By Dr. James M. Dahle, WCI Founder
It's become a bit of a tradition the last few years for me to do a post about our taxes. Like many of you, I do my own tax preparation. I do this not only to save money (I'll bet my tax returns would cost me between $2000-3000 if prepared professionally) but mostly to learn the tax code. Knowing the tax system is useful not only to know what I need to keep track of during the next year, but most importantly to teach me how to tweak my financial life to minimize Uncle Sam's take. I practice tax avoidance, but not tax evasion. I pay the federal and Utah state governments every penny I owe, but I refuse to leave a tip.
New Schedules
Without fail, every year it seems I need to learn a new schedule or two. This year was no different and in fact was a major pain in the rear. Since I gave away part of my business (see recent post) I had to learn how to do a partnership return (Form 1065). Previously, since I was the only member of the LLC, I just did the WCI return on a Schedule C. This year, instead of a Schedule C for WCI, we had two K-1s. Instead of just getting K-1s, I also had to give them. However, doing the WCI return this way did have the nice benefit of not having to input dozens of 1099s, so it was really a wash effort-wise. Since I hired my kids as models in 2015, I also had to issue W-2s and W-3s in addition to the 1099 to my business manager. None of that was really too bad. I could issue the 1099s, W-2s, and W-3s using Turbotax Home and Business. Unfortunately, I would have had to pay another $130 to get Turbotax business to do a very simple partnership return. I cheaped out and just did it by hand. It was no big deal.
What was a big deal this year, however, was dealing with the disposition of my rental property (for a huge loss.) That was all new to me. To make matters worse, while in the midst of doing that I realized that Turbotax had carried forward a figure for the previous 3 years that basically said I was only renting out the property 2% of the time, limiting my depreciation deductions. So I had to go back and correct my 2012, 2013, and 2014 taxes, submitting 1040Xs for each year. I'll get a few hundred bucks back overall, but mostly it just straightened everything up so I could maximize my tax loss for 2015, which was my real goal.
I was also pleased to learn that I didn't have to file a 1040 for any of my new employees. The Social Security Administration did send me a letter asking me to clarify what job the two youngest ones were doing. Apparently they think it's weird to have a 6 year old employee but not an 8 year old employee.
Adding Up the Damage
As my financial life and thus my e-file returns have become more complicated, it makes it harder to compare my effective tax rates from one year to the next. I don't just take what Turbotax says my rate is. I subtract my legitimate business expenses, but not my losses to get my total income. Then I subtract my losses and deductions. As you all know, my income was significantly higher this year and we were expecting to be in the top bracket. However, thanks to savvy tax planning, we ended up with a taxable income well below the cut-off. Our taxable income was around 55% of our total income plus the above mentioned losses. (I see all you out there trying to calculate our income in your heads. It's not that hard. I publish what WCI makes and all you have to do is add that to a typical emergency physician partner income and that'll get you in the ballpark.)
2015 Effective Tax Rates
- Federal 14.8%
- Payroll 6.7%
- PPACA 0.6%
- State 3.2%
- Total 25.3%
That's not too bad, and much better than I had feared. I was worried we would hit an effective tax rate of 30% this year. Of course, the total taxes paid was about five times my salary as a resident, and about 38% more than we paid last year. I don't even want to think about adding property and sales tax to that total. By way of comparison our overall effective tax rate was 23.9% last year and 15.5% in 2011, the year I started WCI and my last year before making partner. I find it interesting that despite quadrupling our income over those four years, our effective tax rate has only increased by 9%.
[Update 4/15/2016: A few brief comments on how I calculate the effective tax rate. First, you should note that this is different from how Turbotax does it. Turbotax takes line 55 (federal income tax) and divides it by line 38 (adjusted gross income.) Under that, I owe 22.8%. That's a dumb way to do it in my opinion. A much more sensible way is to use your total income (line 22) as the denominator and line 63 (total tax) as the numerator. And if you're in a state with an income tax, add your total state tax to the numerator. But even that can be adjusted. For example, I add back in my tax loss harvesting (-$3K on line 13) and my real estate loss (-$29K on line 14) to the total income. If you're an employee, you may wish to add your 401(k) contributions to your total income, since they don't show up on your 1040. You may also wish to add in the employer's half of your payroll taxes to the numerator and denominator. You're paying those, whether you see it or not. ]
The Marginal Tax Rate
Tax software is great for figuring out your marginal tax rate. All you do is add $100 to your earned income and see how much your tax bill goes up by. In my case, my federal tax + payroll tax due goes up by $36 and my state tax due goes up by $5. So my marginal tax rate is 41%. However, we stayed out of the top tax bracket this year. If I add $100K to my income to get us well into the top tax bracket, and then add another $100, my tax bill for that extra $100 is $46.
Estimated Tax Payments
In 2014, we paid a very minor penalty for underpaying our taxes throughout the year. In an effort to avoid that happening, we decided to just take last year's tax bill, divide it by four, and multiply it by 110% and pay that much each quarter. That guarantees we'll avoid penalties by keeping us in the safe harbor. However, by midway through the year, it became clear that WCI was doing very well and we were dramatically underpaying our taxes. That caused quite a bit of worry and difficulties with cash flow planning as I wasn't really sure how much we were going to owe. This year we're going to do things a little bit differently. We're still going to make quarterly payments of 110% of what we owed for 2015, but this year I'm paying 27% of whatever we make into a side account each month to cover the tax bills. Why 27%? I figure we'll make a little more this year and we won't have that rental property loss, so that's why it's more than the 25% we paid this year. Hopefully that'll eliminate the cash flow concerns we had this year.
How We Did It
I'm often asked how we can possibly keep our effective tax rate so low. It's really not that complicated. The truth is our effective tax rate is usually even lower than this post states. That's because a great deal of our income occurs in our retirement accounts, which we have been maxing out since residency. All that interest, all those dividends, and all those capital gains are not taxed. Even if our portfolio doubled in a single year, we wouldn't owe any significant amount of additional taxes due to using retirement accounts to invest. Ignoring that, there are seven keys to our relatively low tax bill.
#1 Learn the Tax Code
More than anything else, I know how taxes work. I read a few books about it, but mostly, it comes from the experience of just doing my own taxes for 20 years. There are minor changes each year, but it's basically the same code year to year and once you learn how it works, you can carry that knowledge with you the rest of your life and apply it to your advantage.
