If you’re making money, you’re going to pay taxes. There’s simply no way around it. However, the nature of your income will determine the amount you pay in taxes. Furthermore, you can change the character of your income to save more of your income.
Your money has character, and its character matters.
From the IRS point of view, different forms of income are not at all equal. For example, your W-2 income may be put in a different tax rate than your investment portfolio income.
There are several forms of taxable income in the US. They each come with their own rates and must be calculated separately. But this factor opens several opportunities for you to pay less in taxes, so long as you plan wisely.
First, it’s important to understand the major tax classifications set out by the IRS.
Your income will be separated into separate “buckets” based on the nature of the income.
The following classifications determine the rate at which your income will be taxed.
Ordinary Income Tax
Ordinary income tax is the class of tax the majority of most physician’s income will be subject to. Ordinary employment income (from your salary or wages) is reported on a Form W-2. This is the most common form of taxation in the US.
Filing your Form W-2 properly is very important. Fortunately, it’s also the easiest form of income tax to file.
For the tax year of 2020, income tax rates are broken down into rates for:
- Heads of households
- Married couples filing jointly or qualified widows
- Married couples filing separately
There are 7 tax brackets for ordinary income for the tax year of 2020. The lowest bracket requires eligible taxpayers to pay 10% of their income. The size of these tax brackets depends on the taxpayer classification you fall under. Have a look at the complete tax structure to understand your current tax burden.
Self Employment Income Tax
Income earned from self-employment is taxed differently. The IRS lays out much simpler rates for calculating your tax burden if you’re self-employed. But your taxes will be broken down into two portions, which makes calculating your tax burden slightly more difficult.
If you have self-employed income, it will be subject to your ordinary tax rates, as discussed above, and self-employment tax. The self-employment tax rate in the US is 15.3% of your earnings. This 15.3% rate is broken down into two portions:
-12.4% for Social Security tax
- 2.9% for Medicare tax
With regular employment income (W-2), employees and employers split the bill 50/50 for social security and Medicare. Self-employed individuals must pay these costs in full on their own.
For the tax year of 2020, self-employed individuals will have to pay the Social Security portion of their taxes for up to $137,700. The Medicare portion remains consistent but is risen by 0.9% if your income exceeds $200,000 if you’re filing as a single or $250,000 if married filing jointly.
There are also differences between passive and active income in the US.
Active income describes any form of income earned actively by a taxpayer. This includes wages, salaries, and self-employment income.
Passive income describes any income derived from:
- Rental properties
- Limited partnerships
- Investment portfolio income (such as interest and dividends)
- Any other activity where the taxpayer is not actively involved
Capital gains taxes are applied to income from assets.
“Capital gains” are the difference between the price at which you sell an asset and the price you paid for it.
These taxes are split into two rates:
-Short-term capital gains tax for assets held for under a year
- Long-term capital gains tax for assets held over a year
Your capital gains income, as it would be taxed, is known as “net capital gains”. Your net capital gains are your total capital gains minus any capital losses you incurred. So, if you made capital gains and losses, you can deduct your losses when determining your capital gains tax burden.
Short-term capital gains are taxed at your ordinary tax rate.
However, the long-term capital gains tax rates for the tax year of 2020 are 0%, 15%, or 20% depending on your income and marital status. If you’re single and make a capital gains income of under $40,000, your rate will be 0%. Most individuals that will pay capital gains taxes will pay 15% for the bracket of $40,001 to $441,500. Once you exceed that bracket, you’ll pay 20% of your income over $441,500.
It’s clear to see that it would be advantageous to try to shift your short-term gains to long-term capital gains to take advantage of the lower tax rate.
Dividends are either unqualified or qualified. What does that mean? In general, qualified dividends are dividends from shares in domestic and certain qualified foreign corporations that you have held for at least a specified minimum period of time and are unhedged. If the dividends are qualified dividends, they follow the same tax rates as long-term capital gains. Unqualified dividends are taxed at your ordinary tax rate.
There are also other taxes with different tax rates from your ordinary tax rate:
- Property taxes
- Estate taxes (if a property is transferred upon the owner’s death)
- Sales taxes
- “Sin taxes” (extra taxes levied on items like cigarettes and alcohol)
- Luxury taxes (placed on items like expensive jewelry and cars)
So, you now have a basic idea of the major categories of tax rates imposed by the IRS. But why does this matter? What can you do about your tax situation?
There are several relatively easy changes you can make to save money on your taxes.
W-2 Income To Self Employed Income
As a healthcare practitioner, you have choices when it comes to your earnings.
For a long time, being a contractor was worse for your taxes than having a salary. But now, a W-2 salary can be more highly taxed than a 1099 self-employed income. If you have the opportunity to earn either a W-2 salary or a 1099 income, you should often opt for the latter.
There are cases to be made for earning a W-2 income. You can often receive superior benefits such as 401(k) contribution matching or health insurance coverage. But as a purely tax-based argument, after the 2017 tax reform, you can pay significantly lower taxes as a contractor. Just make sure to claim your deductions and consider your income bracket. If you can negotiate greater pay for yourself, you can offset your loss of W-2 employment benefits. In this case, trading your Form W-2 for a Form 1099 can save you a lot in taxes.
The reason you’ll want to negotiate greater compensation for yourself is the Social Security tax we discussed. As a contractor, your employer will no longer cover half of the tax. For this reason, employers will often be happy to stop paying for half of your social security in exchange for a raise.
Now for the part where you REALLY start to save. The new Section 199A pass-through deduction introduced in the 2017 tax bill deducts 20% of “qualified business income”. This deduction is available to several taxpaying businesses. But it’s also available to 1099 contractors, sole proprietors, and freelancers. Almost anyone that isn’t a W-2 employee or owner of a C-corp qualifies.
One caveat: This deduction cannot exceed 20% of the difference between your capital income and taxable gains. So, keep in mind that significant capital gains will limit the tax savings this deduction will net you.
Passive To Active
Active income applies to any income you materially participated in earning. Passive income is the opposite. But there are legal ways to take advantage of the distinction between the two. And you can save some money on taxes in the process.
Let’s use the example of Airbnb. Airbnb serves as a great example because many people are actually confused as to whether their Airbnb income is active or passive. Rental income is typically considered passive income. But what about short-term stays that require constant cleaning and maintenance for new guests? This would be considered an active trade or business and reported on Schedule C as a business instead of Schedule E as a passive rental. This would allow you to take any losses from your Airbnb instead of it being subject to passive loss rules.
You can also change take advantage of deducting your losses if you qualify for real estate professional status. This would make your rental activity active instead of passive.
Active and passive income are complicated topics. But the key is that the IRS allows you to deduct passive activity losses. In this way, if you run an Airbnb or participate in another passive income-earning activity, you can claim deductions. If you’ve been erroneously filing passive income as active, you should consider correcting your mistake and claiming the appropriate deductions and credits. But make sure you consult a tax professional and comply with IRS Topic no. 425.
Changing the character of your income to suit more favorable tax rates is a core tax planning strategy. Thinking outside the box but within the law can really help you to save a ton of money!
If you are wondering if your taxable income needs a character change, review Cerebral’s ROI page to see if you would be a good fit for a complementary tax analysis.