Monday, April 15 2019 was tax day, when most Americans are required to file their federal tax returns for 2018. This post is in honor of the tax day-Ed
Taxes. It’s the one word that puts a fearsome loathing into so many people. It remains constant in our lives, whether you like or not. For many reasons, some not well understood, many Americans just do not want to give any of their hard-earned money to taxes. Now there are many forms of taxes: there are sales taxes when you purchase goods and services, property taxes, social security and medicare taxes (comprising the FICA taxes), state (and local city) taxes and federal income taxes. For the purposes of this post, I’ll limit the discussion to the federal income tax, for that is the one that irks most people. Perhaps for good reason, because it takes the largest bite our our incomes.
Some people will do insane things to avoid paying taxes and sometimes, even go to the length of evading taxes. While taxes paid by American colonists to Great Britain were one of the main reasons for the Declaration of Independence (no taxation without representation) and ultimately the Revolutionary War, America’s Founding Fathers knew that the young country would need taxes for essential items such as roads and especially defense. While the federal income tax did not become permanent until 1913, taxes, in some form, have been a part of American history since its earliest days as a nation.
Money raised through income tax is used to pay for programs, benefits, and services provided by the US government for the benefit of the people. Essential services such as national defense, food safety inspections, and federal benefit programs including Social Security and Medicare could not exist without the money raised by the federal income tax. And most Americans benefit from these programs and services that our taxes fund. Why then the angst towards federal income taxes?
Taxes and Evasion
Well, I think it’s mostly because people work hard for their money and want as much of it for themselves as possible. This is only right and makes sense. I get that. Like almost everybody, I believe you should use every legal way possible to reduce your taxes. However I also believe that you should pay whatever is due to you without the need to grumble about it. And the last thing I will encourage anybody to do is to cheat on their taxes. Somehow the IRS is very powerful and if they catch you, you may end up in jail, no matter how wealthy or successful you are. Don’t believe me? Well, you can ask these celebrities convicted of tax evasion what their experience was with the IRS.
All people of all income scales complain about taxes. Recently, the music star, Cardi B posted a video rant on twitter (now deleted). In it she complained how artists like her take care of their whole family and how that is not tax-deductible. In that video, she complained of how she spends about $300,000 a month in expenses. Now, for lesser mortals who make much less money, the story is also the same. I’ve seen some people swear they will switch CPAs because their current CPA is not getting them more tax refunds….as if their CPAs have to do some kind of magic to generate bigger refunds for them. They will argue that they are paying too much in taxes. In reality, these people have not done an honest exploration to see exactly how much they actually pay in taxes. Heck, some people don’t even understand their paychecks. All they look at is their take-home pay.
Marginal And Effective Tax Rates
First of all, most people do not really understand the difference between their marginal tax rates and the effective tax rates. Below is a table for the Federal Income Tax Brackets and Rates for 2019. Now, these are the marginal tax rate brackets.
|Rate||For Unmarried |
Taxable Income Over
|For Married |
|For Heads of |
Taxable Income Over
Now, the marginal tax rate you find yourself in, depending on your income, is not the effective taxes you eventually pay. What you eventually pay in taxes (called your effective tax rate) is usually much lower than your marginal tax rates. You will only know your effective tax rates when you file your income taxes the following year.
Your effective taxes are much lower than your marginal tax rate simply because there are tax deductions and credits that legally help reduce your taxes. If you save for retirement in your 401(k), you will pay less taxes than what your marginal tax rate shows. Likewise if you donate to charitable organizations, have mortgage interest, paid state income taxes, paid for college for a child or have a child in daycare. Each deduction or tax credit affects your effective tax rate differently. There are sundry other deductions and credits. But you get the point here.
For example, you may be in the highest income bracket (37%) but your effective taxes might be 32%. That’s exactly what happened to Jim Dahle, an emergency room physician who also runs the very successful White Coat Investor blog. Between his blog business and his doctor job, he makes 7 figures annually. So he is right there in the 37% marginal tax bracket, but he recently posted on Twitter that in doing his 2018 taxes, he figured out that his effective taxes (including his state taxes) came up to about 31%. Those on the lower end of the spectrum (those in the 22% marginal tax bracket and below) may file their taxes and find that they actually paid no federal income taxes at all.
Yes, everybody still gets to pay FICA taxes, which is about 7.65% for employees (1.45% Medicare tax + 6.2% Social Security tax) and if you don’t live in these states without an income tax, you still get to pay state taxes. In my state of Arkansas, if you make more than $35,099, your tax rate is 6.9%. So it can feel overwhelming when you add up all these taxes (FICA + Federal + State) and feel that most of your money is going to taxes, right? For example, a married couple living in my state of Arkansas in the 24% marginal tax rate will have a total marginal tax rate of 38.55% (24% + 7.65% + 6.9%) but what they eventually pay in all their taxes may be less than 20% of their total gross income. Of course, it helps that the Social Security tax is income capped and this number is indexed to inflation. For 2019, the maximum income an individual can social security taxes is $132,900. So for high income earners making 6 figures, any of your income above the capped limit gets a pass on that 6.2% social security tax.
So the reality is far from this theory. For most middle class and high income households, when you add up the marginal tax rates (FICA + Federal + State) it can get close to 35-50%. However your total tax burden can often be much less than than. I’ve tracked our household’s total tax burden in the last few years and it’s never surpassed 25%. I just finished filing our taxes few weeks ago and our total effective tax burden for 2018 was 23% of our gross income (federal, state, FICA).
Taxes Won’t Prevent You From FIRE
The whole point of this blog post anyway, is to show that taxes really won’t prevent you from achieving your financial goals or from achieving financial independence. People should stop having an out-sized fear of taxes or the IRS. Do not cheat on your taxes, report every income you make, then go make the best of what’s left. It’s just like I argued in this post about Gratitude that tithing does not prevent you from fulfilling your financial obligations. When you analyze it carefully, you will discover that if you make a decent income, you can pay all your taxes and still manage your money like a boss and get to FIRE status within 10-20 years, if that’s your goal.
In personal finance, I believe that one must strive more to maximize the things within your control. You can do everything legally possible to minimize your taxes, but your marginal tax rate is something beyond your control. Regardless of your politics, there’s nothing much you can do about that. If you are blessed enough to make millions of dollars like some celebrities, just pay your taxes due to the government and then go make the best of what you have left. If you attempt to cheat on your taxes, nobody will feel sorry for you when the IRS gets onto you.
Retire And Pay Even Less Taxes
Now when you actually retire, you will get to pay even less taxes. Don’t think so? Go check out this blogger who retired early and makes more than $100,000 annually (mostly passive income), yet pays $0 in federal income taxes. He travels the world enjoying his life with his family, makes some money from his dividends and blog income and pays zero in taxes. He has been paying zero dollars in federal income taxes since his early retirement for more than 4 years, so you know it’s not a fluke. Everything he does is perfectly legal.
So what’s my take home message? Stop whining about taxes. They’re not the real enemy. For most people, the enemy is the person staring at you in the mirror, when you would not pay attention to your finances. America does provide some important services with the taxes it collects (though you can argue the government is a poor manager of resources). But don’t let the tax tail wag. Pay your taxes, then go manage the remaining well so you can achieve all your financial goals.
What do you think? Do you fear or hate taxes? Do you think you pay more than 30% in federal income taxes? Comment below