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How to Pay a Lower Tax Rate

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taxesIt 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.

Tax Rates

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!

(Photo: alancleaver)

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24 Responses to “How to Pay a Lower Tax Rate”

  1. Courtney says:

    FICA contributions aren’t tax deductible. Michael’s taxable income is $35,250.

  2. Good article, Jim.

    One of my goals is to have a large part of my income coming from investments. I respect those that have been able to do this (Buffet and Romney). That may be a while down the road but its a good goal to shoot for :)

  3. yourPFpro says:

    Jim, you bring up some good points in this article. People should not fault Romney and Buffett for paying less taxes than the average American. The tax structure of the US is set up in a way that treats long term CG’s favorably, so they take advantage of that. That would be like asking someone with a house to take the standard deduction instead of itemizing, that is ridiculous!

    If people are really upset with this, they need to be telling Obama to raise taxes on capital gains. I personally don’t think a lower CG tax promotes investment or trickle down..

  4. Ed says:

    I think you might have missed this about dividends.

    “After December 31, 2012, all dividends will be taxed as ordinary income, and ordinary income tax rates return to those in effect in 2000.”

    What are the chances the tax rates get extended after the election?

  5. Anonymous says:

    “You might question why capital gains and dividends are given such favorable tax rates (the argument is that it spurs investment)…”

    Actually, that’s only half the argument. There’s also the bigger issue of double taxation that occurs with earnings from capital gains and dividends. As owners (stockholders) of a corporation, they pay upwards of 35% in taxes before ever seeing a dime. Then they pay an additional 15% on whatever they receive in distributions or from selling their shares.

    “Someone in the highest tax bracket, currently at 35%, is getting a huge discount on taxes…”

    Saying these investors are getting a “discount” of any kind is completely false. They are put their after-tax money at risk (most of which is already net of taxes), then paying upwards of 45% [1-(0.65*0.85)] in federal taxes alone (not including state, local taxes, sales, etc.) for the “privilege” of being an investor, and hoping it pays off in the end.

    If we want to have an honest discussion, people need to stop treating corporate income taxes as if they don’t exist. If people think the “rich” are paying too few taxes, then eliminate the corporate income tax altogether and have all income taxed as personal income. But be warned, you might be surprised with the results.

    • shckr7 says:

      I have a very similar view as you regarding taxation of corporations, but with a modification. Why not tax all income whether ordinary or dividends at standard income tax rates (today’s tiered system), but for any earnings that a corporation pays out in the form of dividends, they pay 0%. Any earnings retained by the corporation should be taxed at the corporate rate.
      People who collect more money in dividends would pay a higher tax rate, and corporations would pay out more money in the form of dividends.

      To be honest, I would really just like to see a tax system that wasn’t part of a political voting tool. Sunset clauses, “I’m not raising taxes, I’m just letting them expires,” etc, etc, etc. I believe one of the main items that prohibits “investment” is the shear uncertainty of what the tax policy will be tomorrow. How about we stick with a system and spend within our means…..just like I have to do with my own personal finances….

  6. uclalien says:

    “You might question why capital gains and dividends are given such favorable tax rates (the argument is that it spurs investment)…”

    Actually, that’s only half the argument. There’s also the bigger issue of double taxation that occurs with earnings from capital gains and dividends. As owners (stockholders) of a corporation, they pay upwards of 35% in taxes before ever seeing a dime. Then they pay an additional 15% on whatever they receive in distributions or from selling their shares.

    “Someone in the highest tax bracket, currently at 35%, is getting a huge discount on taxes…”

    Saying these investors are getting a “discount” of any kind is completely false. They are put their after-tax money at risk (most of which is already net of taxes), then paying upwards of 45% [1-(0.65*0.85)] in federal taxes alone (not including state, local taxes, sales, etc.) for the “privilege” of being an investor, and hoping it pays off in the end.

    If we want to have an honest discussion, people need to stop treating corporate income taxes as if they don’t exist. If people think the “rich” are paying too few taxes, then eliminate the corporate income tax altogether and have all income taxed as personal income. But be warned, you might be surprised with the results.

    • NateUVM says:

      Investors are altogether too aware that they are investing in the NET potential that a particular company/investment represents when they invest their money. More specifically, it’s whatever POST-tax potential a company can achieve that they are betting on.

      To suggest that the individual stake-holder (investor) is somehow put out by the taxes that a company is subject to… Well, that’s being a bit disingenuous. Sure, they would benefit from lower (or no) corporate taxes, but it’s still the NET gains the company makes that an investor is looking for, AFTER any offsets. The company gets taxed on their gain, and then the investor gets taxed on the whatever gets sent to them as a benefit of their investment.

