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Understanding How Income Is Taxed

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Taxes!Remember when Warren Buffett famously declared that he paid a lower tax rate than his administrative assistant? It probably confused a lot of people who aren’t familiar with the myriad of ways our income is taxed and that confusion can lead to misplaced frustration and anger. With how charged politics can be, it’s not uncommon for people to get really passionate and fired up over things that they’ve misunderstood.

A prime example, outside of money and politics, is the issue of vaccines and autism. The link between the two was based heavily on the fraudulent work of Dr. Andrew Wakefield in what has now been declared an “elaborate fraud.” Yet autism is a very real problem, one whose cause is still unknown, and people still insist on not vaccinating their children. While I think I have a right to tell people what to do, the fact that this vehement rejection of vaccines is based mostly on a fraud is just one example of this.

So today, I hope to explain how our income is taxed and hopefully that will remove some of the existing, incorrect, ideas some people have about our tax structure.

Income Tax

The largest tax that most people will pay is income tax. Basically, income tax is assessed on money you earn from your job. It’s declared on your Form W-2, your employer withholds the tax payments, and you are taxed based on the federal income tax rates. The tax rates are marginal tax rates, so the bracket you’re in will dictate how much your next dollar is taxed. For example, as a single filer, your first $8,500 of income (after adjusting for deductions) is taxed at 10%. The next $26,000 earned will be taxed at 15%, and so on. Your actual tax rate will never be as high as your tax bracket. It’s mathematically impossible.

The issue of marginal tax rates is one of the most misunderstood ideas in all of taxation. Many erroneously believe that moving into a higher bracket subjects all of your earnings to the higher rate. That is incorrect.

There are a few other sources of income where income tax is assessed, such as bank interest. Interest you earn from your deposit accounts, like savings accounts and certificates of deposit, will be taxed at your income tax rate as well.

FICA: Social Security, Medicare

In addition to income tax, your salary will also be assessed FICA. FICA stands for the Federal Insurance Contributions Act and it covers Social Security and Medicare. Social Security, otherwise known as OASDI (Old Age, Survivors, Disability Insurance), is assessed at 6.2% of the first $106,800 you earn. Medicare is assessed at 1.45%, with no limit. (for 2011, the 6.2% OASDI portion of FICA will be reduced to 4.2%)

FICA is paid by both employees and employers, 50-50. Self-employed persons pay both halves.

FICA is only assessed on wages, so income from bank interest and other sources are not assessed this “tax.”

Long Term Capital Gains

Long term capital gains is assessed on capital gains where the asset has been held for more than 12 months. This is most often applied to the sale of stock. Qualified dividends is another example of income that is taxed as long term capital gains.

Long term capital gains rates are quite favorable. It is 15% for those in the 25% to 35% tax brackets and 0% for those in the lower tax brackets. As you can see, with Warren Buffett earning the bulk of his income as qualified dividends taxed at 15%, his rate will be lower than that of his administrative assistant who pays ordinary income tax.

If you sell a stock that you’ve owned for less than one year, it’s subject to short term capital gains rates. The short term capital gains rate is simply your income tax rate. The gains are treated the same as bank interest for purposes of calculating taxes due.

Finally, there is one notable exception to the long term capital gains rule when it comes to principal residences. When you sell your principal residence (defined as someplace you’ve owned the home for at least two years and lived in it for 2 of the last 5 years), you can exclude $250,000 of the gain from your home (this doubles to $500,000 if you and another person owned the home) as long as you haven’t claimed this exclusion in the previous two years.

Summary

As you can see, the tax rates are highest on wages – income you earn from your job. One of the biggest complaints about the Bush tax cuts was how much it benefited the wealthy, who have more capital to put into the stock market and other favorably taxed investments. Ultimately, it’s important to understand how your income is taxed so that you can make smart decisions about where to put your money.

How does Warren Buffett pay such a low tax rate? Long term capital gains. Most of his income is taxed as long term capital gains and that pulls any “salary” he may earn from his day job. Contrast that to his secretary, who will likely see most of his or her income as salary and thus subjected to the regular federal income tax rates.

(Photo: alancleaver)

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8 Responses to “Understanding How Income Is Taxed”

  1. cubiclegeoff says:

    Interesting choice of an example, although you could use most science related examples.

    • tbork84 says:

      I think it was a good example for showing that logic and real understanding sometimes plays second fiddle to people’s emotions and conceptions.

  2. NoNonsenseNick says:

    Great Article! It is sad how the majority of the population has no idea how Marginal Tax Rates work!

    It’s a shame that most TV news networks are about political propaganda and not knowledge based useful information about the system we all live in.

  3. Shirley says:

    Thank you, Jim! This is something that has had many people baffled.

  4. zapeta says:

    I’m building a dividend stock portfolio to try to take advantage of the differences between the marginal income tax rates and the dividend rates. Hopefully the dividend rates will remain below the marginal rates in the future but even if not it will be nice to have a stream of income that doesn’t depend on me working.

  5. skylog says:

    keep up the great work on this tax series! i seriously need to get a few of my friends to read these so they can finally understand some of these concepts. i have tried to explain marginal tax rates several times, but they refuse to accept what i am saying.

  6. Strebkr says:

    I agree, everything that has been written in this series would be very easy to send to someone who doesn’t get it.

  7. mikestreb says:

    I own a tax prep business and it is amazing how many people (85% +) don’t understand our Marginal Tax Brackets. They think every dollar they make is taxed at their highest rate…


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