Friday, May 11, 2012

Understanding marginal rates

kw: taxes, analysis

Tax season is more than a month behind us, but the topic keeps coming up, I suppose because it is an issue in the Presidential campaign. I have had conversations with a few people which made me realize that there is deep misunderstanding of marginal income tax rates. In one case, a relative said he'd made a few extra hundred dollars last year, and it pushed him into the next bracket, lamenting, "The extra tax is going to cost me more than I made!" I was astonished. It took quite some time to explain the way income tax really works. He had thought that all his income would be taxed at the new rate.

This Tax Rate Schedule is right out of the Form 1040 Instruction booklet for the 2011 tax year. Let's explore what it means. My relative is intelligent and has a great job. His taxable income had been just below the threshold between 25% and 28%, but now, making about 84,000, he was in the 28% bracket.

He was thinking like this: 25% of $83,500 is $20,875. 28% of $84,000 is $23,520. The difference is $2,645. He thought by making $500 he'd be paying an extra $2,645. I showed him the real calculation:

$83,500 - $34,500 = $49,000 (see the third line of the chart)
$4,750 + 0.25x$49,000 = $4,750 + $12,250 = $17,000
That is what he would pay without the extra income.

$84,000 - $83,600 = $400 (see the fourth line)
$17,025 + 0.28x$400 = $17,025 + $112 = $17,137
That is his tax with the extra income. The difference is $137, not $2,645.

Then I asked him if he took the standard deduction and personal exemption. Fortunately, he knew about that. Did he pay much more than $17,000 in taxes last year? If so, he needed to file an amended return for 2010!

 His actual income, assuming no extra adjustments or credits, had been $9,500 higher, because the standard deduction for a single person is $5,800 and the personal exemption is $3,700 (He didn't contribute to an IRA. Tsk!). So, rather than paying 25% or 28% on all his income, he'd be paying $17,137 with a gross income of about $93,500, which comes to 18.2%.

This is another important point. The Sage of Omaha, Mr. Buffet, said something about his secretary paying a higher tax rate than he did. His main source of income is capital gains, which is a flat 15% for long-term gains (short term gains are taxed at a higher rate – day traders take note). If he has a few extra millions of "ordinary income", they are (mostly) taxed at the 35% marginal rate. So his total tax rate was almost certainly a bit more than 15% of gross income, and perhaps several points more.

What does a secretary earn in Omaha? For a major corporation, it can be $35,000. With that amount of pay, few folks put anything into an IRA, so we can figure it this way:

$9,500 is not taxed (personal exemption and standard deduction)
$35,000 - $9,500 = $25,500
$25,500 - $8,500 = $17,000 (see line 2 of the chart)
$850 + 0.15x$17,000 = $850 + $2,550 = $3,400

The actual percentage of gross income is 9.7%. Take a look at this chart:

This is the result of similar calculations across the first four lines of the tax table. You need a gross income in the $75,000 range to pay a total tax rate over 15%. If Mr. Buffet's secretary is paying taxes in this range, she is well paid indeed! Most folks would be delighted to earn some $75,000 and pay around $11,000 in taxes, having $64,000 in disposable income. And just to be in the 15% marginal tax bracket, the secretary must earn at least $44,000, which is very high-end for that job.

The median income, per person, for 2007 was about $31,000. The actual gross tax rate at that level is well below 10%. Anyone who can itemize deductions, such as a homeowner or someone who gives a few thousand to a church or charity, will pay less…but such considerations are for another day.

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