Westminster's FREE online source of interesting information!

When I was twelve years old and living happily in Litchfield, CT, my father announced that we were moving to Puerto Rico where he would serve as a missionary. This put our family in an uproar, and for the next four years, despite living two blocks from the beach, attending an international school with classmates from around the world, and surfing nearly every day, I remained firmly convinced that I hated living in Puerto Rico. My greatest wish was to move back to the family farm in central PA, a wish that passionately endured until exactly the moment my father called me into his office to inform me we were moving back to the farm in central PA. At that instant my passion for moving was immediately replaced by one thought: “Oh No! I love it here. I don’t want to move back to PA one bit.” However, move we did, and I spent my last three years of high school far from the ocean in an Appalachian time warp populated by the Amish, boys stricken with “buck fever”, girls pregnant and married far below the age of consent, etc.

 

How Taxes Work
I’m not a tax expert, and I’ve only learned this stuff as I get older, but here are a few facts you should be aware of--Since taxes are the main expense for most households, it’s a good idea to know how they work. Since I am not an expert, you should consult an accountant before acting on any information below. This is by no means an ‘all encompassing’ look at taxes—these are simply some examples.

1. Our federal income tax is “progressive”, meaning the more you make, the higher a percent of your income you pay. The top 1% of earners in 2007 (the latest year data is available) paid 40% of all income tax collected, meaning that all the rest of us (99%) paid the remaining 60%. The top 5% of earners paid 60% of all income taxes paid. The bottom 75% (certainly not just the poor) paid just 13% of all income taxes collected. That is a very “progressive” income tax. (figures from the WSJ)

2. Income tax has nothing to do with wealth. If you have $500 million dollars in assets, and take in $100,000 in taxable income, you’ll pay the same rate as someone with no assets but the same income.

3. Not all money you make is taxable like income. You can purchase municipal bonds (which a lot of wealthy people do), that are considered quite safe, and pay about 5-6% interest, completely free of all federal or state income tax (in MA, only MA municipals are not subject to MA income tax). If you have 5 million dollars in municipal bonds, your income will be about $300,000 and you won’t owe one penny in income taxes. Not bad. (note: yields on municipals are down lately as more people have bought them)

4. People who build up a business and then sell it do not pay income tax on the proceeds—instead they pay a “long term capital gains” tax, which is currently 15%, scheduled to rise to 20% next year. The government does this to promote entrepreneurship.

5. Other people, mainly investors, also pay this lower rate—in particular, the managers of hedge funds, which invest in other companies, pay 15%, not the top federal income rate of 35%, on the bonuses they make. This is because they are investing in companies, not technically earning a salary. When you read about an investor or hedge fund manager making $100MM, keep in mind that besides making a lot more money that you, he or she may also be paying a significantly lesser tax rate than you.

6. If you are in the 28% tax bracket, that doesn’t mean you pay 28% on all of your income. Your tax bracket is the highest tax level your income reaches—you might pay 10% on the first $8,350, 15% up to the next income level ($8350 to $33,950), and so on. A “taxable” income of $100,000 falls in the 28% tax bracket, but the average tax rate paid by that taxpayer will be more like 22%, or $22,000. You also only pay income tax on your adjusted income, meaning after deductions for mortgage interest, children, etc. Note that these adjustments to income begin phasing out above a certain level of income, making the effective top tax bracket a larger percent than advertised.

7. Investors, including day traders, might buy an "option" on an ETF (Exchange Traded Fund--a basket of stocks that trades on an exchange like a stock), and hold it for only 2 hours, and they will still pay long term capital gains tax on 60% of it at just a 15% rate on their profits, while the remaining 40% is short term gains, taxed as regular income. The combination of these is considerably better than the income tax rates that would apply to a paycheck. In May of this year this “60/40” rule was repealed but then reinstated three days later.

8. Everyone pays social security and Medicare taxes. These taxes are not progressive—in fact, above a certain level of income, social security taxes aren’t paid at all, making the social security tax anti-progressive (regressive). Many people think that this money is held in a trust fund for their retirement. Actually, it’s just an accounting entry—it’s all in the same (empty) pool, and these taxes are going to the same place as income taxes. That’s why people say Social Security is broke. These payroll taxes could be considered flat, or in the case of social security, regressive.

9. When you hear about ‘closing the sales tax loopholes’ on things like wine, it’s only partially true—it’s true technically because there hasn’t been any sales tax on wine, but it’s not actually true because wine is already taxed plenty via an excise tax that is incorporated into the retail price. Regular wine has a fairly low excise tax of $1.07 per gallon, but sparkling wine is taxed at $3.40 per gallon, with many variations in between. Since that tax is obviously incorporated into the price of the wine, when you pay sales tax you are actually paying a sales tax on the excise tax. This applies to the tax on gasoline, cigarettes, and even cars—when corporations pay a “corporate” income tax, they just sign the check to the government and pass the expense along to the consumer, who then pays sales tax on the corporate income tax, or excise tax, or whatever it might be called. Incidentally, sales of alcohol are booming in NH since the tax on liquor took effect in MA.

10. The bottle bill charge of $.05 is a tax too—the money collected but not redeemed all goes to the state government. This tax might be raised to $.07 or even $.08, but if it gets too high it will be worthwhile to redeem the bottles, so it will probably never be, for instance, 25 cents. At that rate everyone would save their bottles and redeem them, so less money would accrue to the state government.

11. Taxes like the sales tax, the bottle tax, excise taxes, and lottery tickets are ‘regressive taxes’, meaning that they are a lesser and lesser percent of your income the higher your income. Sin taxes, such as taxes on alcohol and cigarettes, as well as lottery tickets, tend to impact people at lower incomes....a person making a million dollars a year isn’t likely to play a lottery ticket hoping to win $5,000, is less likely to smoke cigarettes, and also might very well buy their top shelf wine off the Internet, where sales tax is often not collected.

12. Taxes collected for a particular purpose, for instance lottery sales benefiting education or the proposed new state tax on dog licenses, tend to not actually work that way. Mainly, government revenue is like a balloon…..there’s only so much air in the balloon, and if you push in on one side, the other side pushes out. What that means is that if every penny from the lottery actually went to education, then there might simply be that much less money devoted to education from the general fund. If the lottery money weren’t there, then general fund monies would have to be used.

13. The estate tax system (or “death tax” as opponents of this tax call it) only allows a parent to give away $10,000 a year tax free to a child. This prevents the parent from simply giving away everything to the kids, completely avoiding the tax. There are many ways to avoid this tax, involving trusts and other legal steps, but an article in the WSJ just pointed out a new one. Apparently a parent can lend a child money, at whatever interest rate they want, and after about one year, can forgive up to $50,000 of that debt annually. I would stress again to check with an accountant on this one, but on the surface it appears an effective way for the wealthy to transfer wealth and avoid the estate tax.

 

14. Then there is that tax on ‘rebates’….I think this one is thrown in just to keep us on our toes. Apparently if you are negotiating to buy a new car and get a discount, it’s no problem, but if the manufacturer, or as in the most recent case the government, gives you a ‘rebate’, it’s considered income and subject to income tax. That means anyone who recently took advantage of the ‘cash for clunkers’ program will need to report the rebate received as income on their tax return.

These are just a few (out of probably thousands) of the idiosyncrasies of our tax code. The bottom line is that a good accountant is a necessity if you have anything complicated in your finances, and by the way, the professional expense of hiring an accountant is often tax deductible.