      A good investor would factor taxes into the value proposition of the investment. As such, this “double-taxation” arguement is just an attempt to try to get more out of their investment (no kidding, right?).

      No, there is no “double-taxation”. Just a specious arguement.

      • Texas Wahoo says:

        It all goes back to the original argument that it spurs investment. Obviously investors can factor in any number of levels of taxation, but they will not invest as much if the investments are taxed at two levels.

        • Courtney says:

          People keep saying this, but when dividends were taxed as ordinary income and capital gains taxes were 50-100% higher than they are currently, somehow investors still managed plenty fine.

      • uclalien says:

        Some quick comments:

        1) I never said a word about investors not understanding that they will be taxed through the nose. Any investor would be stupid to focus on anything but net (or post-tax) returns.

        2) You totally contradict your own argument by saying that investors must focus on post-tax returns, and then in the next breath state that a major drain on those post-tax returns (corporate income taxes) is somehow irrelevant.

        3) FACT: An investor’s net gains would be significantly larger absent corporate income taxes. You admit this by saying, “Sure, they would benefit from lower (or no) corporate taxes…” If an investor must take into account these taxes, they matter. And the logical conclusion is that they have been “put out” by having to do so.

        4) Nothing you said changes the fact that taxes are being paid as owners/stockholders two times…once at the corporate level and once again at the personal level.

        I provided a solution — eliminate the corporate income tax altogether and have all income taxed as personal income. It would simplify the tax code, encourage corporations to reinvest in their companies, and promote economic and job growth. What value did you add?

        • shckr7 says:

          Agreed. Put simply – taxes matter and they do affect investment. Whether people do “plenty fine” – is not really an argument I can make or substantiate. What is 100% clear – is they matter. If the government taxed capital gains at 100%, then no one would invest anything. There is a relationship. What specifically the relationship is, what the curve looks like, what is the sensitivity as changes are made? Well, that is the job of academics and economist (is there a difference?) to argue.

          Example: My company started an office in Singapore, specifically due to tax savings. The CEO wanted to do this work from the US. Salaries really weren’t significantly different, but taxes…….Way different.

          “Investors averaged X% returns when taxes were Y% for 30 years.” OK, but if taxes were different, then those returns would have been different. Investment would have been different. Growth would have been different. Right, wrong, or indifferent? That’s not the point. The point is that they are interrelated and always will be.

          Are they the only thing that affects an investors appetite for risk or the perceived return? Nope….

        • NateUVM says:

          There is no contradiction because I never claimed that this “major drain” (your words, not mine) was ever a problem. As such, I don’t see the need for your “solution.” I’m don’t believe that merely increasing shareholder return is a good enough reason to further stress our nation’s balance sheet.

          As for the assertion that higher/lower tax rates on investments somehow hurt/encourage less/more investment… It doesn’t play out. There exists anecdotal evidence from investors stating that the tax rates NEVER effect whether they make an investment or not.

          And if you think it through, it makes sense. If taxes are effecting all investments equally, why would it matter (with regards to taxes) which one you choose? Everything else being equal, the tax rate has no effect on the relative outcome of your investment.

          Put another way, what’s the alternative? NOT making investments? Can’t make any returns if you choose not to participate.

          The gross example of 100% capital gains tax (used in a response) doesn’t apply because that would never happen.

          Taxes on investments don’t matter as much as those opposed to them would have you beleive.

          • uclalien says:

            First of all, if you believe upwards of 35% of pre-tax profits is not a “major drain,” I urge you to send 35% of your pre-tax income to a charity of my choice. After all, it should not materially impact you finances.

            Secondly, based on the following quote, the only conclusion I can reach is that you didn’t even read my entire post, but instead chose to grab a few select words to quote. In addition to the three potential benefits I provided, it would (at least partially) address my third point below.

            “I’m don’t believe that merely increasing shareholder return is a good enough reason to further stress our nation’s balance sheet.”

            Thirdly, do you really believe “taxes are effecting all investments equally”? Not a chance. The current tax system has completely distorted how and what people invest in. As it stands, investors will (rightly) gravitate toward corporations that have the ability and wherewithal to pay as few taxes as possible.

            Suggestion:
            Stop applying the “everything else being equal” approach to the real world. That approach is better suited for an economic classroom and rarely (if ever) reflects reality.

          • Shckr7 says:

            Equal taxes? That would be something. Unfortunately we are a tad but away from that.

            How about 99% tax rate? Would that matter? 98%? 97%….96%….when does it become realistic? When is it no longer applicable? 72%, 71%, 70%……

            If it has no impact, then why do certain countries have zero corporate taxes and why do some companies/investors flock there? Why do municipal bonds trade at lower yields compared to other, less tax advantaged bonds, that are perceived to have the same risk?

            Again, you can argue to what extent it matters (no one knows exactly), but i dont think you can’t argue it doesn’t matter.

