Did you know that a high income can become one’s own enemy? It can also lead to a hefty tax bill — have you ever had to pay taxes on a million dollars?
Taking a deep dive into first-world problems, we’ll see precisely how much one might pay in taxes on a million-dollar annual salary or in taxes on a million dollars of earned income over longer timeframes.
It might be a little. It might be a lot. It depends greatly on how long it takes to accumulate those earnings.
In today’s post, we’ll calculate the taxation on households earning $100,000 a year, $250,000 a year, and $1,000,000 a year as W-2 employees.
We’ll keep things consistent by looking at married couples with one income, filing jointly while contributing $37,000 a year to tax-deferred retirement plans. This could be any combination of 401(k), 403(b), and/or 457(b) contributions, as long as they have access to two of them.
They have two children under the age of 17 but are past the daycare years. They live in a state with a mid-range total state & local income tax at a flat 5% of their federal taxable income per year.
The numbers below calculated for 2020, ignoring the stimulus payments and additional child tax credits, as those one-time credits will not likely be repeated year after year.
Earning $1 Million in Ten Years
The combined salaries in our first household add up to $100,000 a year. After subtracting the $24,800 standard deduction and $39,000 in tax deferral, they’ll owe federal income tax on $36,200 or 36.2% of that $100,000 income.
The tax calculation on $36,200 of taxable income gives them a federal income tax of $3,952.
The tax credit of $2,000 per child gives them a $4,000 credit.
They’ll owe $0 in federal income tax, according to TaxCaster. In fact, they’ll get $48 back from the federal government, despite earning six figures between the two of them.
Their share of the FICA taxes will be $6,200 for Social Security and $1,450 for Medicare. Note that you don’t get deductions on the FICA taxes, which are based on the $100,000 salary.
This couple owes $7,650 in FICA Taxes.
At 5% of $36,200, the state & local income tax will be $1,810.
Add it all up and their tax bill based on 2020 tax brackets and rates will be a total of $9,412 per year, or about 9.4% of their salary.
Note that about 2/3 of this consists of payments to Social Security, and they should get at least some of that back, eventually. Isn’t it remarkable that the federal income tax was negligible with $100,000 in household earnings?
Multiply their annual tax bill times 10 and they’ll pay under $100,000 in total taxes on a million dollars of earned income when spread out over a decade. They were able to keep over $900,000 of their earned income in that ten-year timeframe.
Earning $1 Million in Four Years
Multiplying the income from our first example by 2.5x, this couple is earning $250,000 per year. This could be a dual-income couple each earning in the low six-figures, a primary care physician with a stay-at-home spouse, or a part-time specialist like this guy.
For consistency’s sake, we’ll assume it’s a single-income household. The only place it matters much for purposes of today’s exercise is the FICA tax calculation, although in real life, a dual-income household could presumably defer more tax with more tax-advantaged retirement plan space.
Starting with $250,000 in salary and subtracting the $24,800 standard deduction and $39,000 in tax deferral, they’ll owe income tax on $186,200 or 74.5% of that $250,000 annual income.
Federal income tax, as calculated by TaxCaster, comes out to $28,847.
FICA tax is a maxed out $8,537 for Social Security and the employee’s portion of Medicare taxes, 1.45% of $250,000, is $3,625. That adds up to $12,162 in FICA taxes.
Note that if they had earned one dollar more, they would have also been subject to an additional 0.9% Medicare tax on the additional dollars earned. They would also be subject to an additional 3.8% NIIT tax on long-term capital gains and qualified dividends.
The state and local income tax will be $9,310, a flat 5% of the $186,200 of taxable income.
Based on 2020 tax rates (due May 17, 2021 assuming no extension), this couple owes a grand total of $50,319 on $250,000 in salary, or just over 20%. That’s an effective tax rate more than double that of the couple earning $100,000 a year.
After four years at this salary, they will have paid a total of $201,276 in taxes on a million dollars of earned income, keeping $798,724.
