It doesn’t matter how much you’ve been following the Republican primary, it’s impossible for anyone to escape all the talk about tax rates. When Mitt Romney revealed that his effective tax rate was much lower than that of many Americans, it made some folks upset. Why was someone as wealthy as Romney paying so little, as a percentage of income, in taxes? It’s because of how our tax rates are structured. Being upset at Romney for his low tax rate is like being upset at Parker Brothers (or Charles Darrow) because the rents in Monopoly are too high. Romney didn’t cheat, he (and his financial advisers) looked at the rules and played within them.
That said, it can be a little confusing as to why Romney, and all his millions, are taxed at such a lower rate. It’s actually quite simple and I’ll explain how you might be able to achieve the same thing.
There are several different “tax rates” on the money that enters your household based on how you earned that money. The fundamental idea is that you are taxed on your income, after deductions, on one of two rates. The first, and higher, rate is ordinary income. That’s based on the tax tables. The second, and much lower, rate is that of long term capital gains.
When you hear those stories about how Warren Buffett pays less than his secretary in taxes or how Mitt Romney pays only 14.9%, it’s because a significant portion of their income is taxed at the long term capital gains rate. Every single tax shelter is designed to either shift income into this long term capital gains class or defer that income so you aren’t taxed until some other time.
- Ordinary income: This is money you earn through working, whether for a company as an employee (W2) or as an independent contractor (1099-MISC). You are taxed on that income based on the IRS tax brackets. these are the tax brackets you are probably most familiar with.
- FICA: FICA stands for Federal Insurance Contributions Act and it is the act that imposed a payroll tax to help pay for Social Security and Medicare. For Social Security, the rate is 6.2% (only 4.2% for 2012 because of the payroll tax cut) on the first $110,100 of income. For Medicare, the rate is 1.45% on all ordinary income.
- Self Employment Tax: With FICA, the tax is split between employee and employer. The 6.2% and 1.45% listed in the previous bullet point covers only the employee. If you are self-employed, you are both employer and employee. This means that you pay an additional 6.2% and 1.45%.
- Capital Gains: Capital gains are gains you reap as a result of the sale of assets, such as stocks. If you owned the stock for less than one year, your gains are taxed at ordinary income rates. If you owned the stock for more than one year, you are taxed at the much lower long term capital gains rate, which will depend on your tax bracket. If you are in the 10% or 15% tax bracket, your long term capital gains tax rate is 0%. It is 15% if you are in the higher brackets.
- Dividends: Qualified dividends. such as from stock, is taxed at the long term capital gains rates.
- Tax free payments: There are some payments that you don’t pay taxes on, such as child support and disability payments.
Here’s a real world example of how someone’s income is taxed – Michael works as an accountant and has income of $45,000 a
year. Before he sees a penny, his company will withhold FICA from his income to the tune of $3442.50 (7.65% of $45,000), though it won’t reduce his taxable income. He takes the standard deduction of $5,950 and the personal exemption of $3,800, thus reducing his taxable income to $35250 (assuming no other items to reduce income, we need to keep this as simple as possible!). On that income, he is taxed entirely at ordinary income rates. That means he pays 10% on the first $8,700 and 15% on the rest – total bill of around $4852.50. Between FICA and his federal income taxes, he paid $8295 of his $45,000 for around 18.43%. He will owe some more taxes at the state and local level, increasing his total tax rate.
18.43% doesn’t seem bad, but it’s higher than Romney’s 14.9% and Romney makes many times more than Michael.
How to Lower Your Tax Rate
Before you go through the exercise of calculating your effective tax rate, you can probably just look at your tax return from last year. In years past, software like TurboTax would print your effective tax rate. Simply adjust it based on what you know about FICA and you have your effective tax rate.
From here, there are only a few things you can do:
- Generate income from investments & dividends: You may want to consider investing in dividend yielding stocks instead of putting money into CDs and savings. Interest earned from a bank deposit is taxed at ordinary income rates whereas dividends from a stock, assuming it’s qualified, is taxed at the lower dividend rate of 0% or 15%. The tradeoff is that the stock may fall in value and so you have no principal protection, so there is risk involved. You can mitigate some of this by investing in a dividend mutual fund, rather than individual stocks, but there’s still risk.
- Defer income as much as possible: The most common form of income deferral available to most Americans is through contributions into a retirement account such as a 401(k) or an IRA. You lower your taxes because you don’t have to recognize the income, but eventually you’ll have to pay (some exceptions include 529 plans and the like, so seek those out).
- Invest in tax exempt assets: There are basically two main types of exempt assets – those that are tax exempt when used for a specific purpose (such as education) and those that are tax exempt from either state or Federal taxes. For example, Series I bonds are exempt when the interest is used to finance education and it is exempt from State and local income taxes. A local municipal bond may be just be state and local tax free.
As you can see, most of these methods to reduce your tax rate are completely legitimate. You might question why capital gains and dividends are given such favorable tax rates (the argument is that it spurs investment) but those are the rules. Someone in the highest tax bracket, currently at 35%, is getting a huge discount on taxes with their long term capital gains at 15%. Someone in the 25% bracket is also getting a big discount too (just not as big as the 35%-er), though presumably someone in the 35% is going to have a much larger pool of funds for investment.
That being said, did you find this helpful? To have the rates broken out like that and to look at how various types of income is taxed? Did I miss anything that I should include? Please let me know!