NOTE: THIS IS AN OPINION PAGE. I AM USING FACTS PUBLICLY AVAILABLE AND NOT DISCLOSING ANY INFORMATION PROTECTED UNDER LAW. IT IS NOT INTENDED TO BE USED FOR TRAINING PURPOSES.
The 17.4% or How People With Money Become Subject to Lower Rates
For the record, I have every intent of mocking Warren Buffett in this post. The particular article I’m citing (“Stop Coddling the Super Rich”, NY Times, 08/15/2011) highlighted a few glaring misunderstandings about our tax code and tax law that I felt necessary to elucidate here.
I’m going to start with a basic overview of our tax system, and a breakdown of a tax return. This post may get a bit lengthy, but I’d hope that by the end of it many of you who read it will be able to understand your own tax returns and review them without fear. I’m going to cover the Tax Return it’s self, how tax is calculated and what different tax rates there are, and I’ll go into exam, collection and appeals at the end. For the record, ALL of this is publicly available info, and if you need a citation somewhere just ask.
Our Tax System
We have what’s called a “progressive” income tax. That is, as you make more money, you’re taxed at progressively higher and higher rates. This is as opposed to a flat tax, where everyone pays the same percentage. This is intended to cause people who make more money to pay more tax however, I’ll be discussing why that’s not always the case, and how some people can end up getting more back than what they paid in during the year!
Of course, the whole tax return would be simple if it was just a matter of totaling up your income, then figuring the tax on that income. However, Congress and the President enact laws that complicate the code for the sake of incentivizing certain things in our economy, like buying a new home, going to college or adopting a child. This is the social engineering aspect of the tax return. The tax code is often manipulated to provide incentives for specific groups or actions, and to remedy other problems like double-taxation between your state and the federal government.
The Tax Return
I’m going to cover a little bit about the tax return and its structure to explain what terms like “tentative tax,” “taxable income” and “adjusted gross income” mean. I would highly recommend pulling up the IRS website and the 2011 form 1040 to follow along. We won’t go into any special schedules, but the form guides much of this explanation.
Your tax return is broken down into five primary sections (six, including your name/address/SSN and filing status) which are identified on the left side of the 1040.
1. Income
These first lines (7-22) go about totaling up all of your income. From wages, interest and dividends to capital gains, business and rental income. Line 22 is what we call your “Total Income.” You could call it gross income, but that’s not to be confused with the next total after…
2. Adjustments
This section simply adjusts your income through various “deductions” that don’t require you to itemize. Certain deductions (such as the self employment tax deduction) don’t have to be itemized to take advantage of. These are almost always reductions to your income. After we adjust your gross income in this section we get to line 37 – your “Adjusted Gross Income.” As I’ve implied here, your Adjusted Gross Income may be less than the total we came up with before.
3. Tax
Lines 38 – 44 go through the process of determining the amount of your income subject to tax, and the total tax on that income. In this section we would start reducing the amount of your income with things like your Itemized or Standard Deduction (itemized deductions are just that; listing deductions like state taxes paid, mortgage interest, medical expenses, etc. The Standard Deduction is a pre-calculated standardized amount that everyone can use. You take whichever is most beneficial.) We’re also reducing your income by your personal and spousal exemptions, as well as dependency exemptions.
This section is perhaps the single most important point on a tax return, as it’s where we initially calculate how much tax you’re liable for.
We do this by taking your taxable income (line 43) which is the figure we’ve arrived at after subtracting all the previous adjustments out, and then using that amount to find out how much tax you owe via the tax tables, based on your filing status (single, married filing jointly/separately, head of household.)
4. Credits
The credits section of the tax return are special sections of the tax code that allow you to reduce your tax dollar for dollar. In this section we have things like the Child Tax Credit and Education Credits. Unlike deductions, they don’t reduce the amount of your income subject to tax, but rather the actual tax.
As a matter of mention, there is a small section between this one and the next that deals with special taxes that cannot be offset by credits under the law. These are special taxes like the Alternative Minimum Tax and Self Employment Tax (which we’ll talk about later) and certain penalties.
