January 5, 2011

Families with the Highest Tax Rates. Not what you think.

The highest tax rates in the land are not what you think.  Many families are taxed more heavily on the next dollar earned than are most professional athletes and corporate executives.

Before I get into my discussion, it is important to understand the difference between a marginal tax rate and an effective tax rate.  Your marginal tax rate is the rate at which the next dollar of taxable income is taxed; this is what we commonly refer to as your “tax bracket.” Not all of your income is taxed at your marginal tax rate.  Before you get to the higher marginal rates, your  income will progress through the lower brackets: 10, 15, 25, 28, 33, and 35%.  Your effective tax rate is the percentage of tax you pay on all of your income.  Your effective tax rate typically is lower than your marginal rate.  For example, a family in the 35% marginal tax bracket may have an effective tax rate of only 30% on all of their income. Now here is the rub:  At the lower income levels and with certain family dynamics, refundable tax credits (credits you get even if you owe no income tax), which phase out as your income increases, have a significant impact on the family’s tax burden as they earn more income.

Take, for example, a family of four: dad and mom (both under age 65) and two qualifying children.  Assume they are not itemizing their deductions and have a gross earned income (W-2 income) of $25,000.  With standard deductions and personal exemptions totaling $26,000 (based on 2010 tax law), the family’s taxable income is a negative $1,000.  The result is that they owe no federal income tax.  In fact,  because of refundable credits such as the Earned Income Credit (EIC), the Additional Child Tax Credit, and the Making Work Pay Credit, the family would be “entitled”  to a refund of 100% of their withholding, plus an additional $7,085 of refundable credits.  The  refund is tax free, from income and payroll taxes (the purpose of the EIC originally was  to compensate certain wage earners for the amount of payroll taxes withheld from their pay checks).  In this situation, the payroll taxes withheld on the $25,000 of wages would have been $1,913, and the EIC is $4,285, a  difference of $2,372.  The remainder of the refundable credits is $2,000 for the Additional Child Tax Credit and Making Work Pay Credit in the amount of $800, making a total of $7,085 of additional refundable credits.

I would argue that this family is in one of the highest tax brackets possible (see chart below).  If  wages were increased by $2,000, to $27,000, the refund would fall to $6,563, or by $522. Add in the additional payroll tax of $153, and the total tax increase is $675, or approximately 34% of the $2,000 increase in wages.  A $5,000 increase in wages would be taxed at  approximately 37%.  The increase in tax burden from the family’s current position (earning $25,000) continues to increase until wages reach approximately $46,000, at which point the percentage is approximately 39% .  This is occurring while, according to the tax rates published, including the payroll tax, the marginal dollars should be taxed as follows:
  • $25,000 W-2 wages taxed at 7.65% (0% federal and 7.65% payroll)
  • $27,000 and $30,000 W-2 wages taxed at 17.65% (10% federal and 7.65% payroll)
  • $46,000 W-2 wages taxed at 22.65% (15% federal and 7.65% payroll)

Earned Income

Refundable Credits

Income & Payroll Taxes

Cash Flow after Taxes
Increase in Cash Flow
as Earned Income Increases

Percentage of Tax Paid on Increase in Tax Flow































Now assume a family with the same dynamics, except with gross wages of $1,000,000 and receiving an increase in gross wages of $25,000.  They will pay the same marginal rate, 35%, for income taxes and 1.45% for payroll taxes on that increase in wages, all other items on their tax return being equal. The family will keep almost 64% of the increase in pay. The lower-income family has to almost double their earned income before their tax paid as a percentage of increase in cash flow decreases.

In 2011 families lose the Making Work Pay Credit; it was not extended in the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.  They will receive a 2% reduction in payroll taxes in their paychecks.  With the loss of the expired credit, the 2% reduction in payroll taxes actually does not increase the household income by 2% for many families.  A family earning $50,000 receives $1,000 but loses $800, for a net increase of $200.  A family earning $106,800 receives $2,136 but loses $800, for an increase of  $1,336 in cash flow.

The point of this discussion is to drive home the point that accross all income levels income tax planning is important to families looking to maximize household cash flow.
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