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My FI Journey » Reflections » How Wage, Ordinary, and Qualified Income Are Taxed

How Wage, Ordinary, and Qualified Income Are Taxed

90357_accounting_calculator_1Writing up my previous post on federal income and investment taxes was so enjoyable that I thought it would be fun to delve even further into the hellacious nightmare that is the US Federal tax system.  Specifically, we’re going to learn all about the standard deduction, about how being married affects your take home pay, and most importantly -  the difference between marginal and effective tax rates.  And just for good measure, we’re going to see how shifting more of your income towards investments and away from your day job minimizes your tax burden.

Types of Income

First, a quick refresher on income.  Remember that there are three different types of income.  Presented from the the least tax efficient to the most.

  • Wages - This is income that you earn from work.  Wages are taxed two ways.  With a the flat (actually slightly regressive) payroll tax, called FICA which funds Social Security and Medicare.  And then as ordinary income after that.
  • Ordinary Income - As you can imagine from the definition above, ordinary income does not include FICA taxes.  Ordinary income (without FICA) is how interestfrom bank accounts and P2P lending is taxed.  It’s also how income from investments comes such as BDCs, MLPs, and REITs is taxed.
  • Qualified Income - Is taxed at substantially lower rates than ordinary income and does not include any FICA taxes either.  This is how income from long term capital gains and dividends is taxed.

 

The Standard Deduction

Because the tax system is better when it is confusing and nonsensical, the government first taxes you and then gives you a tax deduction.

We need to have a quick aside here about the difference between tax deductions and tax credits as many people confuse these two.

  • Deductions - Reduce the amount of income that you can be taxed on.  If you have a $5,000 tax deduction, you may reduce your taxable income by $5,000.
  • Credits - These reduce the amount of taxes paid.  If you have a $5,000 tax credit, you owe the government $5,000 less than you would have otherwise.  Credits are better than deductions.

Back to the main story.

The standard deduction for single tax filer is $6,100 for a single tax filer, and $12,200 for married couples (filing jointly).

You are probably aware that if you do things like donate to charity, that you can claim those donations as tax deductions.  Well, not so fast. You see if you choose to itemize (list out) all your deductions the total value of those deductions is compared to the standard deduction.  You may claim the higher deduction of the two.

 

Single or married, you’re still hit by FICA

Thankfully, the marriage penalty tax died back in 2001 with the Bush tax cuts.  And thankfully, it managed to stay dead during the latest round of fiscal cliff idiocy in early 2013.  For those of you too young to remember, back in the dark ages getting married actually meant a higher tax bill for the new couple than if they had remained single.  Because our government is totally rational like that.

But here’s a question for you.  Is it better to have one person in a household earning $200,000 or two people earning $100,000 each?  The correct answer is one person earning $200,000.  Why?  Because there is no escaping FICA.  While the rest of the marriage penalty was patched up back in 2001,  FICA taxes were not.  As of 2013, FICA taxes (7.65% of your gross income) are applied to the first $113,700 of each person’s wage income.  So if you and your spouse both make $100,000 in wages, you’re both hit with FICA taxes across all your income.  However, if you’re an enterprising single who makes $200,000 in wage income, you only have to suffer the Social Security portion of FICA (6.2%) on the first $113,700 of your wage earnings.

The other 1.45% of FICA funds Medicare, and it is applied to all wage income up to infinity dollars.

 

Marginal vs Effective Tax Rates

Marginal tax rates refer to the series of tax brackets, 10%, 15%, 25%, 28%, and so on.  Your total annual income is divided up among these different brackets.  Your income starts being taxed at 10%.  As you earn more income, you exceed the amount of income that can be taxed at 10%.  The excess income is taxed at 15%.  And so on, as you move up the tax brackets.

Your effective tax rate is how much money you actually owe the government.  Simply put, your total taxes paid divided by your gross income.  Effective tax rates on wages are always HIGHER than your top marginal tax rate thanks to FICA taxes.  But, effective tax rates on investments are almost LOWER than your top marginal tax rate (no FICA taxes and the progressive tax situation make this possible).  Study the tables below to better understand how this all works.

 

Federal Tax Rates on Three Different Categories of Income

Before we get to move onto the fun part (the tables),  I wanted to discuss a little bit about how I constructed them.

  • I looked at incomes ranging from $30,000/year to $150,000 per year.
  • I laid out the total Federal tax burden (income taxes and FICA taxes, less standard deduction) for incomes as earned entirely by wage, ordinary income, or qualified income.
  • I assumed that in the married filing jointly category, both spouses were earning roughly equivalent wages (E.g. the husband and wife both earn $50,000 for a combined income of $100,000).
  • I listed the total taxes paid, total take home pay, top marginal tax rate and effective tax rate.
  • Note: This is only for the Federal Tax burden.  State and local income taxes may have to be accounted for as well.  Additional deductions or credits may also lower your tax burden.

 

Wage Income

.

Ordinary Income

.

Qualified Income

.

