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All posts by Dan Whalen,
Providence, RI (resume)

Thursday, October 27, 2011

Income Taxes

        As a compliment to my last post about Corporate Taxes, this post will be about how your personal income taxes are calculated.  Most of us just hand a shoebox full of pay stubs and receipts to an accountant, go home, say a prayer and wait for them to conjure up some good news.  Want to know what's going on in the meantime?  Then read on, brave soldier...

        First off, you don't pay your federal taxes on tax day (April 15th).  You actually pay your income tax little by little every time you receive a pay check.

        Look at your most recent pay stub. There's a line that says "Federal Income Tax" and a dollar amount next to it.  That amount has been automatically deducted from your check by the IRS and moved into a special account with your name on it (technically, your SS# is on it).  This happens every time you receive a pay check.

        Once a year, the amount of income tax that you owe for that year is taken out of your account all at once.  Any money left over is given back to you in the form of a check. That's your "tax rebate."

        Ok, so how does the government figure out how much to take out of the account?  To calculate your tax bill, you need two different sets of information: 1) the pertinent tax brackets and 2) the tax rates that correspond to those brackets.  You cannot calculate your total bill without knowing both.

        I feel like a lot of people hear "the $35,000 to $50,000 bracket has a 30% rate of taxation" and figure that means that if they make between $35k and $50k, they just pay 30% of their total income in taxes.  This is completely incorrect!

        What it actually means is that 30% of any income you are paid that spans through the $35k and $50k interval will be surrendered as taxes.  The income below $35k is subject to taxation at a different rate, and any income above $50k is subject to a yet another.  Each "bracket" has its own rate, and the taxpayer pays the particular percentages of their income as it falls into those brackets.

        Here's an example.  Let's say we live in a country where there are only two income tax brackets, and each bracket has its own unique rate.

First bracket - $0 to $25,000. It has a 10% tax rate
Second bracket - $25,000 to $50,000. And it has a 20% tax rate

        Now in this country we have a taxpayer named Mike.  All year, a portion each of Mike's paychecks has been automatically withheld by the government and moved into an account for him.  Now its income tax season and the government is going to draw what Mike owes in income tax from his account.

        We'll say that Mike made exactly $30,000 over the course of the year.  So his income spans the entire first bracket (the "$0 to $25,000" bracket), and just peeks into the second (i.e. he goes $5,000 over the first bracket).

        So right off the bat he pays 10% on that first $25,000 of his income, for an initial hit of $2500 (25000*.10 = 2500).

        But what about that extra $5,000?  The bit that spills over into the second bracket?  Only the income that makes it into the second bracket is taxed at the second bracket's rate. So Mike turns over 20% of the $5,000 spillover, tacking an additional $1,000 on to his bill (5000*.20 = 1000).

        In the end, Mike's total tax bill comes out to be $3,500 (2500 + 1000 = 3500).  His total disposable income for the year would therefore be $26,500.  Earnings-Taxes = 30000-3500 = 26500.

Mike's total annual income is $30,000.  In our example, his income is subject to two tax rates and two tax brackets.  He pays 10% of the "first" $25,000 of his income for an initial $2500.  Then the remaining $5,000 of his income that spills over into the second bracket is taxed at 20%.  20% of $5000 is $1000.  Mike's total tax bill for the year will be $2500 + $1000 for a grand total of $3500.

        Meanwhile, Mike's neighbor Nikki, makes $50,000 in the same year.  How much will be drawn from her account?

        Try to figure it out on your own.  To see if you got the correct answer, put your cursor just to the right of the first arrow below, hold down the left click button, and drag your cursor down to the second arrow.

The "first" $25,000 of Nikki's annual income is taxed at a rate of 10%. The "second" $25,000 at 20%. (25000*.10) + (25000*.20) = (2500+5000) = 7500. She'll pay $7500 in income tax for the year year.

        So Nikki has $50000-$7500 = $42500 of her yearly pay left over after taxes.

        Why do we tax in "steps" like this?  Why not a "flat rate"?  Why not just have everyone pay 20% of their total income, no matter what that income is, for example?

        The idea of splitting incomes up into brackets, and taxing each bracket differently comes to us from an 19th century British public policy wiz named John Stuart Mill.

        Mill realized that a flat tax would always be a burden that sits heavier on the poor and middle class than on the wealthy.  Sure, everyone would be paying the same portion.  But if you don't make a lot of money, that portion is a larger chunk of the actual income you made.  In other words: If you take a quarter of a middle-class guy's money, you've made him poor.  If you take a quarter of a very rich guy's income, he's still very rich.

        So a "graduated" system - a "steps" system, or what most people call a "marginal taxation" system - like the one we have is ultimately more fair (at least in the eyes of John Stuart Mill...and the US Federal government), since it gives a bit of a break to those with lower incomes.

        Play with the numbers to see the difference more clearly.  Say that Mike and Nikki's entire incomes were subject to a tax rate of 20% - the rate we reserved only for the top bracket in the last example.

        Mike would pay flat out $6,000 in taxes, leaving him with only $24,000 of disposable income to spend on food, housing, and clothes for the year.  Compare that to the $26,500 he walks away with in the graduated system.

        By giving him a break on the lower end of his income he gets to keep a bit more of what he earns in the first place.  In any society, there are certain "base" expenses that all people must pay (food, clothing, shelter, etc.), and Mike's pre-tax income was pretty low, probably just cutting it when it came to purchasing those base goods. We don't want to wind up taking a ton from him in taxes on top of that.

        We especially don't want to take too much from him compared to what we take from Nikki, who earns more to begin with.  We tax her a little bit more since her income can take it and still leave her with enough to afford what she needs...and have some left over.  Even after taxes, she has enough to cover her basics and then some.

        Or if you're a bit more of a numbers orientated person, you'll note that the ratio between Mike's "effective" tax rate and Nikki's is smaller in the graduated tax scenario.

        So in this example, under the graduated scenario, Mike keeps 88% of his pre-tax income (26,500/30,000=.88).  In the flat tax scenario, he keeps 80% (24,000/30,000=.80).  Graduated tax Nikki keeps 85% of her income (42.5/50=.85), and under a flat tax she also keeps 80%.

        The end result of a switch from this flat income tax to the graduated one would give Mike a 3% "bonus" over Nikki, when it comes to how much income he gets to keep after taxes.  And he needs it since his income is lower from the start.

        So even though Nikki pays a higher rate than Mike, she still has more raw cash left over in the end ($42,500 versus Mike's $26,500).  He might get to keep a larger percent of his income, but her after-tax income is still more than Mike's.  Essentially, she's keeping more, but its "a little less more" than it would have been otherwise.

        Of course, this is a super simplified version. In reality, in the US we have 6 brackets, and they are lined out differently depending on the individual's family status. Here's what the 2011 "tax schedule" looks like:

The "Marginal Tax Rate" is the rate that's charged on income that falls into the corresponding bracket.  So a single person making $20,000 a year would pay 10% on the "first" $8,500 PLUS 15% on the remaining $11,500 (20,000-8,500=11,500).  More info here

        There's another key element of your tax bill that I haven't mentioned.  That's the swarms of little loopholes that cloud around the core schedule you see above.  The schedule only shows the "stated rates," which are rarely what taxpayers would end up paying.

        There are plenty of little things that can chip away at a person's income tax bill.  In fact, finding these breaks is what your accountant does for a living!  His job is to find any deductions, credits and exemptions (the "loopholes," if you will) that can apply to you, in an effort to convince the IRS to draw less from your account than they would have otherwise come tax time - and leave more for you come the rebate.

        Two people with the same marital status and income will often end up paying different tax bills, depending on how many of these little loopholes apply to them...and how sharp their accountants are in using them.

        Probably one of the most common of these loopholes is the "mortgage deduction."  If you borrowed money to buy a house, the income you use to make payments to whoever lent you that money is not considered "income" by the IRS.

        Let's say you made $35,000 in 2011.  But in that same year, you also made $5,000 worth of payments on a loan you took out from a bank for your house.

        When your accountant files your taxes for the year - if he can prove you did, in fact, make $5,000 in loan payments on a home - he can claim that you only made $30,000 in income in 2011.  Such an adjustments of how much of a person's income is subject to taxation is called a tax deduction.

        The idea behind this rule is to make homeownership "feel" a bit cheaper than it normally would.  Sure, the loan is expensive: $5,000 a year is nothing to sneeze at.  But the deduction that comes with it will guard some of your income from taxes, making purchasing a house a bit less of a financial challenge for the individual.