5. Payments
This is where your federal income tax that you have withheld gets credited to you. A payment is some sort of pre-paid credit toward tax, but can also include certain credits (called refundable credits) that can be refunded to you, in excess of your tax. So, if you only have $1000 in tax liability, but have $2000 in withholding, and you qualify for a special refundable credit called the Earned Income Credit, you could actually get back more than what you paid in!
So the tax return, despite how disorganized it appears, is actually set up in such a way to determine what your income is, how much you’re legally liable for, how much of that liability you can mitigate and then what you owe or are getting back, in that order.
Now that we’ve very basically covered the tax return…
The Progressive Tax
The first thing to discuss here is the tax brackets and tax rates. The traditional income tax is set up such that you pay tax based on how far your income progresses into that bracket. So the first few dollars are taxed at the 10% rate, then the next amount above that at the 15% rate and so on. This is why we call it a progressive tax rate. I’ve included the 2011 tax rate schedules for the next example.
If this makes sense so far, the first thing you’ll notice is there is no 17.4% tax rate.
To illustrate this with example;
You’re a single filer with no dependents and just wages. We’ve figured out all your income on your tax return totals up to $40,500, and we figure that your taxable income is $31,000. Looking at the tax brackets, we see that your income falls just below the 25th percentile bracket. This means that the first $8,500 of income is taxed at 10%, the next $22,500 is taxed at 15% (just the amount that falls within that bracket.) You would pay $4,221.00 in tax. (Note: This is calculated with the tables, not the rate schedules because the marginal rate is rounded in that table.)
The 17.4% (effective tax)...
The reason we hear strange percentages quoted (like 17.4%), is that many OpEd articles and other sources will use an “effective” tax rate amount. In my previous example, while that person would fall into the 15% bracket, the effective tax rate on all their income would be 10.42%. (4221/40500)
When people like Warren Buffett tell you they only pay 17.4% while his secretary pays 25%, it’s likely because the difference between his adjusted gross income and his taxable income is larger than the difference in his secretary’s, or he has income that’s subject to special tax rates.
“So you’re telling me that I just need to reduce my taxable income more and find a way to have income that’s taxed at a special rate?”
Yep.
“How do I do that?”
Well that’s the whole point of this post isn’t it?!
At this point, things are going to get pretty gray and potentially confusing, if they weren’t already. We’re going to start talking about capital gains rates, depreciation and deductions. I mentioned “reducing your taxable income” and for most of us that boils down to things like mortgage interest and charitable contributions, but there are other things that can have substantial impacts on your tax liability, if you organize your finances properly.
“There is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible.” – Judge Learned Hand, 1947, United States Court of Appeals
Capital Gains Rates and Investment Income
In the law there is a special provision that allows for reduced tax rates on Capital Gains and other types of income. A Capital Gain is the money made on the difference between the sale price and the purchase price of a capital asset (such as your home, stocks, bonds, mutual funds, real property etc.) A capital gain is positive, loss is negative.
Now, despite what is often said, there are actually FOUR(!) capital gain tax rates. Five, beginning 2014.
28% - Collectibles Rate – This applies to capital gains on “collectibles” that is your stamp collection, that pristine 1958 Chevy Belair that you inherited from your father, precious metals etc.
Note: There’s another 28% rate that deals with qualified small business stock and IRC 1202. I’m not going into it here.
25% - Unrecaptured Section 1250 gains – This one is important (and we’ll talk about it later,) but deals with gain on depreciated property and special stock.
15% - This applies if your capital gain is anything OTHER THAN what I just mentioned, and you fall into a tax bracket of 25% or higher.
0% - Same as above, but it applies if your income is below that 25% rate.
Those special rates apply to different types of capital gains. The vast majority of what we deal with will be the bottom two, 15% and 0% respectively. If you sell common stock you bought through E-Trade, or TDAmeritrade, you’ll likely fall into the 15% or 0% bracket. Same goes with mutual funds and most types of gains we regularly encounter. These special tax rates are also beneficial rates, so if you sell some gold you inherited, but your income isn’t even in the 28% bracket, they’re still going to tax it at the most beneficial rate (your regular income tax rate) instead of 28%
In addition, these rates apply only to LONG TERM gains; Assets you’ve held for more than 1 year. They also apply to special dividends called “qualified dividends.”