Earning a Million Dollars a Year
While not common in medicine, public records do show that a number of our states’ highest-paid employees are employed by our public universities. The football and basketball coaches usually top the list, but the neurosurgeons and cardiothoracic surgeons often populate a few of the top 10 positions. There’s also an ophthalmologist in Oregon earning $913,335 per year in retirement as his pension, for an outlandish example.
Yes, that’s insane to me, and no, I’ve never earned anywhere near a million dollars a year, but there are docs like this out there. I’ve featured a urologist earning seven figures and another physician earning upwards of $1.8 Million a year as a practice owner.
In this example, the couple will earn a cool one million dollars in one year. To keep the FICA taxation equivalent, we’ll assume this was one income-earner, but it’s more likely to see this kind of total income from a dual-physician couple, probably in high-paying specialties and perhaps practicing some geoarbitrage.
After accounting for the same $63,800 in deductions for the tax-deferred retirement contributions and standard deduction, they owe income tax on 93.6% of their $1,000,000 income.
The TaxCaster calculation shows $283,532 owed in federal income tax. Note that the “Additional Taxes” of $6,398 credited as paid represent the additional Medicare Tax owed on income above $250,000. Don’t ask me why there’s a $1 discrepancy. A glitch in the matrix, I suppose.
This couple was phased out of the child tax credit based on the phaseout that begins at 400,000 and is completely eliminated at $480,000 for two children. The phaseout occurs over a range of $40,000 per child.
Losing the credit effectively functions as a 5% surtax on a modified adjusted gross income over $400,000. The range in which you’ll feel the effect will be from $400,000 to ($400,000 + N x $40,000), where N is the number of children you have. For more details on the child tax credit, look here.
The Social Security tax is once again maxed out at $8,537 but there is no cap on Medicare Tax, and as mentioned above, the rate jumps from 1.45% to 2.35% on salary beyond $250,000. This couple pays $21,250 in Medicare Tax (this includes the $6,398 in “additional Medicare Tax) for a total of $29,787 in FICA taxes.
Using the simple 5% formula on the $961,000 in taxable earnings gives them $48,050 in state income tax.
The total bill is is $361,379 or about 36% in taxes on a million dollars when earned in one calendar year. They have $638,621 left.
Earning a Million Dollars in Revenue from this Blog
This website is a for-profit blog with a charitable mission. When I designed my drawdown plan for early retirement, I didn’t factor in online income, although I realized such a thing could throw a very pleasant monkey wrench into the outlined plan.
Having met a number of online entrepreneurs who are actually earning a 7-figure income from their online endeavors, I’ve fantasized about what a million dollars in revenue might look like for Physician on FIRE.
Note: I am earning nowhere near that level of income, but I’m not completely ruling it out as a possibility one day. Never Say Never.
So let’s say, hypothetically, this site were to bring in $1,000,000 in revenue in one year. I have some expenses to cover. As a site and its email list grows, the costs of doing business go up.
The profit sharing and business expenses take about one-third of the revenue. We’ll estimate those combined costs as $340,000 on $1,000,000 in very hypothetical revenue. My profits are $660,000 in this scenario.
I’ve got a charitable mission to donate as much as half of the $660,000 in profits. Let’s say $330,000 is donated, mostly to our donor advised fund, but I’ll likely be required to make some cash donations to charity, too, as donations are limited to 30% of adjusted gross income when donating appreciated shares of assets (which is what I prefer to do).
We’re left with $330,000. Let’s say I make $58,000 in contributions to my individual 401(k) and for the sake of this exercise, let’s assume those are tax-deferred contributions.* Taxable income has been reduced to $272,000.
But wait… there’s more!
With the latest round of tax reform passed in 2017, we have the 20% deduction of qualified business income based on Section 199A.