        The cost of some medical procedures are also deductible in the way mortgage payments are, as are other taxes you pay on real estate to states or local municipalities.  There are similar available deductions for student loan debts as well.  Often people can get straight up tax reductions if their accountant can show that they paid out of pocket for childcare expenses, or that they contributed to their own retirement savings.

        Anyway, there are lots and lots and lots of these little maneuvers, and they all have their own little qualifications and rules.  Suffice it to say, this system is pretty complex.  Heck, we have an entire profession (accountants) dedicated just to guiding people though it!

        Also, it's worth it to note that very few Americans will ever pay the tax rate they are initially faced with, given the wide variety of deductions and credits available.  If you ever have received a "tax rebate" check, that's usually an indication that you didn't end up paying what you were originally asked to.  Your accountant "got you out of" some amount of your tax burden. This system sound familiar?

        There's one last piece to this puzzle.  And that's the word "income."  What is "income"?  Most people have a pretty intuitive sense of the word, or at least they think they do.  "It's the money that your employer pays you."  Black and white.  Right?

        Well, yeah.  Mostly.  BUT there are some grey areas.  What about the interest I earn on my bank account.  I didn't work for it, per se.  But its money that I get to spend however I want.  So is it taxable "income"?

        Or what if I own my own business?  Where does my personal income stop, and my business's income begin?  This has been a huge legal/political battle over the last decade.

        Or what if, through some clever stock investments, you made a few million dollars.  Would you want to call it "income" and pay around a third of it in taxes?  Or would you try to get away with calling it a "capital gain," which are only taxed at 15%?  The question is not really an academic exercise.  Every year, the legal definitions of "income" has billion dollar consequences for the US. 

        That's the nutty thing about taxes.  The more I learn, the less I feel I know.  This is why, in the end, I guess I just feel better giving my accountant that shoebox of paper, crossing my fingers...and letting him worry about it.


  1. What about when you ask your employer to take extra out of your paycheck for taxes? Why are people encouraged to do that?

  2. In response to SMRs question:

    The amount that gets withheld automatically from your paycheck is based on estimations of what your ultimate tax bill is expected to be for that year. If the estimation is that your bill will be very low for the year, they won’t take out much per check. If its going to be higher, they’ll take out more.

    So lets say you start a new job on the first day of the year, and that the pay is $25,000. The IRS will start deducting from your first paycheck amounts based on THAT salary. Since anyone’s best guess will be that you won’t wind up being charged much in taxes (given how low your income is), the amounts withheld will be relatively small.

    Then, six months into the year, something changes, and your income increases to $30,000. Maybe you got more hours. Maybe the pay went up. Maybe you got a new job all together!

    Or there might be action on the other end. What if your tax rates go up in the course of the year? Maybe there’s and adjustment to the rates or the brackets. Or maybe you get married or divorced (something that would trigger a change in the stated tax rate/brackets that would apply to you).

    So here we are, six months into the year, you’ve built up very little in your account. But come the end of the year, you’re going to owe a lot in taxes.

    What will probably end up happening is that when it comes time to pay up, you will owe more than what you have managed to bank up in that account. You haven’t put a lot in - since no one thought you would be charged much at the year’s end - but things have changed and your bill is suddenly going to be bigger than what anyone had planned for.

    Nobody likes this. You will get an unexpected additional tax bill (yuck), and the IRS will have to spend its own time, money, manpower and resources tracking you down and making sure you pay up the difference (an activity that may end up costing them as much as you owed in the first place).

    Its easy for the Fed to give you a rebate in the event that they took too much. Its incredibly difficult for them to find you and charge you extra in the event that they took too little. So they do offer the option for people to “overpay,” like what you are mentioning here. It’s a way of building a “cushion” into your account, which is nice for both you AND the IRS in the event of an unexpected change in your income.

    In reality, this happens a lot. Especially if you’re getting paid by the hour, its VERY hard to know down to the penny what your end of year total income will be. So that buffer of extra cash in your account will usually be a handy thing to have.

    If you take the option where more is deducted from your paycheck, than yes, you will get smaller paychecks all year. But you’ll also get a larger rebate at the year’s end (remember, all the “overcollected” money is refunded after your taxes are paid). If you opt for the larger checks you'll get a smaller rebate.

  3. This is why we have to be a little more studied when it comes to paying taxes. I mean, it pays to consider exactly what type of taxes we are paying for any particular situation. Wouldn't hurt though to get some heavy duty help from a trusted CPA, to lay down point by point our actual obligations to society.

    Allison Gill

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