Nobody really likes taxes. Some people hate them. Some people accept them. But no one likes them. However, that is not a reason to ignore taxes. Understanding how taxes work puts you in control. Remember, you need to pay the amount you legally owe in taxes, but you don’t need to leave the government a tip. With this in mind, let’s review how our progressive tax system works and how that knowledge can help us come tax time.
Keep in mind, until the past couple of years, I ignored my taxes. The result was that I often did leave a tip for the government. In fact, paying attention to my taxes and understanding how the progressive tax system works has resulted in huge savings and definitely will accelerate my path to financial freedom.
And one last thing before I start, this post has nothing to do with if I think the current tax system is right or wrong. Honestly, I have no idea. Do I love paying high taxes now? No. But there was a time during my training when Selenid and I did use government assistance when we struggled. I also use public programs today.
My argument is this: Taxes are a reality of our life. Whether we agree with them or not, we still need to understand them. To ignore them out of spite only hurts ourselves. I suppose that makes this a realist post?
What is a progressive tax system?
It’s pretty simple. A progressive tax system taxes citizens based on their ability to pay said taxes. Seems like an odd definition when you first read it.
Basically, it means that people with lower incomes pay less taxes and people with higher incomes pay higher taxes.
This is in contrast to a flat tax system where everyone pays the same percentage of income in taxes.
For completeness sake, a regressive tax system is one in which the same rate applies to all regardless of ability to pay. This is what a sales tax is.
Now that we have the definitions out of the way, let’s talk about what this means for us as physicians.
3 important things to know about our progressive tax system
1. All of our income isn’t taxed at the same rate
This is pretty much the hallmark of a progressive tax system. Yet this misconception persists. Again, I didn’t understand this concept until I started learning about taxes as part of my financial education.
The way that we are taxed is via tax brackets. Meaning that the first $1 of our income is not taxed at the same rate as out last $1.
As the chart below shows, our first $10,275 of income (if filing single) is taxed at 10%. Meanwhile, if we file single and make $539,900 of more, our last $1 is being taxed at 37%.
How understanding this helps us
Once we understand this, we can recognize that stepping down in tax brackets will save us enormously come tax time. And there are ways to do this.
The name of this game is reducing our taxable income. And we can accomplish this through various tax deductions. As opposed to tax credits that decrease our taxes in a $1:$1 fashion (and are better than tax deductions), tax deductions allow us to decrease the amount of our income that gets taxed.
Finance Flash Go! Episode #55: Tax Deductions
By maximizing deductions available to ourselves, we decrease our taxable income within our marginal (top) tax bracket. This is a great help. But even better, if we drop down a tax bracket, the savings become even greater.
And fair or not, remember that employees (like myself) have less tax deductions available to use than business owners like private practice physicians. You can get around this by running your own side business so that you can use these deductions to your advantage. Here are over 20 Physician Side Gigs to Make You Passive Money…
2. Our average and marginal tax rates are different
In a progressive tax system, there is a difference between our average tax rate and our marginal tax rate.
Our average tax rate is simply the averaged rate that we paid for our entire income based on this tiered progressive system. Meanwhile, our marginal tax rate however is the tax rate on our last $1 of earned income.
How this helps us
I think this is important to understand on even just an emotional level. Too many people tell me that the government takes 40% of their paycheck for federal taxes. First, this just isn’t true given the current tax brackets that don’t go that high. But even if they did, all of your income isn’t taxed at that top rate…only your income above the designated level ($539,900 for this filing as single). Again, your marginal tax rate isn’t your average tax rate.
The other emotional argument I hear is that we just shouldn’t work once we reach a certain income because the taxes are too high. While I understand the frustration, this just doesn’t add up. Do I want to keep 100% of my money? Yes. But I’ll take 60% of it over 0% any day of the week.
But there’s a more practical reason this is helpful to understand.
Since our average and marginal tax rates differ, we can take advantage of tax rate arbitrage in an effort to lower our taxes.
By deferring extra income during already high income years to potentially lower income future years, we can minimize the amount of income we have in our marginal tax bracket. This will also serve to lower our average tax rate.
This is one of the huge advantages with tax deferred retirement accounts like 401k’s. We defer our income during peak income years into a 401k. This amount is therefore deducted from our income for tax purposes. Then, we withdraw that money later in life (when we theoretically are earning less or not at all in retirement). Thus, we have shifted income from a higher tax bracket to a lower tax bracket and saved money on taxes.
3. Reduced tax burden on those who can least afford it
This has been implied above. But those with lower income pay lower taxes because they are in lower tax brackets.
There’s not much more to explain in this sense, but…
How this helps us
And I’m going to use the royal “us” here. Due to the basic principle above, progressive tax systems keep more money in the pocket of those with lower incomes. This ensures that they have enough money to live their lives and to spend on goods and services. This is good for the overall economy.
It is also good for physicians. We don’t have a universal healthcare system (again, I’m not arguing if we should or not). This means that on top of insurance, patients have to pay out of pocket in variable amounts for healthcare. As doctors we unfortunately know that socioeconomic factors limit access to healthcare and also patients’ willingness to seek healthcare.
More money in people’s pockets who needs it helps keep them healthier and also keeps them coming to see us as physicians. Oversimplified? maybe. A win-win? I think so.
As an aside, if you invest in real estate, it’s also good that your tenants have money to pay rent.
A Real Estate Investing Guide for Physicians
Taxes and doctors
Taxes are here. And they aren’t going anywhere anytime soon. They will always go up and down slightly depending on politics but they will never go away. That means that it is up to us to understand how they work and what we can do to make sure we only pay what we owe.
Understanding our progressive tax system and what that means for us is a really important first step.
Only then can we start to implement specific tax optimization strategies like these:
- An Inside Look at My Personal Tax Plan
- 5 Important Tax Tips for Physicians
- 5 Ways W2 Physicians Can Lower Their Taxes
What do you think? Is a progressive tax system good or bad? What does it mean for us? How can we understand it better? Let me know in the comments below!