Well, another tax year come and gone. Thankfully lots of first world problems for us this year. In some ways, a higher income eliminates a lot of the complexity in our taxes. We qualify for almost no credits, get no exemptions, and are phased out of many deductions. We don't have to deal with the AMT either. The downside? Well, we PAID more in tax than we MADE in any year prior to 2013, my first year as a full-partner in my practice. Seriously, it was a lot of tax. Basically, everything I made in my practice went to the taxman. In April alone I wrote tax checks for more than a year's worth of our spending. Very painful, but I now take special pride when I see pictures of aircraft carriers knowing who is paying for them.
Every year it seems I get to learn a new schedule. I thought this year was going to be the first year I didn't have to do that, but no, I ended up having to do a 5500-EZ. This is the form you file when your individual 401(k) has >$250K in it at the end of the year. It's just an informational return, like the partnership return we did for WCI and the 1099s, W-2s, and W-3s we do. It's only two pages and Vanguard sent me everything on one page that I needed to fill it out. No big deal, but be sure you do it as there is a penalty associated with it. Since that was the only new thing I had to do, and since I did it back in January along with the W-2s, W-3s, and 1099s, I put off my taxes until the week before April 15th. Over two days I spent around 7 hours total doing them using Turbotax. That's really good for me, not only the total time but the short amount of time between start and finish. Next year we'll be substituting a corporate return for a partnership return, but hopefully it won't be much worse. It's the same number of pages anyway.
Our Tax Rates
Our marginal tax rate this year was 45.8%. (If you're not sure how to calculate that, add $1000 to your earned income with your tax software and see how much your taxes go up. Mine went up $458, so my marginal rate is 45.8%.)
Our effective tax rate ended up being:
- Federal Income: 21.7%
- Payroll (including PPACA) Taxes: 6.1%
- State: 3.8%
- Total: 31.6%
I mostly just use the total income on my tax form (line 22) for that but I cheat a little in that I add back in what I pay my kids and the losses I got for tax loss harvesting into the denominator since I feel those are just smart tax planning decisions. It doesn't change things much since neither amount is very large in relation to my income or my tax bill.
How does that compare to other years?
As you can see, as our income has risen dramatically, so have our effective tax rates. There will never be another tonight and there will probably never be another 2007 (when we paid less than 5% as a total effective tax rate thanks to a deployment to the Middle East.) But you know what? Even Americans who make a lot more than doctors still don't pay 50% of their income in taxes unless you start including stuff like property and sales tax.
The increase in rates over that six year period is impressive, but the increase in total tax burden is even more impressive. To make things easier for this chart, I didn't go back and dig through all my paystubs to sort out how much I paid in payroll taxes as an employee, I just took the numbers off my tax forms, so for 2012 and earlier it slightly understates my tax burden.
This goes all the way back to the year I left residency. When I speak to residents, I often tell them “I know you think you pay taxes, but you don't actually pay taxes.” This chart demonstrates what I mean. Most attendings are going to find themselves paying more in tax than they made as a resident. But even an attending, I managed to keep my taxes very low for a long time, which certainly contributed to us becoming millionaires 7 years out of residency. Note also the benefit of being in a flat tax state instead of a progressive tax state. It's not quite as good as being in an income-tax-free state, but imagine if the slope of my federal line looked like my state line.
I thought it might be interesting to graph the percentage change of total tax burden from the prior year as well. Here's what that looks like:
I wish I could get an investment that performs like that. Sure, the first year is kind of rough, but it's all gravy after that. I'm apparently one of Uncle Sam's best investments! Increases in your tax burden like these do make tax planning and projections pretty hard. If you have similar income fluctuations, be sure you have the safe harbor rules down cold. Despite my final Turbotax screen looking like this:
I didn't owe any penalties or interest on my taxes.
That's all fun and stuff, but let's get into something useful. Despite my tax burden changing in the last year, my tax situation didn't change much. There were few revelations for me this year, but it's worthwhile to emphasize a few things.
# 1 Some Deductions Matter More Than Others
Your biggest deduction is probably your tax-deferred retirement accounts. That was a $189,000 deduction for us this year. Tack on $6,750 for an HSA and $12,062 in insurance premiums paid and that's the lion's share of our deductions. So all that ticky-tacky stuff that you keep track of to try to lower your tax burden–that's just icing on the cake.
# 2 Beware the PEP and Pease Phaseouts
Remember that $4K “personal exemption” you get for everyone in your family? Well, in 2016 that started going away at an income of $259K (single) and was completely gone by an income of $433K (married.) My kids certainly DO NOT give me a tax break.
Donald Pease also hates me. Thankfully the Pease phaseout (reduces your itemized deductions) is very gradual, but I still lost another $15K worth of my itemized deductions (mostly charity) to it. Itemized deductions start phasing out at the same place as the exemptions- $259K single and $311K married. This is one reason why an above the line deduction is more valuable than a below the line (itemized) deduction.
# 3 Consider Foreign Stocks In Taxable
I did get one credit this year- the foreign tax credit. It was worth $205. But since credits are even more valuable than deductions, and since there is no income limitation on the foreign tax credit, this is one reason to consider putting your broadly diversified international index funds preferentially into your taxable account (assuming you have to put something there.) There is a lot more to tax location than the foreign tax credit (and even tax-efficiency for that matter), but it is one consideration. Of course, international mutual funds generally have a higher yield than domestic ones, which may eliminate that benefit. (Total International Stock Index Fund had a yield of 2.75% compared to 1.88% for the all-US Total Stock Market Index Fund.)
# 4 Don't Invest With Companies That Don't Download to Turbotax
It is amazing how much faster you can prepare your taxes when you download your tax forms directly from your bank or investing company to Turbotax. Vanguard does this. So does Lending Club. But Prosper does not. As you'll recall, I've been liquidating my peer to peer loan investments. My form 8949 (Sales of Capital Assets) ran 8 pages this year. It would have been extremely painful to type every Lending Club note I sold in by hand. Thankfully my Prosper account was always very tiny.
# 5 Real Estate Can Be Very Tax-Efficient Or Very Tax-Inefficient
I am amazed at the tax efficiency of my various real estate investments. For example, my debt investments are taxed at, well, 45.8% every year. That property where my partnership manages our business that is giving me such great returns? I actually got a small taxable loss from them even though we sold one building and bought another this year! 1031 exchanges are great!
# 6 State Taxes Can Be Really Easy
No kidding, I spent less than 2 minutes on my state taxes this year. That alone is worth the price of Turbotax. The only thing I have to enter on my state taxes in addition to what it pulls from my federal taxes is my 529 contribution credit.
# 7 Form 8606 Is No Big Deal
Every year between January and April I get literally hundreds of questions about how to do form 8606. The Backdoor Roth IRA Tutorial has over 1000 comments on it. But it's really the same two or three questions over and over again. Want a very, very simple 8606? Do your contribution and conversion one day apart during the regular calendar year. Then every line is either $5,500 or $0. Just double check and make sure line 15 is zero and then you know you did it right.
Well, that's enough about taxes. I'm going climbing. Way more fun and less risk of an audit.
What do you think? What did you learn from doing (or reviewing) your taxes this year? What was your marginal and effective rate? How long did it take you to do your taxes if you did them yourself? How long did you spend on tax-related stuff if you paid someone else to do them? What did you pay? Comment below!