#2 Retirement Account Contributions
Retirement accounts can be a little bit complicated. But it became very obvious to me early in my career that learning how they work would be beneficial to my finances. I was later asked to write the IRA chapter for The Bogleheads Guide to Retirement Planning. So as I've gone through life, I've made decisions that caused me to have more and more retirement accounts available to me. Those decisions include using Backdoor Roth IRAs, using a high deductible health plan so we could use an HSA, going into a partnership where I had a 401(k)/profit-sharing plan and a defined benefit plan, starting a side business, and then this year, adding my spouse as an owner of that side business. Each of those decisions increased the availability of tax-protected accounts. For 2016, we expect to be able to contribute the following amounts to retirement accounts:
- His Backdoor Roth IRA $5,500
- Her Backdoor Roth IRA $5,500
- Partnership 401(k)/Profit-Sharing Plan $53,000
- Partnership Defined Benefit/Cash Balance Plan $30,000
- His WCI Individual 401(k) $53,000
- Her WCI Individual 401(k) $53,000
- Health Savings Account $6,750
- Total: $206,750
- Total Deductible: $195,750
Want to pay less in taxes? Figure out a way to avoid paying taxes on $195,750 of your income. Retirement accounts are truly the best tax deduction out there. Not only do you get the tax break, but you still have the money! While it is true that we will eventually have to pay taxes on that money before spending it, chances are very good we will be able to access it at an average rate far lower than our current 46% marginal tax rate.
As discussed in a previous post, we did dramatically increase how much we're paying in SS taxes this year, but the overall effect of adding another individual 401(k) was to lower our current tax bill, even with the added SS taxes.
#3 Saving for College
In addition to retirement, we also save for college in 529 accounts. From a federal tax perspective, that money is after-tax, but if spent on education the gains will never be taxed. From a state tax perspective, all that money is triple-tax-free, like my HSA. We now have 23 529s. There is one for each of my four children, and so far, 19 for nieces and nephews. We have more nieces and nephews than that, but if their parents won't give us their SS numbers, there isn't a lot more we can do. But Utah gives me a 5% state tax credit on up to $4K a year contributed to every one of those accounts. It's not a huge deduction, but it does help. There are lots of ways to give money to family members you care about, but not a lot of ways to deduct that gift. This is one of them.
#4 Charitable Contributions
I'm told by tax preparers that most people give away less than 1% of their income. We give away a lot more than that. As long as the recipients are registered charities, we basically give money on a pre-tax basis. Granted, some of that deduction was phased out thanks to Donald Pease, but it's still a huge deduction for us.
#5 Health Insurance
Not only do we get to deduct $6,750 for HSA contributions, but since we're self-employed, we also get to deduct the premiums paid. Our premiums are about $1,000 a month, so that's a significant deduction, especially at our 46% marginal tax rate.
#6 Paying Taxes
Another huge deduction for us is our taxes. These are deducted on Schedule A, and so get hit by the gradual Pease phaseouts, but they're still significant. We paid about $25,000 in property and state income taxes. In addition, half of our self-employment taxes were deductible (and that deduction is above the line, so not subject to Pease phaseouts.)
#7 Losses
As regular readers know, we took a bath when selling our accidental rental property. That gave us about a $50K deduction this year between expenses required to sell and the difference between the purchase price and sale price. We were also able to deduct $3K against our regular income thanks to tax-loss harvesting. Those are huge deductions. Nobody likes losing money, but at least Uncle Sam shares the pain. We did have a few thousand in investment income, but it was almost all at qualified dividend and long-term capital gains rates, which were also erased thanks to my early winter frenzy of tax-loss harvesting.
Not only did this kid cost us $5K, but we get no tax deduction for her AND she keeps trying to destroy this business's most expensive asset using drool and direct trauma
A Few Things That Didn't Help
That were also a few things that many people think are deductions that don't really help us much. For example, we have four kids. They're worthless when it comes to taxes. All of our exemptions were phased out, our child tax credits are phased out, and we don't qualify for any childcare deductions. We paid thousands in out of pocket health care expenses, but those are subject to a 10% floor, and 10% of our income is a lot, so we don't get anything there (other than a future tax-free withdrawal from the HSA.)
We also paid quite a bit in tax payment fees since I started making my estimated quarterlies by credit card. But that's subject to the 2% floor, so again, no deduction there (although we did get some rather large credit card rewards.) Lots of people think having a big huge house is a great tax deduction. But despite this huge mansion we live in, we only paid $8,357 in interest. Part of that is our 2.75% 15 year fixed mortgage with less than a 50% LTV ratio, but still, that pales in comparison to our big deductions. If mortgage interest and property taxes were our only Schedule A deduction, it wouldn't even be worth itemizing.
Overall, I'm pleased with how low we were able to keep our tax bill. There are very few people at our earning level paying such a low percentage. We're using the savings to spend, invest, and give in ways that make us a lot happier than paying taxes.
What do you think? What was your effective tax rate this year? What are you doing to lower it? Comment below!
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That’s a whopping amount of deductions. Simply awesome. Having multiple income sources allows you to shelter a lot of money from the Taxman. RMDs might be whoppingly large someday, but those are 30 years away, and that’s not a bad “problem” to have, obviously.
The Pease provision is labeled as a cap on itemized deductions, but it shouldn’t discourage charitable giving; you still get the same deduction for each additional dollar given. It is really just a surcharge on high income individuals. http://www.aei.org/publication/the-myth-of-the-limits-on-itemized-deductions/
Great post WCI, and great article on explaining Pease, POF–I’ve always struggled to find a decent explanation on how Pease actually works.
Thank you so much POF for that great article on Pease provision as it affects charitable giving. it helped to illuminate more on this topic. I was certainly more enlightened after reading it
You’re correct about Pease. It basically raises your marginal rate is all.
RMDs will be whoppingly large if I keep saving that much every year from now until I’m 70. While that’s not a bad problem to have, I kind of doubt I’ll keep saving that much every year from now until 70.
I m looking for someone who wants a tax loss. I m looking for a small investor for my small film FACADES. Anyone? demarcofilm(at)gmail
Is the federal effective tax rate essentially the taxable income (line 43) divided by the tax (line 44)?
