## Friday, January 18, 2013

### Who pays the most income tax?

kw: income taxes, analysis

In the past I wrote about Warren Buffet's outrageous statement, that he paid a lower tax rate than his secretary. I look into it more deeply here. To set this up, we need to understand marginal tax rates, a subject many folks don't comprehend at all. Many, many people believe if they make a higher income, and get pushed into a higher tax bracket, that all their income is taxed at the higher rate. Not so. Here is how it works for Federal Income Tax:
1. Only your Taxable Income (TI) is taxed, after subtracting Exemptions and a few other items such as Itemized Deductions or the Standard Deduction from Adjusted Gross Income (AGI).
2. Your first dollar of TI is taxed at the lowest bracket rate, which is 10% for 2012, no matter how much you make.
3. If you are Married Filing Jointly, for example, the first \$17,400 is taxed at this 10% rate.
4. A couple whose TI is \$17,401 is taxed at the next rate (15% in 2012) only on that last dollar. A married couple has to have a TI of \$70,700 to reach the next bracket (25%).
5. There are six brackets. The top bracket, currently starting at TI of \$388,350, is 35%. By the way, the "one percent" earn \$380,000 or more, so this bracket is for the one percenters. But their first \$388,350 of TI is taxed at all five lower rates, which averages out to 27% for that money. From dollar 388,351 and up, the tax is 35%.
I hope that is clear enough. Now, if Warren Buffet has any ordinary income, he is taxed the same as anyone else. If that income is large, he pays somewhere between 27% and 35% of his total Taxable Income. However, I recall reading that he takes only a \$1 "salary" from his company, and his income is from dividends.

There are two kinds of dividends. Qualified Dividends are taxed at 15%. Ordinary Dividends are taxed at the rate corresponding to your tax bracket, and dividends are used in calculating AGI and TI. So Buffet is taxed between 15% and 35% on his TI, depending on the proportion of Qualified Dividends in his portfolio. You'll have to look up what QD's are versus OD's; we won't go into that here.

Now let's look into this more deeply. I used the Tax Estimator at HR Block to examine five scenarios:
1. An entry-level Clerk at the Snarfle Corp. named Philip Elton. He is single, earns \$36,000, uses the Standard Deduction, and ignores the company's 401K, in spite of the matching provision.
2. An Administrative Assistant at Snarfle named Anne Weston. She is 60 and widowed, with a dependent son still at home. She earns \$60,000—at the high end for "secretaries", so she may resemble Buffet's secretary—and puts 3% into the 401K to get the company match. She rents and gives a little to charity, but uses the Standard Deduction. She files as Head of Household.
3. A Manager, Anne's boss, 45-year-old Charles Bingley earns a \$120,000 salary and \$10,000 in ordinary dividends. He puts 15% into the 401K, owns a home, and deducts \$12,000 in mortgage interest, \$4,000 in property taxes, and \$10,000 in charitable giving. He is divorced, and there were no children, so he files as Single. His wife is a lawyer and makes more than he, so he avoided paying alimony by suing her for alimony, then settling for "no fault, no foul" terms with no money changing hands.
4. The Snarfle Corp. CEO, Emma Woodhouse, is 60 and married. Her husband is retired. There are no dependents. Her salary is \$12 million. Their total income is \$13.5 million, including \$500,000 in QD's. She puts \$23,000 into the 401K, another \$5,000 into an IRA. The couple deducts \$48,000 for mortgage interest, \$15,000 in property taxes, and \$50,000 in charitable giving.
5. John Willoughby, 60, is a major stockholder in Snarfle and a few other companies. His primary income is from dividends, \$12 million. Half of that is QD's. He takes a "salary" of \$1 from another company as an executive "emeritus". He is married. His wife has never worked. There are no dependents. He uses annuities to defer taxes on \$100,000 of income yearly, deducts \$150,000 in mortgage interest, \$30,000 in property taxes, and \$500,000 in charitable giving.
What income taxes do they pay, and more importantly, what percent of their income is taxed?
1. Philip Elton pays \$3,503 in Federal Income Tax (FIT) on TI of \$26,250. The tax is 13.3% of TI and 9.7% of Gross Income (GI).
2. Anne Weston pays \$5,665 in FIT on TI of \$41,900. She is in the 15% bracket. The tax is 13.5% of TI and 9.4% of GI.
3. Charles Bingley pays \$16,580 in FIT on TI of \$82,200. He is in the 25% bracket. The tax is 20.1% of TI and 12.8% of GI.
4. Emma Woodhouse pays \$4,404,850 on TI of \$12,851,400. She is in the top bracket, being a one percenter; the tax is 34.3% of TI and 32.6% of GI.
5. The plutocrat John Willoughby pays \$1,981,450 on TI of \$7,212,401. The tax is 27.5% of TI and 16.5% of GI.
Compare #5 with #2. Who paid the higher percent? Number 5! Either way you figure it. I am sure Mr. Buffet knows this. He has staff who can figure these things out in more detail than we have here. But the one who paid the most is CEO Woodhouse. Current tax law favors passive income over active income, so she pays twice as much tax as John Willoughby, even counted as a percent of GI.

I must conclude that Mr. Buffet's statement was entirely false, and further, that he is either a liar or a fool.

P.S. This post is my 1700th.