Code Green! The Taxman Cometh: Making Sense of Tax Law Gobbledygook
“I am proud to be paying taxes in the United States. The only thing is – I could be just as proud for half the money.”
-Arthur Godfrey, entertainer
What’s that noise? Why, that’s the sound of your bank account crying when tax time rolls around.
Navigating the seemingly complex annals of the tax code and process of filing your taxes can be less painful when you are well-informed (and that knowledge may even save you a little money).
There are three main kinds of taxes: income tax, property tax and taxes on goods and services (i.e., sales tax), which I will discuss over the next three posts. Income taxes will be discussed in two parts. And, yes, there’ll be a judicious sprinkling of “Collinsisms” for you ahead.
This post covers income tax rates, types of income and income tax forms.
As a verb, the word “tax” means “make heavy demands on”, and as an adjective it means “physically or mentally demanding.” I find it easier to understand a word best if used in a sentence, so I offer this: Understanding the income tax code and filling out tax forms can be very taxing!
To DIY or not to DIY? (that is the question)
Hiring a professional to do your taxes can be an expensive endeavor, so some radiologists do it themselves. However, if you aren’t comfortable researching tax law, the idea of working with numbers and calculations scares you, or the entire concept of deductions and credits seems like voodoo, you might be better off hiring a professional. There’s also the issue of time – some radiologists would rather pay someone else to spend the time doing their taxes. On the other hand, if you don’t mind numbers and tax law holds some interest for you, there are advantages to doing it yourself.
I’m an educator at heart and firmly believe that you learn something best by teaching it to someone else. This is true because in order to teach something you have to fully understand it. This holds true with doing your own taxes. Once you’ve filled out the tax forms yourself, you will have a better understanding of tax laws and how you can optimize them to your advantage in a way that you wouldn’t if someone else did it for you. Even if you decide one day that you’d rather pay someone else to do it, you will be better equipped to assess whether your tax preparer is doing a good job. I will say this now and end the post with the same line: No one will look out for you better than you.
Income tax is progressive
About 20 years ago I told my dad that almost half of my income was going towards paying income taxes. He looked at me and said, “how can that be?” I told him that the federal tax rate for married people filing jointly was 39.6% for income over $288,350. And that there was state tax on top of that, which in WI was 6.75% for income over $165,600. After a pause, my dad explained the concept of a “progressive tax.”
The word “progressive” means something that happens or develops gradually or in stages; proceeding step by step. The United States has a progressive income tax scale. The more money you make, the more you’ll pay in taxes. However, earning a high wage doesn’t mean your entire income will be taxed at the same rate because the progressive income tax scale uses marginal tax rates to determine how your taxes are calculated.
To better understand how your income is taxed, imagine your taxable income is divided into sections. The first section is taxed at one rate, then the next section is taxed at a higher rate, and the section after that is taxed at an even higher rate, and so on. These different portions are called tax brackets. There are seven different tax brackets, and their rates differ based on your filing status. The top tax bracket that applies to your income is called the marginal rate.
For tax year 2020, the top tax rate remains 37%. The rates for singles (and married couples filing jointly) are:
- 37% for incomes over $518,400 ($622,50)
- 35% for incomes over $207,350 ($414,700)
- 32% for incomes over $163,300 ($326,600)
- 24% for incomes over $85,525 ($171,050)
- 22% for incomes over $40,125 ($80,250)
- 12% for incomes over $9,875 ($19,750)
- 0% for incomes $9,875 or less ($19,750)
Marginal tax rate is best defined as the amount of tax you pay on an additional dollar of income.
For example, a radiologist with a non-earning spouse and a taxable income of $400,000 would NOT pay 35% of $400,000 ($140,000). Instead, her tax would be:
12% on the first $19,750 (.12 X $19,750) = $2,370
22% on income from $19,751 to $80,250 (.22 X $60,499) = $13,310
24% on income from $80,251 to $171,050 (.24 X $90,799) = $21,792
32% on income from $171,051 to $326,600 (.32 X $155,549) = $49,776
35% on income from $326,601 to $400,000 (.35 X $73,399) = $25,690
Note that only $73,399 of income is taxed at the marginal rate of 35%.
The effective tax rate is the percentage of your taxable income that you pay in taxes (Note: “taxable” income is total income minus deductions). Using the above example, the radiologist pays a total of $112,938 in taxes. Divide that by $400,000 and you get 0.28, or a 28% effective tax rate (compared with a marginal rate of 35%). Note that sometimes the effective rate is based on state income taxes and/or payroll taxes in addition to federal income taxes. It can also be calculated using total income (i.e., income before subtracting deductions) as the denominator rather than taxable income.
