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.

Do the 99 percent pay more taxes than Mitt Romney?

kw: taxes, politicians

It is all over the news: Mitt Romney pays 15% of his income in income taxes. Commentators everywhere are complaining that many people who make less income are paying 28%-35% tax rates. Really???

Let's see. I am firmly in the 99% who make less than $200,000 yearly. Of my total gross income, I paid 8% in Federal income tax. Now, some of my income is in the 28% bracket, but I have a mortgage deduction, I tithe to my church, and I have a tuition credit for a son in graduate school, plus I am putting tax-deferred income into a 401(k). All this means that my taxable income is about half of the gross.

It was also reported not long ago, not nearly with so much fanfare, that 47% of the U.S. population pays no Federal income tax at all, and it wasn't even mentioned that a few million people take the "Earned Income Tax Credit", which gives them a "refund" when they have had nothing withheld. It is a kind of welfare payment without the name.

So let's see, 99-47 leaves 52% of the American public making between $20,000 and $200,000, and thus paying income taxes. Let's look at a couple scenarios, courtesy of the HR Block 2011 Tax Estimator.

1. A 25-year-old married couple with no children eking it out on $20,000, with no deductible expenses. Their total tax for the year is $100.
2. A 25-year-old single person who earns $48,000 and has $120 in interest income (a saver!), who also gives $1,200 to charity. The total tax bill is $5,780 (ouch), or 12% of gross income. Single people have the highest rates.
   
3. Let's take the same person, now married, five years later, with three kids. No advancement, so the income and giving are the same, but now the tax bill is only $408, less than one percent.
4. A middle-aged couple earning $100,000 with $1,000 of interest income and $5,000 of long-term capital gains (they got lucky in the market). They pay $10,000 in mortgage interest, and almost tithe, giving $10,000 to their church. Total income $106,000. Total tax $12,000, or 11.3%.
5. Finally, a couple approaching the "1% level", who have combined earned income of %140,000, $1,000 of interest income, and $20,000 in long-term capital gains. They give less, $5,000, but have a McMansion that has mortgage interest of $30,000. Total income 161,000. Total tax $19,100 or 11.9%.

There you have it. Reasonable scenarios that show how the 15% Mitt Romney paid is by no means "unfair". In fact, he is paying more than most.

There is a second issue. That 15% is a second tax; to make the investments from which he is earning capital gains, he had to first earn money and pay taxes on it (perhaps at 15%, perhaps at 28 or 35%). Then when his investment earns money, he pays tax on the new earnings. If you make an investment that loses money, you don't get 15% back from the government for your losses, though you can use losses to offset gains, but if you have a net loss for the year, you are just out the money.

Let's pick some real issues to heckle the candidates with. This one is a phony issue.

All figured out, on hold

kw: taxes

I like to get my income tax figured out as soon as I can after the forms come in, because if I have a refund, I want it quick! This year, one of the mutual fund companies sent a letter with the 1099-DIV, which said that the form was being sent to comply with the federal time deadline, but that an amended form would be sent about Feb 14. If I want to avoid filing an amended return later on, I gotta wait. It's a good think my refund is rather modest this year. I hit the right number of exemptions on my W-4 just about right.

A caution to others whose refund may be small this year. Whatever the number of exemptions on your W-4 has been, reduce it by one for the coming year. Tax law changes could result in underpaying your withholding tax.

Tax season cometh

kw: taxes, software

Every season is getting earlier every year. Stores put up their Christmas displays on November 17. Now here it is December 14, and the tax software promotional from H&R Block arrived. We have been using their Tax Cut software a few years. This year it is called H&R Block At Home™.

This is no software review. You'll get a great review of the top ten tax preparation programs at Top10Reviews.com. This is a product endorsement. To see this sample screen shot, click on the image. The "big" image is still undersized, but gives you an idea of how the screens look.

We used several products over the past nine or ten years, and have settled on this one. The offer we got, at $14.95 including a free e-file, really puts pressure on tax preparation services.

We have a friend who runs a tax preparation company. Their bread-and-butter used to be the yearly January-to-April tax season. Now it is the quarterly Estimated Tax and Business tax filings. Personal taxes have dropped way off. At $125, more and more people are climbing the learning curve so they can prepare and file their taxes on their own computer, often for free. Some who can't afford a computer, but must still file tax forms, use free computers at the library and a free online service (HR Block has one of those also).

We won't get W-2 forms for another month or so, but the tax software folks already got their foot in the door.