The Bush Cuts – I need to take a moment and explain these cuts. These cuts were enacted in 2008, and reduced the bottom two rates I mentioned (the “any other gain rates”) from 20% and 10% to 15% and 0% respectively. For clarification – 10% drop for the lower incomes, 5% drop for the higher incomes. The 15/0% rates are scheduled to sunset (expire) on December 31, 2012 unless renewed.
For the sake of perspective; Tax cuts for the lower incomes were reduced by over twice what the higher rates were. However, because percentages create scaling effects (think back to your college algebra class and coefficients) the dollar for dollar tax savings for the wealthy is higher, though the difference in the decrease in rate was double for the lower income bracket. (I.e. 5% of 1000. Is more than 10% of 100.)
In summary, most gains are subject to a 15% or 0% rate, some are taxed at higher rates.
NOTE: DO NOT DO NOT DO NOT APPLY THESE CONCEPTS TO YOUR HOUSE. There’s more detail there than I will explain in this post. If you have questions about gains on the sale of your main home, ASK ME DIRECTLY! (There’s special rules, and an exclusion from the gain on the sale.)
Basis and figuring gain.
Your Basis in a piece of property is generally the purchase price plus the costs of purchase and includes any increases or decreases to the basis while the property is held.
We determine capital gain or loss by subtracting your adjusted basis from the amount realized on the sale of property.
The tricky part here is with “increases or decreases while you held the property.” Certain things can increase your basis (like capital improvements you make) while others can decrease your basis (like depreciation and easements you grant.)
The 25% rate and depreciation.
This is one of the important parts of how to reduce your tax liability.
I mentioned before, reducing your taxable income. Depreciation is an itemized deduction for the rental or business use of property. Depreciation is simply the loss in the value of property over the time the property is being used. Through depreciation it’s possible to take substantial deductions from your income, and in many cases it may even reduce your taxable income to zero.
The depreciation deduction allows individuals to deduct the reduction in value of property over time due to the business or rental (income producing) use of the property. Just to throw around some numbers, if you had 4 rental condos that cost you $80,000 per unit, that would amount to at least $11,000 as a depreciation deduction for ONE YEAR. Depending on your tax liability, that could save you between $1,000 and $3,500 in tax in one year. Not to mention the potential rental income. Even if you maintained a mortgage on those units, you’re still developing equity and reducing your tax liability.
Note: I am using the straight-line method, with a class life of 30 years for the sake of example. It’s likely that the actual depreciation would be vastly greater using the “modified accelerated cost recovery system” which could result in a massively higher deduction.”
The end result?
If you’re able to buy and maintain depreciable property you can reduce your income substantially over the course of decades. The catch to it is in your basis.
I mentioned basis and calculating it because that depreciation deduction then reduces the basis of your property. When you sell, the gain that’s equal to the reduction in your basis as a result of depreciation becomes subject to that “Unrecaptured Section 1250 Gains” tax rate of 25% instead of 15%.
The thing is, paying 25% beats any higher rate when your income is going to be subject to it. Moreover, just hold on to the property until you die, then transfer it in trust to your kids so you can dodge the 25% rate… as long as you can hold on to it until you die.
The point in all of this, is that there are many investment strategies that revolve around minimizing tax liability. Capital will always go where it sees the highest return, and tax liability reduces that return. Some investment strategies involve buying high dividend yield stocks that (after a period of time) yield quarterly “Qualified Dividends” which are only subject to the 15% rate, with no strings attached. Some are more real property based, such as what I explained. There’s also means of setting up businesses to write off expenses and hold property in trust to avoid having to deal with the tax liability directly, while still maintaining legal use of the property (ownership held by the business but you’re seeing all the perks.)