Most states follow this progressive tax system, but a handful have flat tax rates. They charge the same percentage to everyone, regardless of earnings.
There are five filing statuses: single, married filing jointly, married filing separately, head of household, and qualifying widow(er) with dependent child. A taxpayer may be eligible to choose from more than one (e.g., married filing jointly or married filing separately), but will usually opt for the filing status that results in the lowest tax.
Types of Income
Income is any money or compensation you work for or receive from invested resources. There are several types of income, and each is taxed differently:
Annual salary, hourly wages, and earnings from self-employment are taxed at the normal income tax rates, but differ in that instead of being subject to the normal Social Security and Medicare taxes, self-employment earnings are subject to the self-employment tax (see below).
Most interest, such as from a checking or savings account, or certificate of deposit, are subject to normal income tax rates, but not to Social Security and Medicare taxes. Some interest, such as from tax-exempt bonds issued by state government and bonds issued by municipalities (i.e., “munis”) are not subject to federal income tax. Interest income from U.S. Treasuries are subject to federal income tax at ordinary income tax rates, but exempt from state and local income taxes.
Capital gains tax is a levy assessed on the positive difference between the sale price of an asset (such as a mutual fund) and its original purchase price (i.e. “cost basis”). Long-term capital gains tax is a levy on the profits from the sale of assets held for more than a year. The rates are 0%, 15%, or 20%, depending on your tax bracket. Short-term capital gains tax applies to assets held for a year or less, and is taxed as ordinary income. Tip: Think twice about selling an asset that has increased in value that you haven’t held for over a year.
Tax on capital gains is triggered when an asset is sold, or “realized.” When you still own an asset that has increased in value, the gain is “unrealized.”
Even if you don’t sell them, you will probably still accrue capital gains if you own mutual funds. That’s because each mutual fund shareholder is responsible for income tax on her share of the net capital gains realized by the fund over the course of the year, even if the value of the mutual fund went down (kick me when I’m down why dontcha!). In this unique situation, your share of capital gains taxes are distributed to you even though you haven’t sold your fund shares. One of the advantages of owning diversified, passive index funds is that they tend to distribute fewer capital gains to shareholders compared with actively managed funds. Note: You don’t pay capital gains tax on investments that are held in retirement and HSA accounts – those investments grow “tax free.” But you do have to pay capital gains tax on investments held in taxable accounts.
Capital gains can be reduced by deducting the capital losses that occur when a taxable asset is sold for less than the original purchase price. Capital losses mirror capital gains in their holding periods. Long-term gains and losses are netted against each other, and the same is done for short-term gains and losses. Then the net long-term gain or loss is netted against the net short-term gain or loss to determine “net capital gains”, and the final number is reported on Form 1040.
If you have a net capital loss for the year, you can subtract up to $3,000 of that loss from your ordinary income. The remainder of the loss can be carried forward to offset income in future years.
Selling a home for more than you paid for it can also generate capital gains, but you can exclude up to $250,000 of that gain ($500,000 if married filing jointly) if you meet certain requirements.
Dividends are distributions of a company’s profits to the shareholders, and are often subject to lower income tax rates. So-called “qualified dividends” are taxed at the capital gains tax rate.
Net investment income (NII) from interest, dividends, and capital gains is subject to an additional 3.8% tax when the NII and modified adjusted gross income (MAGI) exceed certain thresholds. This tax is on top of ordinary income tax and capital gains tax. Many radiologists, because of their income level, are subject to this tax.
This category includes income from trades or businesses in which you do not materially participate and rental income, even if you materially participate (unless you’re a real estate professional). Passive income is subject to regular income tax, but not to payroll taxes or self-employment tax. Losses from these activities can only be used to offset income from passive activities, except when you actively participate in a rental activity (e.g., make decisions about lease terms, property repairs, or who to rent to). In that case, up to $25,000 of losses can be used to offset your nonpassive income each year.
Pensions and some other retirement benefits
Taxation of pensions varies. Most pensions are taxable; however, some types of military pensions or disability pensions may be partially or entirely tax-free. If you contributed after-tax dollars to your pension or annuity, your pension payments are partially taxable.
