Q. One of my partners retired early and said she basically pays no taxes at all. Can that be true?
A. A basic understanding of our tax code can be extremely valuable when doing financial planning with or without a formal advisor. The media and even politicians often mistakenly assume that a high earned income is what defines wealth. In reality, a wealthy person has a high net worth, not a high earned income. That misunderstanding, however, has resulted in a tax code that primarily taxes income rather than wealth. So although physicians who make $400,000 per year may have a negative net worth, they will still have a high tax bill.
Newly minted attending physicians are often shocked to realize just how highly their income is taxed. The progressive nature of the tax code means that the more income you make, the higher the percentage of your income that goes toward income taxes. When it comes to taxes, earned income is the worst kind of income there is. Not only do you have to pay payroll taxes such as Social Security and Medicare on the income, but the taxes might even be calculated using a completely different (and higher) set of tax brackets than unearned income! This might result in an emergency physician paying an effective tax rate (total tax divided by total income) in the 30 percent range and a marginal tax rate (the rate at which the next dollar earned is taxed) in the 45 percent range!
There are not a lot of methods to dramatically lower your tax bill while you are working full-time as a physician. The largest tax breaks are usually tax-advantaged savings accounts such as 401(k)s and health savings accounts (HSAs). However, there is one method that has been used by some physicians to dramatically lower their tax bill: retiring early!
Many physicians, used to paying a very heavy tax burden during their working years, are surprised by just how low their retirement tax bill might be. They no longer have to pay payroll taxes at all and might even move to a state without an income tax. Deductions and exemptions they might have been phased out of before are now available again. Some of their income is likely to be tax-free, and a significant part of it is taxed using the lower qualified dividends/long-term capital gains scale. When you combine all of this, it is entirely possible that your retired partner isn’t paying income tax at all. Let’s run the numbers and see just how much income a couple could have without having to pay taxes.