US Federal Taxes & How to Screw Uncle Sam
Death & Taxes
Few things in life are as certain as death and taxes. Just as death is simply a consequence of life, taxes are simply a consequence of earning money. So, if you earn money in the United States, there is a very high probability you will pay taxes. Some people pay more taxes, some people pay less, but for now, lets get through an introduction on the 2 types of taxes that nearly everyone pays, Federal & FICA.
Federal Income Taxes
In order to understand how federal income taxes work, we need to understand what a “progressive” tax system means. In a progressive tax system, people who earn a lot of money pay taxes at a higher rate than people who earn less money.
To better explain the progressive tax system, let’s create an example. In SkyLand (our fictional country) a regular burger that costs $5 or less is taxed at 5% and a regular burger that costs more than $5 is progressively taxed at 10%.
We want to purchase a $10 burger. In order to calculate the tax, we must pay on the burger, we have to split up its cost into our “tax brackets”, (which are the ranges of money taxed at different rates). We have two tax brackets, a 5% bracket that goes from $0 to $5, and a 10% bracket that goes from $5 onward.
Since the price of our burger covers the range of 2 brackets, the burger will be taxed at 2 different rates. The first $5 will be taxed at 5%, resulting in 25 cents ($5 * 0.05) worth of tax.
The second $5 will be taxed at 10%, resulting in 50 cents ($5 * 0.1) worth of tax. Our total tax is the sum of tax we pay in both brackets. Thus, we pay a total of 75 (25 + 50) cents in tax making the full price of our burger $10.75 ($10 + 0.75).
Our federal income tax code is merely an extension of the burger example. The federal income tax brackets as of 2017 are shown below:
What gets taxed by the Federal Government?
Pretty much everything. As a matter of fact, just about everything except the stuff stated below is taxable:
- Gifts and inheritances (unless its above ~5 million as of 2016)
- Life insurance proceeds
- Child support
- Compensatory damages for personal physical injury or illness
- Workers’ compensation
There are a few other things that are immune to federal taxes (like municipal bonds). An easy rule of thumb to follow is that unless explicitly stated, whatever income you obtain is federally taxable.
FICA Income Taxes
FICA income taxes are much easier to understand than federal income taxes because they are “flat” or taxed at a constant rate. To better understand FICA taxes let’s take a look at sales tax, something that most of us are familiar with.
Should you decide to look at your receipt next time you decide to something, you will notice that the final price you pay is greater than the cost of the things you bought. This is because you are charged “sales tax” on what you purchase. Sales tax is really simple to calculate because its flat. It’s just a percentage of the total price of goods you purchase. To drive further solidify this point, let’s take a look at the flat burger.
SkyLand also sells flat burgers for $10. Since the flat burgers are flat, (and not as good as the regular burgers), SkyLand only charges a 5%, flat tax. The tax you pay on the flat burger will be ($10 * 0.05) 50 cents. Flat taxes can be calculated with simple multiplication.
What gets taxed by FICA?
Almost all income that you make through employment (wage) is taxed through FICA. Your w-4 or self-employed salary will be pillaged by FICA taxes. However not everything is taxable by FICA – most investment income is immune to FICA taxes. The following are immune to FICA taxes:
- Dividend income (cash obtained from holding stocks)
- Bond income (cash obtained from holding bonds)
- Rental income
- Peer 2 peer lending income
- CD & Savings account interest income
- Capital Gains (income obtained from selling something for more than you bought it for)
Thus, if you don’t want to pay for old people’s living expenses and health-care, start investing!
What the FICA tax is made of
FICA, or payroll taxes are comprised of two different taxes used to fund social welfare programs. The two programs that your FICA taxes go towards are social security and medicaid.
Social security is a program where you pay money to supplement the income of old people. Most old people can’t work so you get to support them (with the intent that you’ll receive the same benefit when you are old). If you are self-employed, (i.e. you are your own boss) you will pay 12.2% of your income to social security. If you work for somebody else, you will pay 6.2% of your income to social security and your employer will pay the other half (6.2%).
One important thing to note is that not all of your income is taxable by social security. You only pay taxes on what you make up to $127,200 (as of 2017). This means that if you are self-employed, you will pay a maximum of $15,518.4 and if you are employed by somebody else, you will pay a maximum of $7886.4. Another thing to note is that most self-employed people making around 127K will probably never pay the full amount as there are tax loopholes they can use to avoid paying social security.
Medicaid is similar to social security in that you help support old people. However this time, instead of supplementing their income, you get the privilege of paying for their health care (with the intent that you will also get free healthcare when you are old). If you are self-employed, you will pay 2.9% of your income, and if you are employed by somebody else, you will pay 1.45% of your income. Unfortunately, health care is expensive so the medicaid tax does not end there.
Regardless of whether you are self-employed or not, you will end up paying an additional 0.9% in medicaid taxes (2.35% total if you are an employee) on all of your wage income above 200K (as of 2017). Medicaid’s tax structure is similar to the federal income tax, except it only has 2 brackets.
Furthermore, medicaid imposes a surcharge tax of 3.8% on investment income if your MAGI (modified adjusted gross income) is over 200K (MAGI is essentially your taxable income).
