Navigating the intricacies of tax brackets can be challenging, especially for high-income physicians. In this blog post, we’ll demystify how tax brackets work, provide insights into tax planning strategies, and discuss common pitfalls physicians face when managing their taxes. Our goal is to equip you with the knowledge to make informed decisions, minimize tax liabilities, and avoid unpleasant surprises on tax day.
Introduction: The Tax Misunderstanding
We work with an OBGYN who was offered an additional position at his hospital that would come with higher pay. He reached out to us for our thoughts and asked, “If I earn more, won’t I just end up paying more in taxes on all my income because it will bump me up a tax bracket?” He asked a great question that is one we commonly hear from physicians, highlighting a common misunderstanding of how tax brackets work, especially among physicians.
In reality, the U.S. tax system is designed in a way that allows you to earn more while only paying a higher tax rate, if applicable, on a portion of your income. Understanding this can help you make better financial decisions, particularly when considering additional income or significant life changes.
Flat vs. Graduated Tax Rates
To better understand how tax brackets really work, you first need to understand the difference between flat and graduated tax rates:
- Flat Tax Rate: This is a straightforward system where a fixed percentage of your income is taxed, regardless of how much you earn. For example, if your state has a flat tax rate of 4.5%, you’ll pay 4.5% on every dollar you earn, whether your income is $50,000 or $500,000.
- Graduated Tax Rate: Unlike flat taxes, graduated tax rates increase as your income rises. The U.S. federal tax system uses this model, where your income is divided into segments, or “brackets,” each taxed at a different rate. As you earn more, only the income within each specific bracket is taxed at the corresponding higher rate.
For instance, in 2024, if you are married and filing jointly, your income between $201,051 and $383,900 is taxed at 24%. If you earn above $383,900, only the income exceeding this amount is taxed at the higher 32% rate.
The Misconception: All Income Taxed at a Higher Rate
A common mistake is believing that once your income bumps into a higher tax bracket, all your earnings are taxed at that higher rate – this is the mistake we saw the OBGYN have in his question we shared at the beginning of this post. This is not how it actually works! Only the portion of your income that exceeds the threshold of the lower bracket is taxed at the higher rate. For example, if a physician earning $383,900 accepts a role that adds $40,000 to their income, pushing them into the 32% tax bracket, only the $40,000 above $383,900 is taxed at 32%, not the entire income. So in this scenario, you are only paying more tax because you made more income – the higher tax rate does not apply to any of the income you were previously making and paying tax on.
Dual-Income Households: A Potential Tax Trap
Dual-income households, particularly when both spouses earn substantial incomes, can face unexpected tax challenges. This is because payroll systems are designed to calculate tax withholdings based on individual income, not combined household income. We see this happen frequently in dual physician households, or when one spouse is a physician already earning a high income and then his or her spouse is also earning income in another field.
Consider a scenario where one spouse earns $383,900 and the other earns $80,000. The payroll system for the spouse earning $80,000 will calculate tax withholdings as if that income is taxed independently, placing it in a lower tax bracket. However, because the physician is already paying tax to the top of the 24% tax bracket (remember the 32% tax bracket starts at $383,901) when combined with the higher income, that $80,000 actually will fall into the much higher 32% tax bracket, leading to underpayment of taxes throughout the year and a potentially large tax bill come April.
Real-Life Example: The Impact of Marriage on Tax Withholdings
Let’s take the example of a physician couple, both academic surgeons, who got married in early 2024. Before marriage, they filed separate tax returns, each based on their individual incomes, both between $400-500k. Post-marriage, their incomes are combined, meaning they are reporting a combined income around $900k on their married filing jointly tax return, resulting in a much higher tax burden than each of their incomes separately.
In this case, the couple sat down with Team Vestia to revisit their tax withholdings immediately after their marriage. By reviewing their pay stubs with our team and using the IRS withholding calculator, they adjusted their W-4 forms to ensure extra money was withheld from their paychecks. This proactive approach helped them avoid a massive tax bill on April 15th.
Married Filing Separately: A Word of Caution
Some physicians may consider filing taxes separately from their spouse to avoid higher tax brackets. However, it’s important to know that the tax brackets for married individuals filing separately are much less favorable than those for joint filers. For instance, the 32% tax bracket for joint filers begins at $383,900, but for separate filers, it starts at $191,950. Filing separately can also disqualify you from certain deductions and credits, making it generally an unfavorable option for physician households.
Tax Planning Strategies for Physicians
So how do you avoid tax surprises and put yourself in a good position for April 15? Physicians could consider the following strategies:
- Review Tax Withholdings After Major Life Changes: Whether it’s getting married, having children, or receiving a significant pay raise, any major life event can impact your tax situation. Work with your accountant and your HR Department to adjust your withholdings accordingly to avoid underpayment or overpayment of taxes.
- Run a Tax Projection in September/October: Conducting a tax projection in the fall with your accountant allows you to assess your tax situation before the end of the year. This gives you time to make necessary adjustments to withholdings or prepare for any additional payments that might be required. You have the opportunity to make a quarterly tax payment if needed on either September 15 or January 15 to “catch up” if the projections show that you’re on track to be underpaid.
- Consider Additional Withholdings: If you anticipate owing taxes, it might be wise to have extra money withheld from your paycheck each month. This approach helps manage cash flow and prevents the need for a large payment on tax day. It’s not uncommon for us to have physicians having extra withholdings of $1k/month or more on their paychecks.
- Work with a Financial Advisor or Accountant: Collaborating with a professional can help you navigate complex tax situations, especially if you have a high or variable income. They can help you understand your tax liabilities, suggest ways to minimize taxes, and ensure you’re not caught off guard by an unexpected bill.
Conclusion: Stay Ahead of the Curve
Understanding how tax brackets work and the impact of combined household incomes is crucial for physicians aiming to manage their finances effectively. By being proactive and regularly reviewing your tax situation, you can avoid unexpected tax bills and ensure that you’re making the most of your income.
If you’re unsure about your current tax strategy or would like a second opinion, don’t hesitate to reach out to us! We can help you navigate the complexities of the tax system and develop a plan tailored to your specific needs.
