COVID aside, my airline’s profit sharing (PS) has been nothing short of stellar. In fact, my company has paid more profit sharing over the last decade than any airline in human history.
PS day is always February 14th, and being able to say, “I forgot to get you flowers, so I brought home this check instead,” plays very well with most pilot spouses.
Every year though, we’re subjected to at least a few emotion-laden rants from uninformed pilos like Poor Old Joe who are angry that they have to pay so much more tax on their PS money than on any other part of their pay. They rant and rave, advocating for the abolition of our PS plan altogether, or all kinds of other crazy schemes to address the unfavorable tax situation.
As it turns out, all this drama is based on a simple lack of education, or potentially on a few pilots just failing to comprehend what they read.
Yes, the IRS does require big companies to withhold taxes for some large bonus payments like PS at a 22% rate. That’s a lot. Basically: whatever number the company tells you you’re getting for PS on Valentine’s day, Uncle Sam and his spiked baseball bat are going to snag a quarter of your money without you ever touching it.
If that were the sum total of the situation, it’d certainly be frustrating. Thankfully, it’s not. Most pilots will get a large chunk of that money back in their tax return. Yes, this means each of us unwillingly provides our government with an interest-free loan for more than a year. However, it could be a lot worse.
So, why isn’t this a problem? The key, it turns out, is all in the world “withholding.”
Understanding US Taxes
As an aviator who will likely pay taxes for your entire life, it’s critical that you know some basics about how your taxes work. This is fundamental like knowing the difference between Indicated Airspeed (IAS) and Groundspeed (GS).
The first thing we need to understand is that the USA’s federal income tax brackets are progressive.
Our laws specify several income tax brackets ranging from 10% all the way up to 37%. For 2023, the 10% bracket applies to individuals who have less than $11,000 in taxable income for the year. (For married couples filing jointly, the 10% bracket tops out at $22,000.)
So, any single American with at least $11,000 in taxable income will pay exactly $1,100 in taxes on that income because:
$11,000 x 0.10 = $1,100
Easy enough, right?
What if you made $11,001 though? When talking about this person we say, “Joe falls into the 12% tax bracket.” A shocking number of Americans are somehow left thinking that this means Joe will pay 12% tax on all his money like this:
$11,001 x 0.12 = $1,320.12
Thankfully, these poor, tax-knowledge-challenged souls are wrong!
No matter what “top tax bracket” a taxpayer “falls into,” they only pay 10% on the income in the 10% tax bracket. The only income taxed at 12% is that which lies in the 12% bracket. So, this pilot’s taxes would look like this:
$11,000 x 0.10 = $1,100
$1.00 x 0.12 = $0.12
Total Tax Bill:
$1,100 + $0.12 = $1,100.12
That’s a much better deal, right? (Or maybe a less bad deal, but I digress….)
Let’s look at a slightly more complicated example. Let’s say a pilot has $50,000 in taxable income. What is their tax bill? Remember, we have to account for the bracketed regions of this money individually. We’ll end up doing three separate multiplication problems before adding their answers together. The next key dividing line between the 12% and 22% tax brackets is at the taxable income of $44,725.
$11,000 x 0.10 = $1,100
$44,725 – $11,000 = $33,725 x 0.12 = $4,047
$50,000 – $44,725 = $5,275 x 0.22 = $1,055
Adding those three values together we get a total tax bill of $6,202.
At this point we can calculate what’s called an “effective tax rate” by dividing this tax bill by the pilot’s taxable income:
$6,202 / $50,000 = 0.12404
This means that although our pilot “falls into” the 22% tax bracket, they government only takes 12.4% of this money in taxes.
This idea of effective tax rate is critical to our discussion. You may already see where this is going; however, we have to take a quick detour.
Why We Have Withholding
In lots of old literature, from classic novels to the Bible, the tax collector is frequently the most hated person in town. This traitor sells out his neighbors for a cushy government job and spends his days knocking on doors and demanding people pay the King his due.
While this process probably went smoothly a lot of the time, most of the stories that made it into literature focused on times when citizens didn’t have enough cash on hand to cover their bills and ended up in big trouble.
Sadly, these stories reflect a widespread aspect of human nature. We tend to spend every dime we earn the moment we get it. In fact, modern society even encourages us to spend our money before we’ve earned it.
If Uncle Sam waited until the end of the year to hit up the average American for their taxes, there’s a good chance that American simply wouldn’t have any money to give. It would have all been spent, or spoken-for by creditors, weeks or months ago.
