Writing 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 least tax efficient to the most.
- Wages – This is income that you earn from work. Wages are taxed in two ways. With a 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 interest from 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 donating 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.
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 you’re 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.
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.
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.
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.