No. At a minimum I’d use your total income (line 22) divided by the total tax (line 63). There are some arguments to make some adjustments there, but that’s the best starting place.
You pay taxes by credit card? Is the 1.87% fee worth the points/miles? Or is there some other way you accomplish this?
I have thought about using the ink plus card to buy $300 gift cards but the 8.95 gift card fee and the 2.95 deposit fee eliminates much benefit from the 1500 points earned per gift card doesn’t seam worth the effort.
If you have a different strategy can you please share?
I paid my Q1 taxes using a credit card. The trick is to get a card that offers a significant bonus, such as the Chase Ink Plus, and use the tax payment to meet the minimum spending requirement. The 1.87% in fees, which is tax deductible as a business expense, is offset by the value of the plane tickets I will gain from the bonus.
I want to do this, but cant stomach the surcharge, I cant seem to make the cost work. My taxes are also more than any individual card allows me to pay at once (I dont pay quarterly). Would be awesome to put it on several cards and get companion passes and status on several different airlines at once.
If your income isnt regular there is another schedule you can do that allows your quarterly payments to be smoothed and/or irregular. However, I just dont pay them, the penalty is tiny compared with what I can get in a safe account, and the carry on that allows me to build my taxable account faster than otherwise.
The cost works easily if the card pays you more than the surcharge. I think you should ask your credit card to raise your limit if you want to do this. I put mine on my credit card with an $80K limit. I pay a lot in quarterly taxes, but I don’t pay that much. There’s no reason you couldn’t use multiple cards though if you wanted to.
I have the Ink Plus card, but how is paying lets say $50K in taxes, getting 50,000 points worth paying $935? You are paying 1.87 cents a point. How is that good?
Other option is to use the ink plus card to buy $300 gift cards at staples. The fee is $8.95 per card with a $2.50 fee for redeeming the gift card. So you are paying $11.45 for 1500 points. or 0.7 cents per point which is a much better deal but nothing amazing. Or is this actually a great way to fill up on ultimate reward points?
I dont think its worth it, but I havent done a deep dive into the points/cost because I generally know the value/pt of each card and the costs of the transaction are more than that. I guess you could make it better by calling it a tax deductible expense, making it more of a wash. At least you’d be getting something for your trouble.
The gift card is a 3.8% transaction cost, I wouldnt do that. I spend enough yearly, and get new cards often enough that I have a decent amount of flights for free anyway with normal spending.
well, lets assume a first class flight from NY to rome round trip is 300,000 points. At $0.007/point I would be spending $2100 round trip plus fee of $70 for a total of $2,170.
The same first class ticket for purchase is: $4,814.86
The same ticket in couch with economy plus cause I am tall: $2,027.86
So basically for the hassle of purchasing gift cards and then using them for paying taxes, I get a free first class upgrade but don’t get the miles for flying.
Is it worth it? I dunno. I haven’t done it.
The numbers get better if you are lucky enough to get a super saver ticket (cost of miles is less), but I have never been able to get a reasonable flight with that option.
Those mileages seem high. I was going to do an LA to Paris first class and it was only 150k. AA did devalue after but I sure hope its not that bad now. I think they are down to 1.6c/pt, which is still good.
Not being tax deductible for the charge makes sense, I’d have to think about it, but I do love the flights. It might be worth it if you put it on several cards and thus were able to have companion passes on 2 or 3 major airlines each year (each qtr woud knock out AA or SW, etc). My AA cards only require 30k/y for that and I believe SW does as well, but I dont have that card.
It’s only good if the points are worth more than 1.87 cents.
Do you really think it’s legit to deduct that fee for paying my personal tax bill as a business expense? Clearly it can go on Schedule A, but there it’s subject to the 2% floor. I’m not sure it’s legit to claim as a business expense.
Fees charged for paying a personal tax bill are not a business expense, trust me on that one.
Same principle as legal fees. The basic rule is that you can deduct attorney’s fees you pay to: produce or collect taxable income, or help determine, collect, or obtain a refund of any tax. And then, it’s only deductible over the 2% floor on schA. We run into this all the time – people always think their attorney’s bills are deductible. Of course, for business work, they are deductible through the business.
That was my understanding too after reading the regulation.
I’m not 100% sure either, but this is the first year I’ve paid with a credit card. Since some portion covers the self employment taxes from the business I figured it may be at least partially deductible. Even without deducting it as an expense it’s worth it to me to pay the taxes and meet the minimum spend.
Well, my card pays me 2% cash. The IRS charges 1.87%. Plus I get to keep my money for 6 more weeks. Is it worth it? I dunno. I find it easier than mailing an envelope.
Technically, it isn’t the IRS charging. It’s a private company.
I also pay quarterly tax payments with credit card. It’s easy to find 2% cash back card like the citi double cash. Personally I use BofA travel rewards card which gets you 2.64% back if you have highest tier rewards program (redeemable through travel spending). If you are a diy-er and use a brokerage account, I meet their minimum by using Merrill edge brokerage acct. No fee trades plus no fee atm from banks = no complaints from me.
I think the “float” of having an extra 6 weeks to pay plus, the convenience, plus getting a little cash back is worth it. I changed the statement closing date to maximize the float for quarterly tax payments and property taxes as well.
28% here. “Glad” to see that others are in the same ballpark based on the early poll numbers above.
Effective tax rate: http://www.investopedia.com/terms/e/effectivetaxrate.asp
RE: #4:
If someone is going to donate money to charity anyway, then it’s nice to have that as a deduction. But while donating money to charity might be viewed by some as good for the donor in a number of ways, in all cases it will leave you with less after-tax money than you would have had, had you not donated that money in the first place. One could avoid taxes entirely by giving away all their money, but it’s not a good strategy for becoming physically wealthy in this world.
No doubt this is true. If your marginal tax rate is 40%, you are choosing to give a charity $100 rather than give the government 40$. You come out $60 behind for the giving, but the charity comes out $100 ahead.
You can do a little better than that by donating appreciated assets to avoid capital gains, either directly to the charity, or via a donor advised fund (which is how I do >90% of my charitable giving).
fantastic…love this comment.
