As their income grows, most physicians realize that the tax brackets don't tell the whole story. There are a plethora of tax breaks that lower your tax bill substantially, but as income increases, you become ineligible for them due to phase-outs. This has the indirect effect of raising your marginal tax rate. This page will discuss each of these, and their consequences on you.
Earned Income Credit – $13,660-43,998
This one applies mostly to medical students, unfortunately, as most are phased out even on a resident's salary. It is designed to encourage people to get off welfare and work for a living. This refundable credit can be worth up to $5471 in 2011. You are no longer eligible for it if you are single without children once you make more than $13,660. Even if married with 3+ children, you are phased out at $43,998.
Social Security Benefit Taxation – $25,000-44,000
Not only are you taxed on the money you use to pay into social security, you're also taxed on most of it as it is paid out. But if your “combined gross income” (which includes your regular income, your tax-exempt interest, and 1/2 of your social security benefits) is more than $25,000 (single) or $32,000 (married) you'll be taxed on it. You never get taxed on all of it, as the maximum amount you pay tax on is 85% of your benefit if your income is above $34,000 (single) or $44,000 (married.) Just plan on paying tax on most of your social security in retirement.
Individual Retirement Arrangement Deduction – $56,000-$110,000
You can only deduct contributions to IRAs under two circumstances. First, have no retirement plan at work such as a 401K. Second, make less than a certain amount. In 2011, the phase-out is $56-66,000 for singles and $90-110,000 for married. You can still do non-deductible contributions, but your best bet if you're in this situation is a Backdoor Roth IRA. Even if you don't have a plan at work, if your spouse does your contribution is still limited if your household income is over $169,000.
Roth IRA Contribution Limit -$107,000-179,000
Your ability to contribute to an IRA phases out between $107-122,000 for singles and $169-179,000 for married. But never fear, you can still do a Backdoor Roth IRA thanks to laws passed in 2010.
Saver's Credit -$17,000-56,500
This is a great idea; you can get up to $1000 from the government just for putting $2000 in a Roth IRA or your 401K. Unfortunately, almost no one gets it in any significant amount. Those who qualify for it don't make enough to save much of anything for retirement. Those who can save for retirement make too much to get the credit. It phases out at $17,000-28,250 (single) and $34,000-56,500 (married.) To make things worse, it is a non-refundable credit. Most of the people who qualify to get it really aren't paying anything in taxes anyway. Good idea. Bad implementation.
Student Loan Interest Deduction -$60,000-150,000
This one is a dirty trick by the government in my opinion. You go to school and learn something that will contribute to society and the economy. They let you defer your loans until you start making decent money, then, as soon as you become successful and the interest actually starts accumulating, you can no longer deduct the interest on the loans. This phase-out ranges from $60-75,000 for singles and $120-150,000 for married. The deduction is also limited to $2500 per year. So when taking out $200,000 in loans to pay for medical school realize that you'll probably never get any tax benefit from those loans. Unlike most mortgages, your after-tax rate will be exactly the same as your pre-tax rate.
Hope Scholarship/American Opportunity Credit and Lifetime Learning Credits -$60,000-180,000
These are non-refundable credits you get for paying for yourself or your kids to go to school. Unfortunately, many doctors don't get these. The American Opportunity Credit can pay you up to $2500 per student for up to 4 years of school, but phases out at $80-90,000 for singles and $160-180,000 for married. The lifetime learning credit, which can pay up to $2000 per return, phases out even earlier- $60,000 for single taxpayers and $120,000 for married, but at least it can be used if the student stays in school longer than 4 years. So for most doctors, you can't use them for yourselves because they're non-refundable, and you can't use them for your kids because you make too much. Although some married primary care physicians may slip in under the new $180,000 limit for the American Opportunity Credit, especially if you are cutting back on your practice at the same time your children are in college.
Coverdell Education Savings Accounts (ESAs or Education IRAs) Contribution Limit -$95,000-$220,000
These are post-tax investment accounts that allow your money to grow tax-deferred and, if used to pay for educational costs, taxes are not due when the money is withdrawn. The ability to contribute to them phases out at $95-110,000 for singles and $190-220,000 for married. This isn't that big a deal, as the newer 529 plans are superior to the ESAs in almost every way. They allow for higher contributions ($13,000 instead of $2000 per year), they are often state-tax-deductible, and there is no income limit for contributions. Although their expenses are slightly higher and investment choices are slightly more limited than an ESA at a low-cost mutual fund company, most people should probably still be using 529s over ESAs.
