The Government Doesn’t Want you to Work (Too Much)

A feeling of dread suddenly came over me. The numbers just didn’t add up, yet I could not figure out where I went wrong. Maybe I typed something in wrong or missed a section, but everything looked more or less complete. Maybe I’m just getting too old for this and I should hire a trained professional to do a task I have been in-sourcing for years.

You see, I had just filed my federal and state taxes. Normally this would fill me with great satisfaction (and it did before my panic attack). I have been doing our taxes for many years now, something I think most physicians outsource. I consider myself quite unusual in that I actually enjoy doing my taxes. Yep, you read that right. Doing taxes brings me great joy. It probably makes sense for me to hire a tax professional from a cost/hour analysis, but aside from increased happiness, I feel there is a big benefit to doing my own taxes. It forces me to have at least a basic understanding of how the tax code works. This, in turn, gives me insight into steps I can take to lower future tax liability.

When the new tax bill was passed last year, I poured over blog-posts and fancier articles to try and figure out the impact it would have on me. I even wrote my own simplistic, yet awesome analysis. I figured I would save a small amount of money due to the lower tax brackets across the board, but would probably give back much of it due to new limitations on SALT deductions (state and local taxes). It was difficult to anticipate what all of the moving parts of the tax code would do to a half time radiologist, and none of the online estimators agreed with each other. I was expecting a little relief, but I was shocked at the final result…

Please Sir, May I Have Another CT Scan…

I won’t lie. It’s been a very busy year at work. Like ridiculously busy. In spite of my best efforts to lower my taxable income by increasing my tax deferred retirement savings, my adjusted gross income and taxable income actually both went up this year. Radiology (and much of medicine overall) has become busier in recent years. The volume of radiology studies being done continues to increase, whereas the number of radiologists per capita has remained relatively stable over the years. I’m quite sure this trend holds for many specialties. As the population in the United States ages, there is a greater demand for medical services. As we become older as a population, we consume more medical care per person. Did I mention we were really busy this year? But in spite of my increasing income, my total tax burden, and effective tax rate went down…a lot. Here are the numbers (percentages):

Those numbers are not typos. While my taxable income went up a bigly 17%, my effective tax rate was 21% lower. As you may already know, I work half time. I wondered if I just got lucky and fell into the sweet spot in the new tax code. Just for fun, I estimated what my taxable income would be if I was working full time, and plugged it into turbotax. Doubling my income increased my effective tax rate was an astonishing 60%, and the amount I owed tripled. This was probably also an underestimation, as I did not take into full account the effects of not being able to shelter the same proportion of that money in tax advantage savings.

Effectively, if I was working full time, I would pay at least twice as much tax on the second half of my income compared to the first half.

WTF? If this is not a powerful incentive to cutting back on work, I don’t know what is. I can only conclude one thing from this data: The government doesn’t want you to make too much money. Once you make a decent amount of money, you will be punished harshly for making more.

Fair is Relative

Now we can debate all day long what a “fair” tax code looks like, and we would never come to any consensus. The truth is, there is no “fair” tax code. What is fair to one person is a war crime to another. What is social justice to some is an all out assault on freedom to another. Fairness is not my point. Fairness does not drive human behavior, incentives do.

Humans respond to incentives. If you give them money to do something, they will tend to do it. If you take money away from them for doing something, they will do it less. For example: If you stopped giving people a tax break to buy a house, more people may rent (or the prices of housing may fall). If you raised the fine for speeding tickets to $20,000, traffic would slow dramatically.

Marginal VS Effective Tax Rate

I think it is important to take a slight detour and review how the tax code works for those of you who don’t fully understand it. It is tax day after all. In the Unites States we have a progressive system of taxation which utilizes 7 tax brackets ranging from 10% to 37%. The more you make, the higher your tax rate. This means that wherever your income falls in the table below, for each additional dollar you make your tax rate for that dollar is on the left. If you are married and make $50,000 per year, your next dollar will be taxed at 12%, whereas if you make $350,000 per year your next dollar will be taxed at 32%. This is your marginal tax rate. It is the tax rate at which your next dollar of income will be taxed. Your effective tax rate is simply the average tax rate of all of your income. Remember, life happens on the margins.

To summarize:

Effective tax rate = Average tax rate paid on income.

Marginal tax rate = Tax rate paid on last dollar.

There is a common misconception that it is advantageous to stay in a lower tax bracket, because if you jump into the next bracket there will be a huge jump in tax liability. This is not true. Your increased liability only applies to money earned in the bracket. Some deductions or other benefits which take income into account may be lost or phased out, but there is not a huge penalty for earning that additional income, so don’t purposefully make less money just to get into a lower tax bracket (unless it seems worth it from a trading money for time equation). Here are the current tax rates (as of April 2019):

The Paradox of Work

I write about work often. It is a big part of most of our lives. It is the intersection of our livelihood, our identity, and for many, even the center of our social lives. It defines where we live, what we do, who we hang out with and what we can consume as we trade our hard earned dollars back for cars, colonoscopies and Netflix subscriptions. Our ability and willingness to work is our biggest asset, especially for high earning individuals early in their career. But at the same time, the federal government will take a larger piece of your money as you climb the income ladder, effectively making you work much harder on the last dollars you earn when compared to the first. This article is a nice example of how $1,000,000 is taxed differently depending on the timing of when it is earned.

