a refund claim on their behalf.
Residents will probably receive a FICA tax refund of between $2,000 and $3,000 for every year of residency, plus interest that has accrued. According to Mr. Donohue, residents will not have to report their FICA tax refunds as income, but they will have to report the interest amounts they receive.
Where to find out more about taxes
Here are some Web sites residents can turn to for financial and tax advice:
- The IRS (www.irs.gov) offers more than 500 forms and 100 different publications that can be downloaded to help with tax preparation.
- You can find an excellent explanation of the student loan interest deduction at www.usagroup.com/students/taxbreak.htm.
- For a comprehensive discussion of medical student loans, check out "The Layman's Guide to Educational Debt Management" from the Association of American Medical Colleges at www.aamc.org/stuapps/finaid/layman/start.htm.
- International medical graduates can find an electronic version of the Tax Treaty Table, which lists the details of tax treaties between the United States and many foreign countries, at www.bussvc.wisc.edu/ecbs/uw1139.html
Internist Archives Quick Links
Superior MOC Solutions from ACP
Meet your requirements with our approved activities. See details.
Making the Most of Your ICD-10 Transition
To help you and your practice make a smooth and successful transition to ICD-10 coding, ACP and ICD-10 content developers have created multiple resources available at discounted rates for ACP members.