In this case, my qualified business income (QBI) should be the $660,000 in remaining profits, minus the $56,000 in tax-deferred investments, or $604,000. I could potentially get a deduction of $120,800. However, the final QBI deduction is based on either 20% of (pre-QBI deduction) taxable income or 20% of QBI, whichever is lower.
Since my taxable income above was calculated to be $272,000, and 20% of $272,000 is $54,400, that’s how much I’ll be able to deduct based on Section 199A. After the deduction, I’ll be paying taxes on $217,600 of taxable income.
Plugging numbers into TaxCaster, I come up with $30,431 in federal income tax due in this scenario.
FICA taxes without an employer paying a portion would be $17,075 for Social Security and $26,782 for Medicare (they don’t care about my generosity) for a total of $43,857 in FICA tax. Half of this would be deductible on the federal income tax, and that would slightly alter this calculation but we’ll dismiss that for this thought exercise.
Finally, paying my 5% to the state on the $217,600 gives me $10,880 in state tax.
Therefore, if the site had been much, much more successful last year, I would have owed a grand total of $85,168 in total tax.
That’s 8.5% of the million-dollar dream revenue. Generosity pays!
*At some level of income, it might make better sense to make all Roth contributions to take full advantage of the Sec 199A deduction. The White Coat Investor covers this calculation in great detail.
Is it Better to Earn More?
Let’s summarize what we learned about these fictional one-income couples earning one million dollars over various periods of time.
- When earned over 10 years, the total tax is about $94,000.
- When earned over 4 years, the total tax is about $201,000.
- When earned over 1 year, the total tax is about $361,000.
While higher earnings are taxed at a higher percentage, the fact remains that the more you earn per year, the more you have at the end of the year. The couple earning $1,000,000 a year would have over $6.5 Million in after-tax pay after 10 years.
In these examples, the first $60,000 or so dollars are clearly the most valuable dollars as the tax owed is completely offset by the child tax credit on two kids.
Once you’re in the 37% tax bracket and completely phased out of the child tax credit, each additional dollar earned results in about 58 cents in your pocket.
This simplified example ignores the Alternative Minimum Tax (AMT), which now affects far fewer people than it did prior to the Tax Cut and Jobs Act.
What’s perfectly clear in these examples is the progressive nature of our income tax structure and the diminishing returns of additional dollars earned in a given year.
Conversely, we also see the regressive system in place to fund Social Security. The couple earning $100,000 paid nearly as much for the Social Security portion of FICA as the million dollar earners. The Medicare Tax, on the other hand, is a progressive tax with two tiers.
For the same amount of work, I’d take a higher salary eleven times out of ten. However, when you realize that you’re maybe keeping a little more than half of any extra money earned once you’ve got the salary of a physician specialist, more work for more income becomes less appealing.
How I Have Applied These Principals to My Own Life
Personally, I took advantage of the progressive nature of taxation in my own life when I worked part-time over the final two years of my career. I calculated that the shifts I gave up were the shifts that paid 30% less after tax than the shifts I was keeping.
We also considered the role of our marginal tax rate when deciding whether or not my wife would work as a dietitian after our children were born. Knowing that a $40,000 salary would only add maybe $20,000 to $25,000 to our bottom line and factoring in the cost of childcare, the correct decision for our family was obvious.
Dual physician households will face similar calculations. When the work is stressful and long, and your kids spend twice as much time with their nanny than you, keeping half of a $200,000 salary may not seem so appealing, either. You can always run the numbers based on your individual situation using TaxCaster.
Our 2019 Tax Return Released
For the financial voyeurs out there, I’ve revealed our 2019 1040 tax return line by line. I have not yet submitted my 2020 return, and I’ve filed an extension while I wait for some K-1s to come in.
We didn’t have a million dollars of income in 2019, but our total income exceeded half a million while our taxable income was less than half of that. See the full breakdown in our 2019 tax return reveal.
Has our nation’s progressive tax system played any role in your decision-making? Have you chosen to work less as a result or kept one partner home for similar reasons? Let us know in the comment box below!