Mathematically starting with your total income, you’re obviously right. Although I think there’s a case to be made that charitable people perhaps make more money because they are charitable, in which case they end up with more after-tax, after-tax money than less charitable people. I don’t have the data to prove this, and perhaps it isn’t even right, and I can’t even explain why it might be right other than divine providence and/or people are more likely to do business with charitable people, but I think it’s possible. Even if it isn’t, I’m still going to give to charitable causes I support because I think it’s the right thing to do.
Question about how to arrange the charitable contributions to be given through the business entity rather than as a personal contribution: WCI – can your business contribute your charitable contribution instead of you doing this as a person? Can this contribution originating from your business be a 100% deductible business expense instead of your personal contribution on Schedule A subject to Pease phase-outs? I am trying to find out if there is any legitimacy to do this for myself with 1099 income, instead of having personal deductions phased out.
That would be great, but my understanding is this:
http://www.foxbusiness.com/features/2014/11/03/small-business-guide-to-deducting-charitable-donations.html
Thank you! Good to know about C-corps, another thing for me to research vs. sole proprietorship model.
This is one of the few good reasons for a professional to form a C-corp. S-corp or LLC (unless you’re in CA) are almost always preferred.
I think the biggest reason your effective tax rate is so low is your individual 401(k) accounts. That is not an option for most doctors on top of a company 401(k).
That’s true. The problem with many doctors is they go work for an employer that offers no retirement plan or at most a 401(k) with an $18K limit. Most self-employed docs in partnerships at least get a $53K limit on their plan and often stack a defined benefit plan on top of that like my group.
Aren’t the 401k deferral limits per person not per plan? I.e. You can only defer 18k once, not in both the partnership and in WCI? I do appreciate you taking all this time. Trying to pay less tax is on my mind. My wife finishes residency next June and we’re keeping the 401k options in our mind while she job hunts
Yes, but an unrelated employer can still contribute another $53k ($59k if age 50+) to a separate plan using the 25% rule.
One employee limit no matter how many 401(k)s. But you get as many $53K limits as you have unrelated employers.
Just to make sure I understand the mechanics here, you contributed your employee max ($18k) to your partnership 401k and got whatever match your partnership has written into its benefits, say $7k. Then you had the partnership pay you the next $28,000 into that plan in lieu of giving it to you as income. This is allowed because it’s less than 25% of your total income as an EM doc.
Then, for the WCI 401ks you didn’t actually make an employee contribution, you just received $53k of income as a 401k contribution from WCI the company. Then your wife who is also employed by WCI is allowed to contribute $18k, receive a match, then get paid income via contributions until hitting her $53k max.
Sorry if this comes across as naive, the tax part of this site is definitely the part I find most confusing.
Sounds like you have it to me.
Having a 2nd 401k account is the key. My husband and I are both physicians and both in private practice (different specialties). I also have an individual S. Corp, my husband does not. We both receive K-1s from our practices. My husband has a SEP IRA, he contributes 53k, I have a 401k/profit-sharing, I contribute 53k. I also do backdoor Roth IRA (only me) and HSA. My practice used to also have a DBP, but had to dissolve it once we hired employees, it was too cost prohibitive. Having the DBP was HUGE in reducing our tax burden. Not having it this past year, our effective tax rate was pretty high (37%). I’ve toyed around with making my husband an employee of my S. Corp to create another 401k to reduce our taxes, but I think it would be limited to 20% of whatever income I paid him plus, I would have to pay double payroll tax. Not sure it is worth it. Because of our limited tax deferred options our extra savings have gone into creating a sizable taxable account. Am I overlooking something?
Your payroll taxes shouldn’t go up putting your husband on unless you’re turning distribution into his salary (which you probably are) but even then you’re only losing Medicare since he’s already maxed out SS taxes.
Plus then you could roll his SEP into the individual 401(k) each year and do a backdoor Roth IRA for him.
Yes, not SS, but I still have to pay double Medicare. Although, this solution may be cheaper than paying the corporate tax rate on the passive income taken from S. Corp. I need to look into this further…
I did entertain rolling over his SEP IRA to a solo 401k awhile back. But all of our accounts are with Vanguard and from what I remember, unless something has recently changed, they only offered investor share classes for solo 401ks, resulting in higher ERs. Currently, he is invested in admiral shares. I would have to switch providers. I didn’t think it was worth the hassle for an extra $5,500.
Why double? You don’t pay corporate tax on S corp distributions- those are taxed at your marginal rate.
I was thinking Medicare is double (1.45% employer+ 1.45% employee). Sorry, I misspoke, yes as S. Corp there is no separate corp tax, it is added to our personal income and taxed as ordinary income tax. Still need to crunch the numbers…
That article says:
>>An individual’s effective tax rate is calculated by dividing total tax expense
>>(line 63 on your 1040 Form) by taxable income (line 22).
That makes sense to me. The real question would be that this method of calculating the effective tax rate doesn’t take into account your contributions to tax-deferred vehicles and thus overestimates one’s true effective tax rate, doesn’t it? Just to throw some numbers around, let’s say that WCI has a total income of $500K. Deduct his $200K of tax-deferred money gives him an income of $300K. Assume $100K of adjustments and deductions to get to a taxable income of $200K. With a taxable income of $200K, an effective federal tax rate of 15% would mean he would pay $30K in taxes.
But does this reflect reality? The effective tax rate as calculated above (divide total 1040 taxes by taxable income) doesn’t account for the tax-deferred income. A much more realistic picture of the TRUE effective federal tax rate (reflecting how effectively WCI was shielding income from the taxman) would divide total 1040 taxes of $30K by total income of $500K to get a TRUE effective tax rate of 6%.
Using the article’s method, my effective tax rate is 18%. Using total income rather than taxable income, I’m down to 6%.
That’s very low. But that’s about where I was at while I was in the military. You’re probably in a income tax free state, no?
Sorry, I was just including federal. With all income-based taxes (including my wife’s self-employment tax) it is 32% vs. 9%.
As you get into the details, you realize there is a lot more that could be done. For example, if you’re an employee you should add back in your 401(k) contributions and what your employer paid for their half of the payroll taxes. Perhaps a self-employed dude should add back in the business expenses he would have spent anyway but deducted off his schedule C.
But the quick and dirty is total tax divided by total income. Not sure why the article calls line 22 taxable income. Taxable income is line 43.
