Sunday, March 27, 2011

Tax facts

NOTE: I'm not a trained tax preparer, talk to an expert for expert advice. But anyone can read the tables...

This is specific to the US, where I find there are huge myths and misconceptions about how federal income taxes work, and at almost every education level. I sat in a college class with a professor who made gross mistatements about how tax rates work. Of course, I've also found that history academics generally have an allergy to math anyway. And this post is not meant to be controversial, just lay the facts out clearly for people who've been confused by things they've been told.

First, there is not a magical point at which your tax rate changes and suddenly all your income is taxed at that new rate, making a large increase in your total tax (what my professor asserted until I brought him proof in the form of detailed calculations). I often hear this as "Oh, you can get a small raise and end up making less money because you're in a new tax bracket." Nonsense. You may lose certain deductions or credits that could, theoretically, cause that to happen, but it isn't the tax rate change that did it.

If you look closely at the tax tables, logic will tell you this. There is NO place where the amount of tax takes a huge leap, as it would if your overall tax rate jumped by 5-10%. For example, look at the difference between the rate for $8300 and $8350 and the rate for $8350 and $8400, the point at which the rate changes for a single filer from 10 to 15%. If the change in tax bracket  was applied to all of your taxable income, there should be a noticeable change in the amount of tax owed. But there isn't. The difference between the two is about $7 if you're single ($833 to $845). If your taxable income was all now taxed at 15% instead of 10%, you'd be paying about $1260 in taxes for $8401 in taxable income.

Let's take another approach. If your taxable income, married filing jointly, is $75,001, you're solidly in the 25% tax bracket. If you were being taxed at 25% for your entire income, you'd be paying $18, 750 in taxes. Consult the tax tables for your filing status and for $75,000 to $75050 , the tax is actually $11,119, slightly less than 15% overall ($75,001 x .15 = $11,250). What you actually pay when you file a joint married return is 10% on the first $16, 750, then 15% on the next $51,249. Then anything more than $68,000 is taxed at 25%. There is no huge sudden increase.

And remember, this taxable income is after deductions. A family of four with children young enough for the child tax credit can earn $26,000 before any income is taxed (standard deductions, plus 4 deductions for family members) regardless of income, then the first $2,000 in tax is eliminated by the child tax credit. So, that family of four would actually have to make at least $101,001 to have that tax rate, and then their tax is reduced to $9,119, less than a 10% tax rate on actual income. Start adding in itemized deductions for things like mortgage interest, all the pre-tax deductions and untaxed benefits like employers' contributions to health insurance which can easily be $15,000 a year and 401K contributions and matches, and your family of 4 probably has a REAL income of much closer to $125,000 and that tax of $9,119 is a bit more than 7%. And none of this even begins to touch on non-income extras from a job, such as travel and per diem meals in nice restaurants (a big "bonus" for some people at a couple of places I've worked). I also want to note here that I have not referred to tax rules for when people lose the child tax credit or fall under the AMT, but at the same time, I didn't include a number of credits and deductions that often apply.

I've been told by people involved in tax preparation that millionaires generally pay 10% or less of their real income in taxes, in spite of the top rates.  Some of that is apparently because capital gains are taxed at a lower rate than work income, supposedly to encourage investment. Remember that they also only pay SS on a small percentage of their income, and only on the work income, not investment income. Plus they are much more able to take advantage of tax shelters like 401Ks and fancier instruments like living trusts, and can often arrange to have what are personal expenses paid for by their employer, who in turn gets to treat that as a business expense.

At the lower end of the spectrum, people complain that the poor don't pay taxes. That's absurd. They may not pay income tax, but they generally pay a high percentage of their income in OTHER taxes, and they are much less likely to have benefits, particularly not pre-tax benefits, and many deductions people take for granted, they don't get. People tend to forget about property tax, sales tax (a BIG bite in some states), SS tax, gas tax, and all the others. Even renters pay property tax indirectly through their landlords. Remember, you aren't paying federal income tax on that first portion of your income either.

Whatever you think about the tax system, at least keep to the facts. Remember, if you make a claim that's overtly absurd, like the one about paying tax at the higher rate on all income, anyone who's informed will stop listening to anything else you say, no matter how good your argument is.

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