Education Savings Bonds – $85,100-135,100
You don't have to pay taxes on the accrued interest of US Savings Bonds if you use them for educational purposes for you or your dependents. Unless you make more than $85,100 (single) or $135,100 (married.)
Education Tuition and Fees Deduction -$65,000-160,000
You can deduct up to $4000 worth of educational expenses from your taxes if you make less than $65,000 (single) or $130,000 (married.) That deduction is reduced to $2000 if you make $65-80,000 (single) or $130-160,000 (married.) Above those limits, there is no deduction.
Child Tax Credit – $75,000-$130,000
The child tax credit is worth up to $1000 per child. The credit phases out at $75-95,000 for singles and $110-130,000 for married. Sometimes this credit can even be refundable, but the rules on that are pretty complicated and don't really apply to most doctors anyway. Don't feel too badly about losing this one, it is supposed to be reduced back to $500 in 2013 anyway. At least you still get the exemption for the child.
Child and Dependent Care Credit – $15,000-43,000
If you make less than $15,000 (married or single), you get to deduct 35% of your childcare expenses. If you make more than $44,000, you only get to deduct 20%. This one probably only applies to students and residents with children.
Adoption Credit – $185,220-225,220
It turns out it costs a lot of money to adopt a child. You can get a refundable credit of up to $13,170 for your expenses. Unless your income is above $185,220-225,220, at which point you can't. I guess the government prefers children to be adopted by lower income families. Yet another one of those unintended consequences of government policies.
Personal and Dependent Exemptions – None!
Luckily, this one only affects some physicians. You know that $3700 you get to deduct from your income for each member of your family? It used to be that this deduction phased out between $156,400 and $278,900 for singles and $234,600 and $357,100 for married. The phase-out was eliminated for 2010-2012, and is then scheduled to return.
Itemized Deductions -None!
Another dirty rule of the IRS. They tell you that you'll get a deduction for buying a house, paying for medical costs, giving money to charity etc. Then they start limiting those deductions as your income goes up. The good news? This phase-out was eliminated for 2010-2012 as well. Stay tuned to see if it comes back. Hopefully not, as the phase-out began at $156,400 for both married and single in the past.
Alternative Minimum Tax Exemption -$47,450-$362,250
Why have just one tax system when you can have two? Due to all the tax deductions and credits authorized over the years by Congress, some bright people have been able to reduce their taxes to amounts that Congress now considers unfair. So they instituted a “minimum” tax amount. So after spending hours figuring out how much you owe each year, you have to check and see if you would owe more under the alternative minimum tax system, then pay whichever tax turns out to be higher. Factors that increase the likelihood of paying alternative minimum tax include: Higher income, married status, more children, and higher state taxes. As part of the process of determining your AMT, you exempt part of your income from the calculation. The amount you can exempt goes down as your income goes up. The current threshold is $47,450 for singles and $72,450 for married. Your exemption is reduced by 25% of the amount of income you made over the exemption amount. That's a complicated way of saying that as your income increases from $47,450 to $237,250 (single) or from $72,450 to $362,250 (married), you become more likely to have to pay the alternative minimum tax.
Conclusion
So what can you do about all this? For most of it, very little. However, lowering your adjustable gross income by putting money into retirement plans can make you eligible for deductions or credits you would otherwise be phased out of. Sometimes just putting a few extra bucks into your 401K can save you thousands in taxes. So it is important to be familiar with the phase-outs that are near your income range to spot possible tax savings.
If your specialty has little fixed overhead, you may also consider part-time work more attractive than you otherwise would given the much lower overall tax rates possible by taking advantage of tax breaks you would otherwise be phased out of. It is important to note that there is never a point in the tax code where your after-tax income goes down when you make more money, but the law of diminishing returns is definitely in effect as your income climbs through the tax brackets and especially these phase-outs.
Last Updated May 2011 (will update soon for 2012)