Episode 253: February 7, 2012
by Laura Adams
This podcast is sponsored by Audible.com the Internet’s leading provider of audiobooks with more than 100,000 downloadable titles across all types of literature, including fiction, non-fiction, and periodicals. For a free audiobook of your choice, go to AudiblePodcast.com/MoneyGirl
Since presidential candidate Mitt Romney revealed his tax return which showed an effective tax rate of 15%, there’s been a lot of talk about whether the rich get away with paying less income tax than ordinary folks. Today, I’ll reveal how income is taxed and how much millionaires really do pay.
What is Payroll Tax Withholding?
The first tax that we’re all familiar with is income tax. It’s a rite of passage to receive your first paycheck and be stunned by how much the government takes.
There are 4 main types of taxes that employers are required to withhold from your paycheck:
Federal income taxes
State income taxes
Social Security taxes
Additionally, depending on where you live and the industry you work in, you may also have unemployment, disability, and local income tax withheld.
I’ll summarize each of the 4 payroll taxes so you know what they are and how much you’re paying for them.
What is Federal Income Tax?
Federal income tax is collected by the Internal Revenue Service (IRS) to fund the country’s expenses for everything from education to the military. You pay federal taxes according to tax brackets, which are ranges of income that are subject to different tax rates. As your income goes up, the amount that falls into each of the 6 brackets is taxed at a progressively higher rate.
In other words, federal income tax is staggered, with part taxed at 10%, part at 15%, and so on up to the maximum tax bracket of 35% for 2011. To pay the top tax rate, you must have income that exceeds the highest threshold, which is $379,150 for single taxpayers.
How to Reduce Your Taxes
To pay the top tax rate, you must have income that exceeds the top threshold of $379,150 as a single taxpayer.
You don’t typically pay tax on all your income. You’re allowed to reduce your taxable income by certain amounts, including “exemptions” for the number of people you support, like yourself, a spouse, and dependents.
You can also reduce your taxable income by claiming deductions for qualified expenses like medical care and charitable contributions. Additionally, the total amount of tax you have to pay is reduced if you qualify for a tax credit, such as the child tax credit.
What is State Income Tax?
In additional to federal taxes, you may also pay income tax to your state—unless you live in one of the 9 states that don’t collect it: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming.
State tax rates vary; however, they’re generally treated as a deductible expense, which lowers your taxable income when you file your federal tax return.
What is the Social Security Tax?
The last 2 payroll taxes, Social Security and Medicare, are collectively called FICA, which stands for the Federal Insurance Contributions Act Tax.
If you’re a fan of the TV show Friends, you might remember the scene when Rachel opens her first paycheck and says, “I earned this. I wiped tables for it, I steamed milk for it, and it was totally (she looks down at her paycheck) … not worth it! Who is FICA and why is he getting all my money?”
You’re familiar with Social Security, a vast social program that provides income for the elderly, survivors, and the disabled. The Social Security tax rate is 6.2% for employers and is typically the same rate for employees, on income up to $110,100 (there’s no Social Security tax on income you earn above that amount).
However, employees got a temporary 2% reduction in 2011 which has been extended into January and February of 2012. Right now we don’t know whether the reduced rate of 4.2% for employees will stick or go back up to 6.2%.
What is the Medicare Tax?
Medicare is the federal health insurance program for those age 65 or older. It also covers younger people with certain disabilities, but it doesn’t pay all medical expenses or the cost of most long-term health care.
The tax rate for Medicare is 1.45% for employers and employees, regardless of how much you earn. By the way, if you’re self-employed, you’re required to pay both the employer and employee portions of Social Security and Medicare taxes.
How is Investment Income Taxed?
Now that we’ve covered taxes on your earned income, let’s talk about how investment income is taxed.
Let’s say you earn interest on a bank savings account, a CD, or a bond. Even if you don’t cash out the income, it’s still subject to federal and state tax, but not to Social Security or Medicare taxes.
Another type of investment income is stocks or funds that pay out a dividend. In some cases, the dividends are taxed as regular income, but in most cases they’re taxed as a capital gain.
What is the Capital Gains Tax?
The capital gains tax is very different from ordinary tax on income and interest that we’ve covered so far. It’s not levied on an ongoing or annual basis—it only applies when you sell a capital asset—like a stock or an exchange-traded fund—for a profit.
If you’ve owned the capital asset for a year or less, that’s called a short-term gain and it doesn’t get any favorable treatment. You pay the same tax rate as for ordinary income, which ranges from 10% up to 35%.
However, when you’ve owned a capital asset for more than a year before selling it, the very favorable, long-term capital gains tax rate applies, which is capped at 15%.
For instance, if you sell a stock that you owned for more than a year and make a profit, no matter how much you earn or how wealthy you are, you don’t pay more than 15% tax on that income. That’s obviously much lower than the 35% maximum tax rate on ordinary income. Additionally, capital gains are not subject to Social Security or Medicare taxes.
Who Pays the Most Tax?
This should shed some light on why a multi-millionaire like Mitt Romney had an effective tax rate of 15%: Most of his income comes from long-term capital gains and dividends on his investments.
Recent IRS data shows that the average tax rate for all American taxpayers is 11%. Here’s how the average tax rate breaks down by earnings:
Less than $100,000: pay an average tax rate from 0% to 8%
$100,000 to $500,000: pay an average tax rate from 12% to 19%
$500,000 to $1 million: pay an average tax rate of 24%
$1 million to $10 million: pay an average tax rate from 25% to 26%
So this data shows that even with the very preferential tax rate on capital gains, those earning $500,000 or more pay at least twice that of the nation as a whole.
Romney’s rate of 15% is higher than the average (11%), but is considerably less than other multi-millionaires who are shelling out around 25%.
You can use the Marginal Tax Rate Calculator at dinkytown.com to find your average tax rate, tax bracket, and marginal tax rate to see how you stack up.
Get More Money Girl!
If you have tax questions, post them on the Money Girl Facebook page. If you’re on Twitter, be sure to follow me under user name @LauraAdams. Also, if you’re not already subscribed to the Money Girl podcast on iTunes, that’s how most people get the podcast. Subscribing is free and simply means you’ll get each new episode as soon as it’s published on the web.
Download FREE chapters of Money Girl’s Smart Moves to Grow Rich
To learn much more about taxes in easy-to-understand language, get a copy of my book Money Girl’s Smart Moves to Grow Rich. It tells you what you need to know about money without bogging you down with what you don’t. It’s available at your favorite book store in print or as an e-book for your Kindle, Nook, iPad, PC, Mac, or smart phone. You can even download 2 free book chapters at SmartMovesToGrowRich.com!
Check Out These Related Posts and Podcasts: