Thorough Overview of US Taxes
When you ask people what their biggest expense is they often will reply with ‘mortgage’ or ‘tuition’ or ‘child expenses’. However, stats show that Americans spend the majority of their income on taxes. Our tax system and tax laws are absurdly complicated so here I offer a simple overview for you. Next time someone asks you what you pay in taxes you will know exactly how much you paid, why you got a refund, why you owed, what your effective tax rate was and what your marginal tax rate was. I’m writing this in 2015 and I’m sure our tax code will change by 2016 and so on but the concepts won’t change.
Where Do Income Taxes Go
Remember, we are talking about income taxes and not your real estate or sales taxes. A portion of your gross income will go towards federal taxes, another towards state income taxes and some towards payroll taxes (S.S. and Medicare). Your entire gross income generally isn’t taxed, you get put some money aside for retirement and you get some deductions and exemptions which lower your taxable income, more on this in a few paragraphs. So in summary:
Federal Income Taxes – taxes you owe to the federal government (10-39.6%).
State Income Taxes – taxes you may or may not owe to your local state (0-13.3%). Some states don’t have state income taxes.
Social Security Taxes – 12.4% for only the first $118,000 of your income (your employer may pay 6.2% of this).
Medicare Taxes – 2.9% for your first $200,000, then 0.9% for anything above $200,000 (your employer may pay 1.45% of this).
Federal Income Taxes
We have a ‘progressive’ federal tax system. If you make more than your neighbor then you will pay a higher percentage in taxes. So yes, as a higher income earner you carry a higher burden of supporting society. I’m going to base most examples on 2014 taxes. Here is a table which you have likely seen before:
Essentially, 2014 has the tax brackets you see in the first column. I have only included the ‘Single’ column and ‘Married Filing Jointly’ column. ‘Head of Household’ and ‘Married Filing Separately’ have slightly different numbers but essentially follow the same system. So take a look. If you make $18,000 a year you fall into the 15% tax bracket as a single person. If you are married filing jointly however you fall into the 10% tax bracket. I’m telling you this just to illustrate the difference between the 2 columns.
Gross Income Versus Taxable Income (or AGI)
If Dr. Mo made $420,000 in 2014 and he was single then he would be in the 39.6% tax bracket. However, it doesn’t mean he paid $166,320 in federal taxes because Dr. Mo gets to subtract $10,150 from his income for personal exemption and the standard deduction. You can see those 2 numbers in rows 2 & 3 of the table above. Every individual automatically gets these 2 ‘credits’. So if you made $10,000 of income in 2014 you wouldn’t owe a dime to the federal gov’t because your income is lower than the exemption and deduction together.
Back to Dr. Mo’s situation. In actuality even though Dr. Mo made $420,000 he won’t be taxed on this full amount. Another way of saying it is that $420k is his gross income and not his taxable income. He was also able to deduct $18,000 for his 401(k) and another $35,000 for another tax-deferred account (Keogh). So with this $53k and the exemption+deduction it just became $356,850. Therefore, Dr. Mo’s taxable income is $356,850, also referred to as AGI, Adjusted Gross Income.
Marginal Tax Rate vs. Effective Tax Rate
Now let’s look at the table again… $356,850 falls in the 33% tax bracket but this does not mean that Dr. Mo would pay 33% ($117,760). The reason he would pay less is that 33% is only the tax bracket which means the entire income isn’t taxed based on this bracket. Instead the income is broken up into chunks. The first chunk taxed at 10%, the next at 15%, then 25% and so on. 33% is the marginal tax rate. Looking back at the table:
-the first $9,075 is taxed at 10% ($907),
-the next $27,824 ($36,900-$9,076) is taxed at 15% ($4,173),
-the next $52,449 is taxed at 25% ($13,112),
-and finally the last $218,749 is taxed at 33% ($72,187).
We then add all the above values and obtain the total owed in taxes. This comes out to $90,397, or the effective tax rate. So what percentage is that? 25.33%. It’s not the $117,760. So, our marginal tax rate is 33% meaning that any amount we make on top of the $356,850 will be taxed at 33% but our effective tax rate is 25.33%. Furthermore, Dr. Mo only paid 21.5% of his gross income towards federal taxes ($90,397/$420,000). This last value is probably what most people will inquire about in daily conversation (well, if they are nosy I suppose).
“Hey Mo, how much did you owe in taxes last year?”
>I owed $90k .
“What tax bracket were you in?”
>33% tax bracket.
“How much of your income did you lose to taxes?”
>I paid 21.5% of my taxes to Uncle Sam.
“Wow, you are so rich! Do you want to go out with me?”
>Only if we go dutch!
State Income Taxes
I hope the federal taxes were explained well in the above paragraphs. Sometimes rereading it and plugging in your own values with a calculator in hand will help. Now, state income taxes are a chaotic bunch. I live in Oregon and we have a progressive tax system similar to the federal system (gradually increasing tax brackets). Look at the table below, it’s more simple than the federal but the numbers change for married couples and head out household just like with the fed’ table. Now, if I moved north by one state to Washington I would owe $0 in state income taxes. There are other states with $0 state income taxes . Oregon gives me a standard deduction of $2,025 along with a personal exemption of $188 which means if I had $10,000 of taxable income I could knock off $2,213 off the top dropping my taxable income down to $7,787. Looking at the table I would owe 5% ($165) for the first $3,300, 7% ($314) for the next $4,487 for a total of $479. Again, my state marginal tax rate is 7% but my effective tax rate is 6.15% (=$479/7,787).
What about Dr. Mo with the $420k of gross income. For state purposes he can still deduct $53k for retirement accounts leaving him with $367k. He gets the state exemption and state deduction totaling $2,213. This leaves him with $364,787 of income that Oregon can tax him on.
-the first $3,300 is taxed at 5% ($165),
-the next $4,949 is taxed at 7% ($346),
-the next $116,749 is taxed at 9% ($10,507),
-and finally the last $239,786 is taxed at 9.9% ($23,738).
Adding all that up, Dr. Mo would owe $34,756 to Oregon. That’s a marginal tax rate of 9.9% but an effective tax rate of 9.5%. As far as total (gross) income Dr. Mo paid 8.3% towards state taxes.
“Hey Mo, how much did you pay for state taxes?”
“How much did you pay for federal and state combined?”
“So what percentage of your income did you lose to state and federal taxes?”
>29.7%! I know, I should have been a plumber.
Payroll Taxes = S.S. + Medicare
‘Payroll tax’ is a term referred to the sum of your social security taxes and your medicare taxes. Interestingly this is completely ignored or forgotten by many. My colleagues don’t know about this or assume it’s included in their federal tax rates. True, it is paid to the federal government so it’s calculated on your federal taxes if you are using a software but rest assured you are paying for this on top of your federal and state income taxes. If you are employed as a W2 employee generally your employer will pay half of your payroll taxes for you. This is a direct cost to your employer, it comes out of their pocket. Let’s tackle each one separately, these 2 are fairly straight forward.
Social Security Taxes
If you are self-employed you would owe the whole 12.4% for social security taxes. Only the first $118,000 of your taxable money is taxed at this 12.4% rate. For Dr. Mo we go back to his taxable federal income which was $356,850, and we ignore any amount above $118k. So 12.4% of $118k is $14,632. However, if Dr. Mo was employed then he would only be liable for 6.2% which would equal $7,316.
His medicare tax liability is also calculated based on his taxable federal income. The first $200,000 is taxed at 2.9% ($5,800) and anything above $200,000 ($156,850) is taxed at an additional surtax rate of 0.9% for a total of 3.8% ($5,960). If Dr. Mo was employed he would pay 1.45% ($2,900) instead of 2.9% of the first $200k. However he would still be on the hook for the full 0.9% even if employed. Therefore, Dr. Mo who is employed by a large medical group would owe an additional $12,386 for medicare taxes.
Dr. Mo made a gross income of $420k. $53k of his income was not taxable because he was able to stash it away in tax-deferred accounts. He got some federal and state exemptions/deductions which lowered his taxable income a little more. He ended up owing $90k to the federal government for federal income taxes, he owed $35k for state income taxes and another $11k for payroll taxes. He therefore paid 32% of his gross income towards taxes total.