Some Income Types are More Tax Efficient

I would define tax efficiency as paying as little taxes as possible, thus maximizing your take home pay.  So how do the three types of income as well as the two different marital situations described above stack up against each other.  Since you probably didn’t look at those spreadsheets that I toiled for hours on, I also present the data to you in graph form.

The following graph displays gross income on the X axis and the take home pay provided by that income on the Y axis.  Each line represents either a single (S) or married (M) tax filer whose income is derived entirely from either wages, ordinary, or qualified income.

To use the graph, find your desired take home pay on the Y axis.  Then use the graph to get an estimate of how much gross income you’ll need to produce that take home pay.  You’ll quickly see that you need a lot more wage income to produce the same take home pay as qualified income.

gross income vs takehome pay

A few points should be obvious from the above graph.

  • Being married is more tax efficient than being single.  Why?  Because the increased standard deduction reduces taxable income starting at the highest marginal tax bracket and working its way down.
  • Qualified income is superior to ordinary income.  Both of which are better than wages.

There’s quite a bit going on in that bottom left hand section of the chart around $40,000.  So in order to bring clarity to that section, I offer the below graph which zooms in on that region.

gross vs takehome pay

The same general points should be obvious on this graph.  Once again, wages are the least efficient way to bring in income, qualified dividends are the best.

 

Conclusions

Let’s wrap this up with an example.  My annual household expenses are around $35,000 per year.  In order to cover those expenses with wages, I need to find a job that pays around $42,000 a year.  In terms of investment income, I only need enough $35,000 a year, not $42,000 a year, in dividend income in order to cover my current expenses.  Why?  Because I’m would not be paying any Federal taxes at all on my investment income.

If you haven’t figured it out by now, saving and investing is a hell of a lot better way to increase your income than by getting a second job.  If you don’t understand why that is, go back to the top and reread this.

Readers:  Have you thought about ways to shift your income away from wages? 

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8 Responses to "How Wage, Ordinary, and Qualified Income Are Taxed"

  1. executioner says:

    I would argue that the marriage penalty has been lessened but not eliminated. The Standard Deduction amount for single filers is exactly half the standard deduction for married joint filers. But the tax brackets do not offer the same accommodation. Look at the tax brackets for 2013 (below). Focusing on the 25% bracket, for example, a single earner can bring in up to 87,850 before getting hit with the next higher tax rate. But two married people each earning 87,850 would be taxed partially at the 28% rate (since twice that income amount is 175,700 — squarely in the 28% bracket).

    Maybe I’m missing something, but to me it seems that it’s still more efficient to file as single earners if each spouse makes approximately the same amount. This is especially true as incomes rise.

    Single filer:
    10% on taxable income from $0 to $8,925, plus
    15% on taxable income over $8,925 to $36,250, plus
    25% on taxable income over $36,250 to $87,850, plus
    28% on taxable income over $87,850 to $183,250, plus
    33% on taxable income over $183,250 to $398,350, plus
    35% on taxable income over $398,350 to $400,000, plus
    39.6% on taxable income over $400,000.

    Married filing jointly:
    10% on taxable income from $0 to $17,850, plus
    15% on taxable income over $17,850 to $72,500, plus
    25% on taxable income over $72,500 to $146,400, plus
    28% on taxable income over $146,400 to $223,050, plus
    33% on taxable income over $223,050 to $398,350, plus
    35% on taxable income over $398,350 to $450,000, plus
    39.6% on taxable income over $450,000.

    1. MFIJ says:

      I think you are correct. It looks like the marriage penalty has been reduced for lower income earners, but is still around for higher income earners assuming that the two spouses pull in roughly equal salaries.

  2. Scoonie says:

    Long story short, investment income is generally taxed at lower rates than wages from your job. Another reason to invest in the stock market and collect dividends from your investments!

    And the wealthy in the U.S. have most of the power, so I would probably expect the tax rates on investment income to remain low for the foreseeable future. If it benefits the wealthy, then it will remain law. So invest your money like the wealthy!

    1. MFIJ says:

      Exactly! Plus, thanks to the reduced taxes on investments, you won’t need nearly as much gross investment income as you do wage income in order to support the same lifestyle. Depending, of course, on how good your benefits package at work is.

  3. John Quinn says:

    The federal tax code does not allow a married couple to file as single, but they can file as married and filing single. This married filing single is a higher rate. Yes, married couples do pay a higher rate of tax if both have the same income, but in theory it is cheaper to live as a couple so I think that is why government justifies the higher difference.

    1. MFIJ says:

      You’d think that it’s cheaper to live as a married couple, but it’s not exactly true, especially for higher income earners with specialized degrees. Where I live there are lots of married people who live apart for some of the week because their workplaces are so far apart that daily commutes are unreasonable. So they’ll rent a room or an apartment and use that for a few days a week. And telecommute one or two days.

      I think that this is crazy, but it’s not uncommon.

  4. Great job explaining the differences on how income it taxed. This point is overlooked by so many people. Understanding this concept can allow for a huge change in your outlook and goals in life.

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