This is the fifth in a series of posts made in preparation for a presentation I will be making for physicians in fellowship training at the upcoming ACCP meeting. Whether you do your own income taxes or you pay an accountant to do your taxes for you, you have to understand the basics of how taxes work in order to maximize your yield from your various retirement accounts. In the last post, I discussed some of the common mistakes physicians make in their investment decisions that can erode total returns. In this post, I’m going to give a very general overview of income taxes and capital gains taxes to set the stage for future posts about the best retirement investments for physicians.
Let’s start with income taxes. I am continually amazed at how much misconception there is about the American income tax system. The first thing to understand is that although we have tax brackets, we operate on a marginal tax system. This means that as your income goes up, your tax rate also goes up but it does so incrementally so that you pay a different tax rate for each successively larger chunk of income that you have. The table at the right shows the 2016 regular income tax brackets.
One of the problems with tax brackets is that you can’t predict where they will be in the future. Presidential candidates love to run on promises to change tax rates, generally by either increasing the taxes on the rich or by decreasing the taxes on the rich. One of the common ways that politicians change taxes is on what the income tax rate is on the top income tax bracket. This number has fluctuated considerably over the past 30 years, depending on who was president. As you can see from the graph below, the biggest change occurred during Ronald Reagan’s term when the tax rate on the highest tax bracket fell from a tax rate of 50% at the beginning of his presidency to to a tax rate of 28% at the end:
To understand how the marginal tax system works, let’s take an example of a single physician who makes $250,000 in taxable income. For the first $9,275 of her income, she pays 10% income tax ($927). For the next $28,375, she pays 15% income tax ($4,256). For the next $53,500, she pays 25% income tax ($13,375). For the next $99,000, she pays 28% income tax ($27,720). For the last $59,850, she pays 33% income tax ($19,750). Her total income tax is the sum of each of the components from each of her tax brackets ($927+$4,256+$13,375+$27,720+$19750 = $66,028). Many people have the mistaken belief that if they have a taxable income of $250,000 (the 33% tax bracket), that they have to pay 33% income tax on the whole $250,000 (i.e., $82,500). You will pay income tax on your income from your regular salary and on your income from interests (for example, from bond investments).
The other tax that most physicians will pay is capital gains tax. This is tax that you pay for income you get from dividends and the profit that you get from what you sell a stock for compared to what you originally bought it for. The capital gains tax rates are lower than the regular income tax rates. Unlike regular income tax, the capital gains tax is not a marginal tax, in other words, whatever your total taxable income is, that dictates your capital gains tax rate for all of your capital gains. The table above to the right shows the 2016 capital gains tax rates.
So if we put all of this together for several hypothetical taxable incomes, for a married couple filing jointly, here is the tax bracket (the amount you pay on the highest portion of your income) versus the effective tax (what you actually pay overall for your entire salary) versus the capital gains tax:
As you can see from the table, the income tax bracket is not what is really important, it is the effective tax rate, since what you are really going to pay is the effective tax rate. The table also shows that for the range of typical physician incomes, you are better off paying a capital gains tax than a regular income tax if you can. This will become important in future posts as we look at how to select investments for a physician’s retirement portfolio.
Another feature of taxes is when you pay them. For some taxes, you pay during the distribution year, that is the year that you take the money, for example, withdrawing money from a 401(k). For other taxes, you pay during the contribution year, that is the year that you actually earned that money. Of note, Pennsylvania is unique in that state income tax is paid during the contribution year rather than the distribution year**.
Now that we’ve covered the basics of taxes, we can determine the best place to put your money in order to maximize the amount that you will actually have in your hand when you retire. The next post will examine this in more detail.
August 24, 2016