Our government (and others) invented the concept of “withholding” to avoid all this. Instead of trusting dumb citizens to set aside money to pay their taxes, the government simply requires our employers to take taxes out of our paycheck and send it to the Treasury without us ever touching it.
This is a very effective strategy overall. Now the question isn’t whether to pay taxes throughout the year, but how much tax to pay throughout the year.
Although most jobs try to keep pay stable, it’s tough for us to project precisely how much money we’ll have earned at the end of the year. When you add in the United States’ convoluted (and frequently ridiculous) system of tax deductions and credits, it becomes even more difficult to predict an individual citizen’s taxable income.
Enter: Withholding Rates
Remember our last tax example above? Our pilot had $50,000 in taxable income, putting him into the 22% tax bracket, but his overall effective tax rate was just 12.4%.
Knowing this, how much of the pilot’s paycheck should the government withhold in taxes each month? If it looks like that pilot is going to fall into the 22% tax bracket, Uncle Sam could just withhold 22% of each paycheck. However, that’s 10% more than our pilot is obligated to pay.
That’s a lot of money tied up in the US Treasury until tax refunds show up sometime after April 15th. It’s not an effective use of our pilot’s money to let that money sit there losing value to inflation. This amounts to giving the government an interest-free loan for a year or more, and it wouldn’t be fair to our pilot.
On the flip side, if the government doesn’t withhold enough, maybe they only take 5% from each paycheck, we get back to the problem that our pilot will have spent all the rest of his money by the end of the year and won’t have any cash to pay the 7.4% he still owed in taxes.
And so, the modern equivalents of tax collectors, the shoe-clerks who sit in dark closets at the IRS, have done lots of math and come up with some standard tax withholding rates. You probably don’t even remember it, but when you started your job you probably filled out an IRS Form W-4.
This confusing and complicated document tries to figure out how much you think you’ll earn per year, whether you know you’ll have any big tax deductions, if you’ll be filing single or married, and several other parts of your tax picture. It also has a block offering each of us the opportunity to withhold extra money from our paychecks to make sure there’s no shortfall. (What a generous offer from Uncle Sam, huh?)
Most of us know so little about taxes that we put the bare minimum on here. We worry for a moment that we’ve screwed up something and will get arrested. Then, we forget about it and start flipping burgers or slinging gear handles.
Our employers and the IRS use this form to calculate how much of each paycheck to withhold as taxes.
We must realize that this is still only a guess. It’s almost certain that your actual tax bill for the year won’t perfectly match the expectations set forth by your W-4, and that you’ll either get a tax refund or owe the IRS a check on April 15th. This is okay (ish). It’s how the US tax system has worked for years.
Updating a W-4?
In theory, a pilot could submit an updated W-4 if things change in their life. Maybe an airline pilot upgrades to Captain or a military pilot gets promoted, meaning they get a big pay bump that also bumps them into a higher tax bracket. Maybe a family has a new kid, making them eligible for extra child tax credits. Maybe you start a side-hustle that brings in extra pay and/or deductions.
In any of these situations, it might be wise to submit an updated W-4 to ensure your monthly tax withholding more closely reflects your actual tax situation. This should help protect you from having to write a big check at the end of the year, or from wasting Time Value of Money by paying too much in taxes during the year and only getting the excess back as a refund.
Most of us won’t do this, but we could. In a moment, we’ll look at a graduate-level example of why we might want to.
Back to Profit Sharing
Now that we’ve covered a frustrating amount of tax background, we can finally get back to the Profit Sharing tax withholding rates that Poor Old Joe keeps complaining about.
Since big bonuses or PS payments are usually one-time events sent to a large number of employees, they don’t fit well into W-4-based paradigm of monthly tax withholding the IRS likes to use. Instead of trying to get tens of millions of working Americans to put effort into yet another convoluted form (maybe it’d be the IRS Form W-4PS) the IRS just made a rule that all of these bonus payments will be subject to the same tax withholding rate. In the case of pilots at my airline, this rate is 22%.
Is this sloppy and lazy? Absolutely! We’re talking about the US government that allowed Southwest to demand and Boeing to build the B737MAX. Sloppy and lazy shouldn’t surprise us at all.
I believe that most pilots will have an effective tax rate well below 22%. (Many airline pilots can use the MBCBP Calculator that I recently posted to quickly find a decent estimate for their effective tax rate.)