Anywhere from 0% up to 85% of your Social Security income may be taxable, but never 100%. If your other sources of income are below the thresholds set by the IRS, then all your benefits will be tax-free, but if your other sources of income are in excess of the threshold, then a formula determines what percentage of your benefits will be subject to taxation. For example, if you and your spouse have a combined income that is between $32,000 and $44,000, you may have to pay income tax on up to 50 percent of your benefits; if it’s more than $44,000, up to 85 percent of your benefits may be taxable. Most retired radiologists will pay federal income taxes on 85% of SS benefits. State income tax laws vary. Only thirteen states (Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont and West Virginia) collect state income tax on Social Security payments.
When do you pay income taxes?
If you’re an employee, taxes are taken out of your paychecks in a process called withholding, and your employer sends the money to the government on your behalf.
If you’re a self-employed radiologist (doing locum tenens or other contract work, for example), you aren’t subject to withholding so you have to pay estimated taxes on your income four times a year. If you don’t pay enough tax throughout the year, either through withholding or by making estimated tax payments, you may have to pay a penalty for underpayment of estimated tax. You can avoid this penalty if you owe less than $1,000 in tax after subtracting withholdings and credits. You can also avoid a penalty if you paid at least 90% of the tax for the current year or 100% of the tax shown on the return for the prior year, whichever is smaller.
Paying 100% of the taxes you owed in the previous year is referred to as the safe harbor rule. One important caveat—if your income is more than $150,000 per year (ahem, most of you practicing radiologists), then you’re required to pay 110% of what you paid in taxes last year. Note: If you live in a state that charges income tax, you may also need to set up quarterly state tax payments.
Forms, forms, and more forms!
If you prepare your own taxes, or review the returns prepared for you, you’re likely familiar with some or all of the forms described below. If not, here’s a chance to increase your tax form literacy!
A W-4 form is used by your employer to know how much money to withhold from your paycheck for federal taxes. Accurately completing your W-4 can help you from having a big balance due at tax time. It can also prevent you from overpaying your taxes, putting more money in your pocket during the year.
A W-2 form, also known as the Wage and Tax Statement, is the document an employer is required to send to each employee and to the IRS (Internal Revenue Service) at the end of the year. A W-2 reports your annual wages and the amount of taxes withheld from your paychecks.
Form 1040 is the “U.S. Individual Income Tax Return.” It’s the primary form used by individuals to file their income tax returns with the IRS. It changed for the 2018 tax year after passage of the Tax Cuts and Jobs Act with the intention of making it “as small as a postcard”, to make filing taxes easier. Sounds good, right? Imagine filing your taxes on a postcard! What could be easier? But alas, the 1040 is still two pages in length and the new tax law introduced an additional six new supplemental schedules (more forms). Some people are eligible to file Form 1040EZ instead of form 1040, but they must meet several requirements to do so, including but not limited to having less than $100,000 of taxable income, and not claiming any above the line deductions or credits aside from the earned income credit.
“Schedules” are attachments to a “form.” Most tax schedules are attached to Form 1040. The most frequently used schedules are:
- Schedule A: Used to list itemized deductions
- Schedule B: Used to report interest and dividend income
- Schedule C: Used to calculate and report a business’s profit or loss if you run a business as a sole proprietor
- Schedule D: Used to report capital gains and losses
- Schedule E: Used to report income (or loss) from rental real estate, royalties, partnerships, S-corporations, estates, or trusts
Form 1099-MISC is similar to a W2 in that it is provided by employers. However, whereas W2s apply to employees, 1099s apply to independent contractors who have earned at least $600 over the course of the year. You will receive a 1099-MISC from each entity that you received payment from as an independent contractor.
Form 1099-DIV is used by banks and other financial institutions to report dividends and other distributions (e.g., total capital gains, qualified dividends, non-taxable distributions, federal income tax withheld, foreign taxes paid) to taxpayers and to the IRS.
Form 1099-INT shows interest income from the previous tax year such as that paid from savings accounts, interest-bearing checking accounts, and US Savings bonds. The form is issued by banks, brokerage firms, and other financial institutions.
The SSA-1099 reports any social security benefits earned, including retirement benefits, disability benefits, and survivor benefits.
The 1098-E is known as the “Student Loan Interest Statement.” Like the name implies, this form displays the amount of interest paid on student loans during the previous tax year. These interest payments can often be deducted from total income on federal income tax returns.
You should now have a good understanding of income tax brackets, the distinction between marginal and effective tax rates, different forms of income and how they are taxed, and common tax forms.
To finish your education on income taxes, be sure to see my next post, where I will cover deductions, credits, Social Security/Medicare taxes, and state income tax, as well as provide filing tips, references for further learning, and, of course, my personal anecdotes—or more stories from the “Collins collection of lessons learned,” AKA “Collinsisms.”