Guest post by Contributing Editor, Matthew Amster-Burton, Mint.com.
Think you’re unlucky? I know a guy who’ll pay 99% of his income in taxes if the Bush-era tax cuts expire at the end of December.
Our mystery man lives in Pico Rivera, California. He owns a business and pays himself a healthy salary that puts him in the highest federal tax bracket, 39.6%. He’s also in the highest California income tax bracket, which voters raised on election day to 13.3%.
He pays both the employer and employee side of the payroll tax (which funds Social Security and Medicare), at 15.3%. He owns a bunch of dividend stocks and pays 15% tax on dividends (this rate could go even higher, thanks to the fiscal cliff).
He pays Pico Rivera sales tax, among the highest in the nation at 9.75%. His business is located in the City of Los Angeles, where he pays 5.07% business tax. Finally, he owns his home and pays property tax of 1.25%.
Add up all of those percentages and you get 99.27%. That means if our mystery man makes $1 million next year, he’ll only get to keep $7300. Right?
Give me a break, you’re saying. He’s not paying sales tax, property tax, or dividend tax on his entire income; property tax is deductible; and so on.
And you’re right. I made this guy up and anybody making $1 million in California (or anywhere else) has plenty of spending money after the taxman gets his share.
But people—including members of the press who should know better—make a similar mistake when thinking about their own taxes or their neighbor’s.
Most people don’t understand the difference between marginal and effective tax rates and have no idea what their own tax rates are. Because taxes are a big part of our financial lives, this leads to some less-than-smart financial decisions.
If people know anything specific about their taxes (i.e., not just “they’re too high”), it’s likely to be their tax bracket. The US income tax system is progressive: As you make more money, that money is taxed at a higher rate.
Currently—for tax year 2012—the highest tax bracket is 35%, for anyone (single or married) making more than $398,350. For those high-income folks, 35% is their marginal rate, meaning each additional dollar they make is taxed at 35%.
That doesn’t mean, however, that a person making $400,000 turns 35% of it over to the IRS.
First of all, the tax code is full of exemptions, deductions, and credits—for children, mortgage interest, health insurance premiums, retirement savings, college tuition, and so on. Practically everybody benefits from these…well, “loopholes” is such a coarse word.
A gross income of $400,000 can easily turn into a taxable income of $300,000, and a middle-class income of $40,000 can easily turn into a taxable income of zero.
Second, not all of the income is taxed at the highest rate. Even if someone ended up with a taxable income of $400,000, only the amount in excess of $398,350 is taxed at 35%. The rest is taxed at an assortment of lower rates.
It’s one thing for Joe Taxpayer not to understand this, but some reporters should know better. A recent news piece asked, “A middle class taxpayer pays 25 percent of their income in Federal Income Tax. Sound ok?”
No, it doesn’t sound okay, because it’s not true. It’s as mythical as mermaids, free beer, and the guy I made up at the beginning of this column. No middle-class taxpayers pay 25% of their income in federal tax and most of them aren’t even in the 25% bracket.
I’ll open my books and use myself as an example. Last year (rounding for clarity) my family made $91,000 before taxes (the IRS calls this number total income).
After credits, deductions, and exemptions, our taxable income was $60,000, putting us in the 15% tax bracket. Our effective tax rate—the percentage of our income that actually went to federal income tax—was 8.4%.
We didn’t do anything sneaky to achieve these numbers; they’re typical for people in our income range and our effective tax rate would have been even lower if we owned a house and paid mortgage interest.
Lest you think I’m picking on reporters in a partisan way, the New York Times took many hits in the blogosphere this last week for a similar mistake, leading to the following pronouncement from the paper’s Public Editor: The Times Should Explain Marginal Tax Rates — Repeatedly, if Necessary.
Why does this stuff matter?
Most important, it matters because when people confuse their marginal rate with their effective rate, it raises the blood pressure of your local personal finance writer.
Seriously, it matters because misunderstanding tax rates causes financial mistakes that are easily avoidable.
Here’s a classic example: Say you’re in the 25% tax bracket and your workplace offers a choice of traditional 401(k) or Roth 401(k).
A traditional 401(k) is funded with pre-tax dollars and you pay income tax when you withdraw the money in retirement. A Roth is the opposite: You pay the tax up-front and withdraw tax-free in retirement.
People love the Roth because they love the idea of magically tax-free withdrawals but it’s probably a mistake. When you contribute to a traditional 401(k), you’re avoiding taxes now at your marginal tax rate (in this case, 25%), but will make withdrawals later at your effective tax rate.
Few retirees, even those who made healthy incomes throughout their career, are in the 25% bracket or higher; a majority of Americans 65 and over pay no income tax.
To figure out your own marginal and effective rates, check the 1040 you filed in April or use Intuit’s Taxcaster, a quick, free online tax estimator. And quit complaining: Effective federal tax rates for middle-class families have been declining since 1981.
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