I’ve heard mentioned on the news several times recently that Warren Buffet has declared that he has a lower effective tax rate than his secretary, who only makes $60,000/year. Now, this is a bit of a touchy subject, since it is a method of politicking to raise taxes on the wealthiest Americans.
This post from Consumerism Commentary discusses how, while Warren Buffet might have a lower effective tax rate than his secretary, this is typically not the case. Most millionaires do have a higher tax rate than most middle class families. In this case, maybe Warren Buffet’s secretary even needs some tax planning advice.
How do you calculate your effective tax rate?
Your effective tax rate is the total tax you pay, in any form, divided by your total gross income. There are different versions of effective tax rates – you could only consider federal income taxes paid, or you could consider all income taxes paid (state and federal), or you could consider every tax you paid during the year – including excise tax on gasoline, cigarettes, and alcohol.
What about your tax bracket?
If you earn $50,000, like the average American family, you will be in the 15% tax bracket (if married) or in the 25% tax bracket if you are single. Your tax bracket is not your effective tax rate. In fact, you and a colleague may both be single, the same age, and have the same gross salary, but have completely different effective tax rates.
First of all, if you are in the 25% tax bracket, you don’t pay 25% tax on every dollar you earn – you only pay 25% on your income that is above the threshold for being one bracket lower.
Second of all, you can reduce your income with deductions – if you have kids, or have a mortgage, your deductions will be totally different than someone else who does not have these tax-changing items.
Social Security tax
Each paycheck, 6.2% (4.2% in 2011) of your income is taken out to pay social security tax. Your employer pays an additional 6.2% of their own income for each dollar you earn too. However, you only owe social security tax on the first $106,800 that you earn each year. So if you earn $110,000, or if you earn $200,000, you will still only pay a maximum of $4,485.60 (in 2011) in social security tax. The more you earn, the smaller percent of your money goes towards this tax.
The less money you earn, the greater the percent of your money that gets spent, rather than saved. The greater the percent of your income you spend, the greater the percent of your income that is subject to sales tax.
Lets say you and your neighbor both send your kid to Local Elementary School. You earn $50,000 ($4,166/month), but your neighbor earns $60,000 ($5,000/month). You probably spent a similar amount on back to school supplies for your kids. Each kid needed a backpack, the same crayons, notebooks, new shoes… So if you both spent $300 on back to school, then you both paid the same amount of sales tax. However, you paid sales tax on 7.2% of your monthly gross income (300/4,166), while your neighbor paid sales tax on only 6% of their monthly gross income (300/5,000). Meanwhile, your neighbor is more likely to be able to save that difference of 1.2%, and never pay sales tax on it.
Capital gains tax
Right now, long term capital gains are taxed at only 15%. If $0 of your income comes from capital gains, you won’t be getting any advantage from these low tax rates.
If you are a single person earning $50,000/year, what percent of your income do you put away in investments each month? Other than your 401(k), which is already tax deferred, probably nothing. Whereas someone with a very high salary is no doubt putting quite a lot of that away and (when the stock market recovers) will have additional income coming from capital gains. Rather than being taxed at the 25% income tax rate, this is taxed at only 15%, thus further lower the average taxes paid on each dollar earned.
Taxes are deceptive
Taxes can never be judged on surface facts – that’s why skilled tax preparers are in demand! We set tax rates, but then add so many other taxes and tax breaks, that it is very difficult to guess how much tax someone pays, even if you know how much they earn.
Try sitting down one day and determining your true “effective” tax rate. Estimate how much you spend that is subject to sales tax. Look up the gasoline excise tax in your state, and include that too. The result may surprise you!