How do you use CC to pay taxes? When I log into EFTPS federal website to pay estimated taxes, it only lets me put bank account information and no CC options are available.
https://www.irs.gov/uac/Pay-Taxes-by-Credit-or-Debit-Card
https://www.irs.gov/uac/Pay-Taxes-by-Credit-or-Debit-Card
I use the first option (1.87% fee.)
If I am donating small amounts of money repeatedly, for example $200 every month to for example UNICEF. Is there a way to give this small amount of money through stocks vs paying post tax cash?
Is there a big benefit doing it that way? or just more hassle?
For small recurring contributions, using appreciated stock would be too much trouble.
You could run it through a Donor Advised Fund (DAF) like the Fidelity Charitable Trust. I have been using it for over ten years, and it allows making donations as little as $50.
http://www.fidelitycharitable.org/
That sounds like a big hassle. Why not donate $2-3K in December? Then it’s probably worth the hassle to donate shares. Or you could gradually add money to a donor advised fund and then pay a bit each month. Or add it all at once to the DAF and then pay it a bit each month.
https://www.vanguardcharitable.org/guide_to_giving_with_a_donor_advised_fund/
I have always made all of my donations in December each year. This has a number of benefits:
1. When I get solicitations, I don’t have to go back to my records to see if I have already given to charity x this year.
2. All the checks are written at one time, so it’s easy to get the records together (although using Quicken that isn’t really a big issue).
3. When an organization calls asking for a contribution, my wife or I can say, “We make all of our charitable contributions every December when we are able to know how much we have made during the year and how much we can donate to organizations like yours. Please send us one solicitation in the mail and we will put it with the others and evaluate it at that time.”
Great handle on the U.S. tax laws. I always stare at envy at your reports. My specialty and job situation pays me through a W2, which unfortunately does not grant me as much control over my tax situation.
As you have mentioned previously, the only way out of this situation is to start a secondary business, generate some income through 1099’s, or find a new job.
Not true! It took me between 2-3 years from when I started disseminating knowledge/info about a cash balance pension plan until my large single specialty medical group eventually adopted one (in addition to our $53k profit sharing plan). This is absolutely huge for me. If you look at the maximum contribution levels for cash balance plans you will quickly realize that you don’t need to be a small business owner or independent contractor to dramatically improve your tax situation.
Nobody, even W2 employed physicians, should be fatalistic about their tax situation: if it sucks, make it better! Don’t bemoan your tax situation unless you are actively fighting to improve it.
I’m a W-2 Radiologist but also have 1099 income from Teleradiology on the side which just started in January of this year. My wife is also a W-2 physician (University Pathologist) and has the usual TIAA-CREF 403(b). I would like to make Individual 401(k) contributions and for some reason I always get hung up on this: through our W-2 jobs we contribute the max 18K to the 401(k)/403(b) plans. Of course we do his/her back-door Roths, $5500 each. What, in addition, am I able to do: can I put up to $53K in my Individual 401(k) from my 1099 income (sole proprietor, Schedule C)? What about a SEP-IRA? Can I set one or both up for my wife & how would I do that–do I have to hire her in some manner? She actually does Tele-Pathology from home for the University though they don’t pay her extra for it, but to me our Tele-Rad/Tele-Path situation definitely allows home office/internet/cell phone deductions. Anyway I would appreciate advice on the best way to go, to expand my/our retirement account space and reduce our taxes now that I have the 1099 income. Thanks!
Yes, $53K into an individual 401(k), but not more than 20% of your net (of payroll tax) self employment income. You could do a SEP-IRA too, same limits in your case, but that would screw up your backdoor roth. Your wife can only contribute if she has self-employed income too. So yes, you can hire her to do something. But keep in mind if you don’t make enough to max out an individual 401(k), splitting it with her isn’t going to help.
OK right, as I thought–I think the key to this is that with the Individual 401(k) there is the option of the contribution being either employer or employee-made. In which case, if one has already made an $18K contribution to some other 401(k) as a W-2 employee, then the additional must be treated as employer-made. In the case of a sole-proprietor 1099 income, the employer and employee are the same person, so in actually making the contribution one should choose (and report it as) an employer contribution. Rather mind-bending but I think this is how this actually operates, unless I am misunderstanding something.
Every unrelated business gives you a $53K total limit for a 401(k). But you only get a single $18K employee contribution no matter how many 401(k)s you have access to. So once you use up that $18K, everything else must be employer.
Forgive the ignorance, but I thought that one cannot contribute more than 18k in aggregate as employee contribution to both employer sponsored and solo 401k. If one contributes 18k from W2 job, how does one get up to another 53k via individual 401k (assuming adequate self employment income)? Thank you.
Well, I had a hard time grasping this at first but I think the key is that the 53K must be treated as an employer contribution, not an employee contribution, which is capped at 18K as you said. But for a sole-proprietor, you are *both* the employer and the employee. So you can make an $18K to yourself as an employee into whatever 401K you are eligible for, and then put on your “employer hat” and give yourself up to $53K as an employer contribution for your sole-proprietor Individual 401K. When you make the transaction, say on Vanguard, it will ask you to choose which type of contribution it is for reporting purposes. It’s very non-intuitive, especially if you are new to the 1099 income situation in addition to W-2 income and at first I thought this cannot be possible, but I believe it is. But I would like to hear the WCIs comment on this.
You answered it- adequate self-employment income. If you make enough, the employer contribution can be up to 20% of net self-employment income. Here’s the post you’ve missed at some point:
https://www.whitecoatinvestor.com/multiple-401k-rules/
Lightbulb moment! Thanks to you both for the clarification. Need to get my side hustle going strong!
I would also look closely at your wife’s plans, most university places that I have looked at have a 457 account on top of the 403(b). Since they are unrelated, they each have a separate 18k cap, and a governmental 457 is for most intents the same as a 403(b)/401k. WCI wrote a post explaining the differences a while back you could probably find, but it would be an additional “bucket” that you could fill.
Looks like I am the winner here, so far, at 30.5% (Line 63 divided by Line 22).
What am I doing to make that number lower? Going part time as soon as possible.
PS 2016 is looking to be higher. Wife got a huge bonus. I guess that’s a good problem to have.
I guess 30.5% is a good problem to have.