This means pilots at my airline are all but guaranteed to waste a large portion of their PS payment giving the government an interest-free loan. Maybe Poor Old Joe is on to something when he complains about this situation. (Although, when I pay attention to the language he uses in his rants, I frequently conclude that he doesn’t know the difference between withholding and an effective tax rate. Please send him the link to this article, and encourage him to hire a tax pro to convince him to step his New Balance sneakers off his soapbox before he hurts himself.)
Yes, it sucks that the IRS requires our company to withhold 22% of our PS checks for taxes. However, most of us will get that money back at the end of the year. There are more important things in life to think about than this…especially for airline pilots with incomes around or above the top 11% of all people in America.
That said, if you’re bothered by giving the government interest-free loans, and you’re willing to put a little extra effort into educating yourself, there’s a graduate-level option to mitigate the effect of this unfortunate taxation situation.
W-4 as a Strategic Weapon
What we’re about to discuss is 100% legal. However, it’s also advanced-level shit that will cause you problems if you screw it up. Do not take any action based solely on reading this article. Use this information to start a conversation with a tax professional before you make any changes to your W-4.
This entire situation, and indeed the entire US tax system are based on one domineering assumption: that you and I are all idiots.
Contrary to whining you’ll hear from every walk of life and side of the political aisle, it’s no secret that we all have to pay taxes or go to jail. Only an absolute moron would knowingly spend money due as taxes during the year without having a plan to cover their tax bill at the end of the year. The Form W-4 and entire concept of tax withholding exists because the vast majority of us have demonstrated that we are, in fact, great fools.
However, what if you could be the exception to the rule? What if you had the wherewithal, education, and integrity necessary to take responsibility for your own existence? You might be capable of collecting your entire paycheck every month, and setting aside enough money for your future tax bill.
You could sink that money into a savings account and earn a few pennies on the dollar during the year. If you’d built up enough wealth to cover even bigger contingencies, you might even be able to invest your tax savings in more lucrative investments.
Yes, you’d have to write a big check to the government every year on April 15th, but you’d happily do it knowing that it was Uncle Sam who gave you the interest-free loan. In fact, you might be very pleased at all the interest you’d earned on that money throughout the year.
It turns out that you likely have the option to implement this strategy. You absolutely need to consult a tax pro to help you figure out how to implement it, but the basic steps are simple.
- You’ll go to your employer and fill out a new W-4. You could use a variety of ways (like having a large quantity of tax deductions) to prompt your employer to only withhold a very small amount of each paycheck for taxes.
- Then, you’ll set up some type of savings or investment account for the specific purpose of holding tax dollars that you transfer in yourself every month.
And that’s it.
Yes, the government will still withhold 22% of your profit sharing check (remember: sloppy and lazy), but you’ll have been investing so many of your future tax dollars throughout the rest of the year that you’ll be far better off than Poor Old Joe.
Now, as I hope you’ve already caught on, there are some very important considerations here that you must address with a professional tax advisor if you want to do this. If not, you can get yourself into all kinds of trouble.
First, you need to make sure that the way you fill out your W-4 doesn’t violate any IRS rules. You could, theoretically, fill our a W-4 saying that you expect to get 10 child tax credits at the end of the year. However, if you then only claim a couple (or zero) child tax credits on your return in April, it might raise some red flags.
There are also a lot of convoluted laws about how low you’re allowed to set your withholding rate. Small businesses aren’t allowed to do this at all – they have to pay taxes every quarter based on a percentage of past or expected earnings. If they guess wrong, they pay big penalties.
If you’re subject to state income tax, you should probably move somewhere else. However, until you can make that happen, you’ll need an advisor who knows your state tax laws and can help make sure you aren’t violating any rules there as well.
If you have a family, you also have to ensure that your spouse understands all of this and is onboard with the plan. If your spouse happens to notice a savings account with tens of thousands of dollars just sitting around and decides to spend it all, you might be in trouble.
Also, if your spouse is the kind of person who would stress about managing your own tax savings account and having to get the check to the right place on time at the end of the year, the strain on your marriage might not be worth the relatively small financial gains. (This is why my family does not implement this strategy.)
If you’re really stressed out about the size of your tax bill, check out an upcoming post on how you can easily reduce your tax bill as much as you want, while earning big investment returns.
In the meantime, please stop complaining about how much money gets withheld from your profit sharing check. It doesn’t matter. At the end of the year that money is subject to the same effective tax rate as everything else you earn.
Instead, go enjoy flying and spend some time with people you care about. Spend lots less than you earn, wisely invest the rest, and your money will take care of itself.