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.
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.
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!