There are doctors who aren’t in a field to make a killing on their income, and the tax burden is not great. A doctor paid through a W2 earning in the $250,000 range in a state with a 6% tax can end up shelling out ~30+% in effective income tax too. Hurts.
First world problem for sure.
Knowing what you know now WCI, do you wish you put more into Roth when you were making less? ie, taking the hit on a 25% (or 15/10%) tax bracket in order to invest in Roth? Obviously, Roth 401ks did not exist for you most of the time while you were making less money.
I maxed out every Roth option available to me from the time I graduated from med school. I even borrowed money on a credit card to do it as a resident one year. So no, no regrets there. I wish the military had offered a Roth TSP back then though. That would have been nice. But I never even had a chance to do Roth conversions at less than 28% + 5%.
Great article, love the transparency. It feels as if you’re sharing with family.
One small correction – HSA contribution limits are $6,650 for 2015, going up to $6,750 for 2016. Make sure you didn’t over-contribute!
Small tip for those of you with underpayment penalties – if a client’s penalty calculation is less than $100, we remove it from the return and tell them to see if they get a bill. We’ve been doing this for years and, so far, the IRS hasn’t bothered to collect.
I definitely didn’t. Not sure where the error is though. Was I referred to last year or this year?
Interesting tip, but it goes against my moral code. My goal is to pay every dollar I owe, but not a penny more. If it was just about what I could get away with, I would be claiming a lot less WCI income.
Penalties aren’t taxes. Some software calculates the penalty, some doesn’t. So are you saying if your software doesn’t tack it on, you would follow up with the IRS to make sure they assess the correct penalty? It is within the IRS’s purview to determine whether to assess a penalty or not. Just because we don’t send it in with the tax payment doesn’t mean we are hiding anything – the IRS has all of the information necessary to calculate and send a bill.
What good is a tax software program that can’t calculate any penalties you may owe? Which ones don’t calculate penalties?
Just asking – if the IRS didn’t assess you a penalty and you thought they should, would you notify them? I’m only saying you should let the IRS calculate it. If you get an “interest-free loan”, what difference does a few more days make, anyway?
Some people still prepare their returns manually.
I had to fix some incorrect 8606 due to pro-rata rule and Roth conversions maybe from 4-5 years ago. It was done incorrectly by one tax preparer. I learned on my own that what was done incorrect. Then I paid another tax preparer for amended returns, but by that point I pretty much knew how to do things correctly – I was willing to pay them though for the confirmation. I sent checks to IRS for underpaid taxes for 2 tax years. I did not know there would be underpayment penalties, and the second tax preparer did not include those in the arithmetic.
There was a letter that was sent by IRS for one of the years first, for something like 60 bucks. Then I wondered about the other tax year and called the second tax preparer, they told me to wait and not worry if I never heard back. But a few weeks later I received another letter from IRS (oddly enough from a different address in a different state) about the underpayment penalty for the other tax year, similar amount, so I paid that also.
I don’t know if software would be able to calculate this – it would have to know the % charged on the underpayment amount, and I don’t think it was the same % for each of the tax quarters that was listed in the letters… It would be hard to estimate this yourself. Tax preparer didn’t bother calculating it or even telling me to expect the letters from IRS. This is just my personal experience with this, for what it’s worth. The amounts were small in the greater scheme of things.
I’m pretty sure the one year I actually owed a tiny penalty, Turbotax just added it on to the tax bill and I paid it.
Interesting article. I think the main take away point is that there are massive advantages to being a business owner that people just don’t immediately realize. There are actually ways you can structure your work retirement plan so that you could put even more away than what WCI does (or so I’m told, I have no first hand experience).
I bet if someone was motivated, the difference could actually be quantified. Imagine a W2 employee who makes 250K/yr vs a solo-practice private practitioner whose business nets 250K/yr after all expenses are paid. How much better off roughly is the second guy than the first? It wouldn’t surprise me if the business owner’s position was worth something like an extra $50-100K if he took maximum advantage of his position (but did nothing illegal).
If you are making lets say $265K/year (current defined benefit plan maximum) then you can have a 401K and a DBP working for you. Through the 401K you get $18K employee contribution, 6% or $15.900 employer contribution, plus you can get a defined benefit plan that based on your age can be another $50K+ a year. I have seen calculations as high as $130K based on age and years to retirement. This doesn’t even include the HSA, backdoor Roth, and 529. A 1099 physician could put away $100K+ every year tax free.
Disclaimer (defined benefit plans come with a yearly fee and a setup fee that I have seen ranging from $1200-$3500 per year depending on who you use.
Maximum DB plan contribution is $210k. In general, they work best for a practice with older owners and much younger employees. It’s important to be able to project future income (that it will remain fairly steady or increase).
Max DBP plan contribution is NOT $210k. It is the maximum annual benefit one can generate at a normal retirement age of 62. I’ve seen DBP plan contribution limits as high as $480,000 in certain years to fund a $210,000 annual benefit at age 62. DBP contributions vary based on assets accumulated in the plan, years left to fund plan, plan performance and 3 year highest average of net schedule C income.
Correct – maximum DB plan BENEFIT is $210k in 2016.
Not sure if WCI has done an entire post about this before but I’m curious about hiring your kids as models for the website. What rules do you have to follow? How do you decide what is a reasonable wage?
Lots of interest in that. You have to follow the rules for hiring employees although its easier when the employees are your kids. I chose the highest reasonable rate I could find on the internet for child models- $100 an hour. I think I can justify 15 hours a year and that rate in an audit, so that’s what I do. More info here:
http://www.ehow.com/info_12021713_much-money-kid-model-paid.html
How did you come up with your marginal tax rate of 46% when top federal tax rate is 38.6%? Utah appears to be 5% state (if I read that right)?
Also, do you calculate FICA taxes in the above calculations at all? Are they included in marginal or effective tax rates posted?
I’m guessing the ACA tax for anything over 250K is included.
If we divide line 63 into line 22 isn’t that only our effective federal tax rate? Mine was 10% (14,450/144,00) which seems low. But I paid another $8900 to my state and $9600 in payroll so doesn’t that mean my effective tax rate is: 14,450 + 8900 + 9600 / 144,000 = 22.8% ???
This $144,000 does not include my 401k contributions so isn’t that a factor as well?
Yes, you need to add those all in if you want to compare your figures to mine.