          • NateUVM says:

            Clearly, I overreached in my use of the term “equally.” And, quite rightly, you folks jumped all over it. As if my rhetorical skills (or lack thereof) somehow made your argument any better…

            The bottom line is that if Capital Gains were 0% as opposed to 25% or whatever else you think it might/could be under any scenario, people would still make the investment because there is still that gain to be made (100% of the gain – whatever % is taxed away).

            Your argument is that you want to pay fewer taxes. Well, I do too, but there has to be a better arguement than, “because I don’t want to.”

          • uclalien says:

            Nate- “Your argument is that you want to pay fewer taxes. Well, I do too, but there has to be a better arguement than, ‘because I don’t want to.’”

            Who has stated that corporate income taxes should be lower simply because they desire to pay fewer taxes? Please debate on what other people actually write, rather than your own talking points. In more than one post, I have spelled out potential benefits.

            While I do prefer to pay fewer taxes, to this point, my argument has had nothing to do with that fact. I said nothing about lowering personal income tax rates, which would currently have a much larger impact on my tax liability.

            Low taxes (corporate and individual) are not only beneficial to economic growth, but should also be a goal of any society that claims to be built on freedom/liberty. And as I stated before, lower taxes result in fewer economic distortions.

            Your belief that nothing would change if capital gains taxes were something lower than they are currently is a horribly flawed assumption.

            Under my suggestion above, it is not a foregone conclusion that more investment would flow into the stock market. Perhaps people who were previously investing in the stock market would prefer alternative investments (e.g., start a business, directly invest in a private start-up, support a charity, etc.).

            The basic summary of my argument is that by removing even a small portion of the distortions that taxes create, we get a more free-flowing and efficient economy.

          • NateUVM says:

            Okay, let’s boil it down to your ‘basic summary’, as clearly we have lost each other’s arguements along the way…

            It sounds like you are saying the less/fewer taxes, the better. Everything becomes “more free-flowing and efficient,” right?

            IWe need a government to provide certain services. As such, taxes are necessary. Certainly we can argue as to how much taxation we are all subject to, but can we agree that we cannot follow your arguement to its ultimate, and extreme, end. I.e. SOME taxes ARE necessary.

            If so, shouldn’t we try to come up with some sort of fair distribution of taxes? If you want to say that this particular tax (on gains) is unfair, fine. But lowering the tax on gains benefits the more wealthy of tax-payers (as has been demonstrated ad nauseum lately), which is continuing the trend of pushing more and more of the tax burden to the less well-to-do in this country, making the tax system MORE unfair.

            Bottom Line: Given the current sentiment to reign in spending to be more in line with revenues(balancing the budget), if you are going to lower one tax that “the rich” pay, which tax on “the rich” are you willing to raise in order to 1) keep the system at least as fair as it is now, and 2) maintain current tax revenues?

          • uclalien says:

            “…if you are going to lower one tax that ‘the rich’ pay, which tax on ‘the rich’ are you willing to raise…”

            Once again, I urge you to actually read my posts. Please! I believe this is the third or fourth time I’ve made this request. I will repeat my suggestion one more time, “eliminate the corporate income tax altogether and have all income taxed as personal income.”

            Secondly, we’ve gotten totally off topic. The basis for this whole discussion was corporate tax rates. I provided a suggested solution to the distortions that the current tax system creates. Based on the fact that I’ve had to repeat myself over and over again, you obviously never read my proposed solution, but have still managed to disagree with it. And now you’ve changed the discussion to taxes as a whole.

            “If so, shouldn’t we try to come up with some sort of fair distribution of taxes?”

            I think you and I will have to agree to disagree. You believe the fact that the top 1% of taxpayers pays more than the bottom 90% of taxpayers (in both nominal and effective terms) is somehow unfair to those who do not pay for the services they enjoy. I disagree. The problem is that a large portion of the population has almost no skin in the game. It’s the same approach that lead-up to the subprime mortgage meltdown.

            It is also my belief that the Federal government can and should cut at least $1 trillion from its budget.
            Most people would agree that the late 90’s were a fairly prosperous time in America. There is no reason the Federal government can’t and shouldn’t be spending the way it did at that time. Even when adjusted for inflation, the Federal government spending in 2011 was roughly 50% greater than it was in 1998 (that’s roughly a trillion dollars). There is no reason (or legal authority) for the Federal government to be involved in all aspects of our lives.

  7. Karan says:

    Great article! Lots of useful information posted in a compact, clear fashion.

  8. A Ross says:

    What is the tax rate on rental properties, and why is it higher than the tax rate on ordinary income?

  9. A Ross says:

    What is the tax rate on income from rental properties, and why is it higher than the tax rate on ordinary income?


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