The united states is a country ridden with taxes, so I can almost guarantee that you will pay more than just Federal and FICA taxes. However, these are two of the biggest taxes placed on workers in the united states and just about every single US citizen pays them (except those who abuse loopholes to get out of them).
How to pay less taxes
Now that we have covered two of the largest taxes that Americans pay each year, let’s talk about ways to reduce the amount you pay to the government. After all, most people would rather keep their hard-earned money. There are two main tactics you can use to lower your tax burden. The first is to reduce your taxable income, and the second is to earn income that is taxed favorably (or not at all).
Reduce your taxable income
One strategy to lower your tax liability is to lower your taxable income. This just means that the numerical dollar amount that the government says you make is lower. There are two ways to lower your taxable income:
- Earn less money
- Use deductions
Earn less money
If you get taxed more as you earn more money, one sure-fire way to lower your taxes is to make less money. Take a look at the graph below, which shows your FICA & Federal tax burden vs your salary. As you can clearly see, the less money you make, the less you pay in taxes.
Now, I don’t recommend blindly quitting your job or working less hours just so you pay less taxes. However, I do recommend thinking about the following:
- number of hours you work
- amount you are paying in taxes
- how much you value your time.
In order to understand how these factors work together to drive financial decisions, lets talk about Bob’s finances. Bob earns 100K a year. Because US taxes are progressive, bob keeps much more of the first 50K than the second 50K he makes (the numbers in the following figure were calculated using the 2016 federal tax code).
Bob keeps roughly 81% of the first 50K he makes for himself, but only keeps 67% of his second 50K. Let’s look at it another way, after 6 months, Bob will make roughly $40K. However, in the next 6 months, Bob will only earn about 34K. In both of the 6 months, Bob works just as hard and just as long, yet his compensation is different. Essentially, you have to ask yourself if it is worth your time to work for less pay as you move up the tax ladder. If it is not, work less hours or try to get more time off.
Use tax-advantaged accounts & deductions
The second strategy to pay less taxes involves using deductions to lower your taxable income. A deduction lowers the amount of tax you pay by lowering your taxable income. For example, if you earn $50K a year and have $10K worth of deductions, you will pay Federal income tax on $40K ($50K – $10K) instead of $50K. The US federal tax code has too many deductions to count. That being said, I’m going to list the most common ones that most people can take advantage of.
Personal + Standard Exemption
You get a tax benefit for simply existing! If you choose to not itemize your taxes (i.e. list out every single arcane deduction you qualify for), the government gives you a $6,300 standard deduction (if you are filing as a single person as of 2016).
In addition, the government also allows you to have a personal exemption of $4,050 (as of 2016). This means that you can earn up to $10,350 before paying a penny of federal income tax. (However, you will still pay FICA taxes on that money).
Regular IRA (NOT Roth!)
If you want to save for your retirement, and do so through a regular IRA, you can deduct your contribution against your income. Currently, the limit is $5,500 per year. It’s very similar to a Roth IRA except there are different rules regarding withdrawal and taxes.
If you work, (self-employed or for someone else), you can probably contribute money to a 401K of some form. For employees, the current pretax limit is $18K, and for the self-employed, the current limit is $53K (with some additional rules).
Change how you earn your money
After you have lowered your taxable income as much as you can, the next step to lowering your tax bill is to earn money that is taxed favorably. In the United States, money that you obtain from investing is taxed less than money you earn from actively working. Thus, if you want to pay even less in taxes, you want to shift your income source towards investment income over employment income.
Long Term Gains & Qualified Dividends
The best part about investment income is that you pay zero FICA taxes (unless you get hit by the medicaid surcharge). This alone saves you 7%+ on taxes. In addition, the tax brackets for investment income are significantly lower, consisting of 0%, 15%, and 20% brackets. The table below shows the correlation between your marginal tax rate and your long term gains + qualified dividends rate:
|Marginal Tax Rate||Long Term Gains Rate|
The graph below shows taxes on qualified dividends and long term capital gains vs income:
One thing to note is that you are taxed significantly less on investment income verses W-4 income. Now, that’s fine and all, but what are qualified dividends and long term capital gains? Well to be concise, qualified dividends are simply cash payments from (US) stocks that you have held for 60-90 days. Long term capital gains means that you sold something for profit after holding it for at least 1 year.
Short Term Gains & Unqualified Dividends
Unfortunately, not all investment income gets favorable tax treatment. Short term gains (profit you make from selling something you have held onto for less than 1 year) and unqualified dividends (cash payments from stocks that you recently bought) are taxed at your marginal tax rate. Basically, if your top income tax bracket is 25%, you will end up paying at least 25% of your short term gains & unqualified dividends to the government. However, its not all that bad, since you still avoid FICA taxes.
Bond & Interest Income
Just like short term gains and unqualified dividends, bond & interest income are subject to your top tax bracket. For example, any interest you earn on your savings at a bank would be taxed at your top rate (25% for most Americans). The same would apply to most income earned from a bond.
The tax code is a lot more complicated than it needs to be. It would be really easy to simply have everyone pay a fixed % of what they earn, but then there would be issues of “income equality”. However, just because the tax laws are unclear, doesn’t mean that we can’t understand them. We just need to sit down and decode – something we are all more than capable of. Ultimately, all of us have to pay taxes, however, with proper knowledge, the amount of tax that we each pay becomes a choice, not a burden.