How can you contribute $53k to a partnership 401k and $53k to WCI 401k? Thanks
I have the same question – I was under impression (which is probably wrong) that you were allowed 18k of your own “employee” contribution across ALL possibilities that you have to contribute to 401k’s and then each separate 401k also allowed for 35k “employer” match, so with 2 sources of income, it’s: 18k+35k (first source) and 0k+35k (second source).
Or is the second income source total 53k that is all “employer match” and no “employee” contribution, with that 53k not exceeding 20% of second income? I’m asking this to see how it would apply to me and my income sources, not to be excessively nosy about WCI retirement plan contributions… Thank you!
$18K employee max no matter how many jobs you have
$53K total per employer that you do not have significant ownership of.
You do not need employee contributions to total up $53K it can all be done from just the employer side.
It is also 25% of income to calculate individual 401k contributions
https://www.irs.gov/Retirement-Plans/One-Participant-401(k)-Plans
see example as well.
The 25% figure confuses some people. It’s 20% of your net income counting the contribution, 25% of your net income minus your contribution. It’s really the same number.
First 401(k)- $18K of employee contribution, $35K of employer contribution- requires an income of ~ $185K
Second 401(k)- $53K of employer contribution- requires an income of ~ $285K.
Please correct me if I am wrong, but please take a look at the IRS example I linked above. I think you are mistaken on how to calculate the 25%.
They used $50k salary using $18k employee, $6K catchup and then 25% of $50K as employer contribution equaling $12.5K.
You’re not wrong. Neither am I. It’s just how you look at it. It’s the same number either way. From your link:
Okay, now we go to the discussion below:
Did you catch that? So you first deduct the employer portion of your self-employment tax, THEN YOU DEDUCT YOUR CONTRIBUTIONS. That’s the key point.
So, it’s 25% of what’s left AFTER DEDUCTING YOUR CONTRIBUTIONS which is precisely 20% of your total earnings including your contributions.
For example, if your earnings after deducting 1/2 of self-employment tax are $100K. Your maximum contribution is $20K. That’s 20% of the total earnings but 25% of the total earnings minus your contribution.
Maybe Ian dense but
It look a lot like 25%
$50K salary at 25% = $12.5K
Unless for some reason we are trying to make it more complicated by adding the contribution.
$50K+12.5k = 62.5K
62.5K X 20% = 12.5K
Why make it more complicated?
For example: I have a salary of $140K. I can therefor contribute $53K in a i401K.
$18k employee
$35K employer (140K X 25%)
The business has an expense of ($140K+35K) + employer portion of employment tax on the $140K salary.
The 20% number makes things more complicated I think. Especially when the IRS publications don’t even use it.
The IRS publications certainly do use it. If you follow their worksheet, you’ll see what I mean. For example, for a SEP-IRA, it is found here:
https://www.irs.gov/pub/irs-pdf/p560.pdf
How Much
Can I Contribute?
The SEP rules permit you to contribute a limited
amount of money each year to each employee’s
SEPIRA. If you are selfemployed, you can
contribute to your own SEPIRA….
Contributions you make for 2015 to a commonlaw
employee’s SEPIRA cannot exceed
the lesser of 25% of the employee’s compensation
or $53,000. Compensation generally does
not include your contributions to the SEP. The
SEP plan document will specify how the employer
contribution is determined and how it will
be allocated to participants.
Example. Your employee, Mary Plant,
earned $21,000 for 2015. The maximum contribution
you can make to her SEPIRA is $5,250
(25% x $21,000).
Contributions for yourself. The annual limits
on your contributions to a commonlaw employee’s
SEPIRA also apply to contributions you
make to your own SEPIRA. However, special
rules apply when figuring your maximum deductible
contribution. See Deduction Limit for
SelfEmployed Individuals, later…..
Deduction Limit for
Self-Employed Individuals
If you contribute to your own SEPIRA, you
must make a special computation to figure your
maximum deduction for these contributions.
When figuring the deduction for contributions
made to your own SEPIRA, compensation is
your net earnings from selfemployment (defined
in chapter 1), which takes into account
both the following deductions.
The deduction for the deductible part of
your selfemployment tax.
The deduction for contributions to your
own SEPIRA.
The deduction for contributions to your own
SEPIRA and your net earnings depend on
each other. For this reason, you determine the
deduction for contributions to your own
SEPIRA indirectly by reducing the contribution
rate called for in your plan. To do this, use the
Rate Table for SelfEmployed or the Rate Worksheet
for SelfEmployed, whichever is appropriate
for your plan’s contribution rate, in chapter
5. Then figure your maximum deduction by
using the Deduction Worksheet for SelfEmployed
in chapter 5….
Here’s the worksheet:
Deduction Worksheet for Self-Employed
Step 1
Enter your net profit from line 31, Schedule C (Form 1040); line 3, Schedule CEZ (Form
1040); line 34, Schedule F (Form 1040)*; or box 14, code A**, Schedule K1 (Form
1065)*. For information on other income included in net profit from selfemployment,
see the Instructions for Schedule SE, Form 1040. ………………………..
*Reduce this amount by any amount reported on Schedule SE (Form 1040), line 1b.
**General partners should reduce this amount by the same additional expenses
subtracted from box 14, code A to determine the amount on line 1 or 2 of
Schedule SE.
Step 2
Enter your deduction for selfemployment tax from Form 1040, line 27 ………….
Step 3
Net earnings from selfemployment. Subtract step 2 from step 1 ………………
Step 4
Enter your rate from the Rate Table for SelfEmployed or Rate Worksheet for
SelfEmployed ……………………………………………….
Step 5
Multiply step 3 by step 4 …………………………………………
Step 6
Multiply $265,000 by your plan contribution rate (not the reduced rate) ………….
Step 7
Enter the smaller of step 5 or step 6 …………………………………
Step 8
Contribution dollar limit …………………………………………. $53,000
• If you made any elective deferrals to your self-employed
plan, go to step 9.
• Otherwise, skip steps 9 through 20 and enter the smaller of
step 7 or step 8 on step 21.
Step 9
Enter your allowable elective deferrals (including designated Roth contributions) made
to your selfemployed plan during 2015. Do not enter more than $18,000 ………..
Step 10
Subtract step 9 from step 8 ……………………………………….