This paradox is why we feel so conflicted, and why it seems like we should be doing better financially than we really are. This is why working full time is often not twice as lucrative at working half time. Between taxes and increased outsourcing of services (because we have no time to do them), there is a bigger financial hit then you might expect. Although decreased tax liability was not my main reason for cutting back to half time work, it is a rather pleasant side effect.

But Why Did My Taxes Go Down So Much?

All this being said, I was still intrigued as to why my taxes were so much lower. I grabbed my tax forms from the last few years and poured over them. A large portion of my tax savings did indeed come from the drastically lower middle tax brackets. My top marginal rate went from 33% to 24%. This is a big drop. But my deductions were quite a bit lower, like less than half of what I was able to deduct last year. Like most people, I now take the standard deduction with the new limitations on SALT deductions. I was able to take the tax credits for having kids, which was nice.

The biggest difference though, was the fact that this is the first year since I’ve been working that I was not hit with the dreaded AMT(alternative minimum tax). This is perhaps the best thing about the new tax bill. Regardless of where you fall on the political spectrum or income level, you probably agree that the AMT is not a great thing. Originally written into the tax code to make sure high income individuals paid at least some tax, the geniuses didn’t index it for inflation, and prior to the new tax reform was hitting millions of people each year (instead of the couple hundred thousand it was intended for). Eventually, if no changes were made, we would all be paying AMT. I admit, I do not fully understand the mechanics of the change (maybe someone can explain it to me in the comments), but the end result is no more AMT for The Happy Philosopher. Good riddance AMT!

Adding in state tax, my marginal rate is currently around 33%. If I was working full time it would be about 45%. If I pick up extra shifts or do more work I have to keep this in mind. You should too. If I go make another $1000, I will be giving $333 right back to the government. In order to determine your marginal tax rate just look at a copy of your taxes and find the box labeled “taxable income” (Line 10 on the 1040). Check the tax tables (be sure you use your correct filing status) to find your tax rate. Do the same for state taxes. Add them together and Voila.

By the way, here is a cool table I made showing my effective tax rate over the last 19 years (yes, super geeky I know). It has ranged from about 14% (as a resident) to a mind numbing 36% (at peak earning). Again, this is effective rate not marginal. My marginal rate was higher. Just for fun I added up all of the state and federal tax I have paid in my lifetime, and the number was mind boggling. 31.5% of my lifetime earnings has gone towards income tax payment…and there are still potholes in the roads I drive on!

How to Pay 0% Marginal Tax

Time to geek out a bit to taxes. This may be super boring to you, but I love this stuff, and it’s my blog so deal with it 🙂 A 0% marginal tax rate is in theory possible for a physician, but requires some accounting gymnastics, and probably can only be accomplished later in your career after some serious savings. Most physicians are at a spending level where they will need some capital gains and dividends income to pull this off. These numbers assume married, filing jointly. This will probably not work at very high income levels and also requires access to a cash balance plan or other equivalent. Oh, and I’m not a tax professional, so follow this advice at your own risk, or maybe check with someone who actually knows stuff about taxes. Enjoy.

Step 1: Earn W2 income. You have a standard deduction of $24,000 (married). If you only made $24,000, congratulations. You are finished and no need to go to step 2. Instead start looking for a higher paying job!

Step 2: Take all other earnings over $24,000 and put them in tax deferred savings (IRAs, 401k, health savings account, cash balance plan). If your income is $250,000 you will need to figure out how to shelter $226,000 (250k-24k). Here is an example of how to do that for our hypothetical married couple:

• 401k/profit sharing plan: $53,000 ($59,000 if 50 or older)
• IRAs: $12,000 ($14,000 if 50 or older)
• HSA: $6900 ($8900 if 55 or older)
• Cash balance plan: $154,100 (or less if over 50 or 55)

Step 3: Get money to live off of. So you have $24,000 in W2 income, which would be difficult to live off of, even for the very frugal. If you need around $75,000/yr to live your lifestyle, you would obtain the other $50,000 or so from a combination of dividends, long term capital gains and qualified distributions from your HSA for medical expenses. This obviously requires assets that can generate dividends or long term capital gains.

Step 4: Brag on social media about how awesome you are, and that only losers pay taxes. Just kidding. Don’t do that.

So should we call HR and start setting this stuff in motion? Probably not. Even though it may be intellectually satisfying, you are going to have to pay taxes on most of that 401k/IRA/profit sharing money eventually. A better idea is to try and keep your taxable income below about $77,000, which will keep you in the 12% marginal tax bracket and the 0% qualified dividend/long term capital gains. If you can pay income taxes at 12% you are winning the game.

Thinking Ahead

I’m on the glide path to early/semi-early retirement. I’ve been working more days, harder days, and longer hours this last year or so. At times it has been fun. It feels good to be very productive, but I’m not sure how long I want to continue at this frantic pace. I’m really glad I’m not working full time. The combination of extreme frugality relative to my income, lack of major financial disasters in my life, and many years of practicing medicine has put me in a pretty good spot. At a marginal combined state and federal tax rate of 33% I don’t think I will be looking to earn more money when I have to turn around and give a third of it back to the government. This is something for you to keep in mind as well. There is a balance between work and optimal happiness, and knowing how much is actually going into your pocket at the end of the day is powerful information. Know when enough is enough.

So now that your taxes are (hopefully) filed, what was the effect on you? Did they increase, decrease or stay about the same? Please share your experiences in the comments below. And happy tax day!