Step 11
Subtract step 9 from step 3 ……………………………
Step 12
Enter onehalf of step 11 ………………………………………..
Step 13
Enter the smallest of step 7, 10, or 12 ……………………………….
Step 14
Subtract step 13 from step 3 ………………………………………
Step 15
Enter the smaller of step 9 or step 14 ………………………………..
• If you made catch-up contributions, go to step 16.
• Otherwise, skip steps 16 through 18 and go to step 19.
Step 16
Subtract step 15 from step 14 ……………………………………..
Step 17
Enter your catchup contributions (including designated Roth contributions), if any. Do
not enter more than $6,000 ……………………………………….
Step 18
Enter the smaller of step 16 or step 17 ……………………………….
Step 19
Add steps 13, 15, and 18. ………………………………………..
Step 20
Enter the amount of designated Roth contributions included on lines 9 and 17. …….
Step 21
Subtract step 20 from step 19. This is your maximum deductible contribution. …..
Next: Enter your actual contribution, not to exceed your maximum deductible contribution,
on Form 1040, line 28.
Note Step 4. That comes from here:
Rate Table for Self-Employed
Column A
If the plan contribution
rate is:
(shown as %)
Column B
Your
rate is:
(shown as decimal)
1 …………….. .009901
2 …………….. .019608
3 …………….. .029126
4 …………….. .038462
5 …………….. .047619
6 …………….. .056604
7 …………….. .065421
8 …………….. .074074
9 …………….. .082569
10 ……………. .090909
11 ……………. .099099
12 ……………. .107143
13 ……………. .115044
14 ……………. .122807
15 ……………. .130435
16 ……………. .137931
17 ……………. .145299
18 ……………. .152542
19 ……………. .159664
20 ……………. .166667
21 ……………. .173554
22 ……………. .180328
23 ……………. .186992
24 ……………. .193548
25* ……………. .200000*
Note that 25% = 0.20, or 20%.
Run through the worksheet and you’ll understand. I confess it took me a while to wrap my head around it.
the 20% process makes sense when trying to figure out how much money will be shelled out by the employer as a total. So I understand why 20% works.
I guess when you are self employed and looking at figuring out what how much salary you want to pay yourself, you are thinking in the 25% realm. Therefor to maximize my i401K I must pay myself a minimum of $140K on my W2 to have $35K employer and $18K employee contribution.
On the employer/business side, I get to deduct $175k + employer tax on the $140K from the profits. That comes out to 20% of $175K.
I guess it is how you want to look at it and how you want to figure it out. I prefer thinking of it in the 25% range since I make well over $175K and want to minimize medicare tax while still paying myself a fair salary.
If on the other hand I had a side business only bringing in $50K after business deductions I have to think in terms of 20% since I have a finite amount of money. The wage ends up being $40K where I can deduct $18K employee 401K and then the business has an extra $10K to add under the employer portion of the 401K. It is 20% of $40K or 25% of $50K.
So yes, I get it now. Thanks for explaining it.
How does the individual 401K for you and your wife work if it’s the same business you own? Wouldn’t you have to have a 401K that includes both of you then?
I’d love to get some clarification on this because it seems like the business is related, or in this case the same, so that would disqualify the individual 401K option. Tell me where I’m wrong as I’d love to have 2 individual 401K’s instead of a group one for my wife and I.
You and your spouse are treated as the same person under the “rules of attribution”. This allows you to continue with a SOLO-k and max out for both of you.
I was under the impression that you contributed 18K to the Roth component of your 401K. Is that not the case?
No, I’ve never done that. I’ve been in quite a high bracket ever since Roth 401(k)s were available. I suppose there are some scenarios where I would do that in the future. Obviously I don’t want to have a $20M tax-deferred account.
Is there a limit where you have too much tax deferred contributions? I can see someone in your shoes can easily have $1.5 million by the time they are 45. If you continue working part time for another 15 years you will easily have over $3million by the time you are 60. Even if you plan on doing Roth conversions of $100K/year for the next 10 years, that value will still continue to grow. By the time you are 80, you will end up with very high RMDs.
I am not sure what the number is, but I am pretty sure if you have too much tax deferred investments, eventually you may very well be thrown right back into the same tax bracket you tried to avoid 30 years earlier.
Do you have any thoughts or concerns about this?
Wouldn’t that be a terrible problem to deal with- RMDs of half a million bucks a year in today’s dollars. I’m sure I’ll manage okay.
The only thing I’d probably do is make my $18K a year employee contribution Roth instead of tax-deferred and do more Roth conversions. But it doesn’t make sense to invest in taxable when there are tax-deferred accounts available to me.
Besides, I still don’t even have a $1M tax-deferred account, and the RMD on that is only $40K at age 70. I’ve got a ways to go. I haven’t been deferring $190K a year for 10 year. I haven’t even been deferring more than $100K for more than 2 years.
How do you contribute $53K to your partnership 401K and solo 401K? Your employee contributions are limited to $18000, so are your contributions to your solo 401K 100% employer?
Just found the answer to my question above, no need to reply. Thanks!
That’s the way it is done. $18K+$35K for one 401(k) and $53K for the other.
I think a great post would be how to calculate the various effective tax rates you refer to and others have mentioned on the forum. Several examples are usually the best way to drive home a point. That would be excellent.
https://www.whitecoatinvestor.com/doctors-dont-pay-50-of-their-income-in-taxes/
That post might help. I’m not sure what else to write about effective tax rates. The easy way is total tax divided by total income. If you want to monkey with either number a bit, that’s fine. I guess I could do a post about the very most accurate way to do it (what to add into total income and what to add into total tax) but I’m not sure there’s a whole post there.
For example:
You could add the following to total income (line 22):
Losses from tax loss harvesting or real estate
401(k) contributions that weren’t included in total income
Employer’s half of SS taxes if you’re an employee
You could add the following to total tax (line 63):
State income tax
Employer half of payroll tax if you’re an employee
I can’t think of anything else right now to modify it with. It’s just not that complicated.
Perhaps I’ve missed it in the article or comments, but shouldn’t you also add in Employer Match as income? Also the $53K profit sharing from a 2nd business?
I don’t add in employer match as income I have no employer and have never had a match. But you could. My profit-sharing from a second business is added in. It shows up in total income then is subtracted below in the above the line deduction section.