Chances are, most of us can’t afford to buy and maintain rental property, but we can buy stocks, mutual funds, ETF Shares and Gold, and deal with transactions on a much smaller level to the same effect; Reducing your tax liability in a very legitimate manner established by the tax code. None of this stuff I mentioned is illegal (or immoral.) The only real question is “to what degree?” Warren Buffett can afford to wrap up millions in investment strategies that minimize his tax liability because he has the resources to do it.
Warren Buffet’s Secretary – Credit phase outs difference in effective tax rates
Hopefully the direction this is heading is clear. “Why then does Warren Buffett’s secretary pay so much?”
I think it’s fair to assume that Warren Buffett’s secretary makes a decent sum of money. I’m going to use $125,000 as her adjusted gross income, and I’m going to assume she’s single and has 2 kids, both in college. I don’t know that these are facts, but it should illustrate my point about how this kind of thing occurs.
At $125,000 Adjusted Gross Income (102,500 taxable), Buffett’s Secretary falls into the 25% income tax bracket (which means her capital gains are taxed at 15%.) Her income is all wages, and we’ll assume she doesn’t have the resources to go out and buy a bunch of property to offset her income through depreciation. She’s pretty average, with a solid salary.
For those of us with much smaller salaries, we qualify for a number of tax breaks, like the Earned Income Credit, Child Tax Credit, First-Time Homebuyer Credit just to name a few. At $100k, she won’t qualify for anything. The Child Tax Credit phases out at $75k. That means she simply doesn’t qualify for the credit because she makes too much money. The American Opportunity Credit that most of us would qualify for, for sending two kids to college phases out at $90k. Basically, she has no breaks because $150k qualifies as “too much money” for most of these tax breaks.
“Phase Outs” are provisions built into the tax code to prevent high income earners from taking advantage of special tax credits – To keep them paying “their fair share.”
So here’s the numbers.
Head of Household filing status
2 Dependents, 3 total exemptions including herself.
$125k Adjusted Gross Income becomes $105,500 taxable income.
Her tax liability is $21,142.50
Effectively, her tax rate is 16.91%
Wait! I thought Buffett said she paid 25%! Why, with high income and almost no benefits because of phase outs and intentionally skewing the numbers out of her favor, does she only pay 17%?! (I used the standard deduction instead of estimating itemized deductions, and included no other potential tax breaks that would have resulted in a lower tax.)
In order to reach a figure that would reflect an effective tax rate of 25%, we’d have to inflate the figures to well over $250k worth of compensation with no itemized deductions, no investments, no tax breaks of any kind through financial management and the like. If we used her taxable income instead of adjusted gross, we would need to inflate the numbers to about 175k, to reach 25% effectively. Unless she was subject to special taxes depending on her situation, or WB is including State and other Taxes in his estimation of 25%, there's no way she's paying 25% without some seriously substantial compensation.
Paying their fair share, other taxes and legal pigeonholing
There are a number of special provisions like phase outs in the tax code, that ensure high income taxpayers can’t avoid paying the tax rates they’re subject to. I mentioned earlier the Alternative Minimum Tax. This tax applies to people who have a large income and large amount of deductions that cause a significant difference between their gross income and taxable income. It could apply in some situations, to that depreciation model I explained earlier. The Alternative Minimum Tax (AMT) was designed to ensure that people with incredibly high deduction totals pay some tax. But again as I’ve mentioned, there’s ways to plan properly and avoid encountering that tax. (If you’re able to use Straight Line Depreciation as I did in my rental property example, it’s not a factor in determining if you’re liable for AMT. Using MACRS is, however.)
The other (and more important) is the Self Employment Tax.
The self employment tax is a compilation of Social Security, Medicare and FICA taxes. Under the law, if you earn a wage, you pay half of these taxes, and your employer pays the other half. The total is a 15.3% (on income up to $105k or so, in 2012.) If you’re self employed however, you pay the entire 15.3%, instead of 7.65%.
This 15.3% is called the Self Employment tax when you pay it without an employer.
I’m just going to abridge this, but the simple version is that if you’re self employed, the tax code views you as a special class of citizen, subject to higher tax rates (your half of the SE tax) as well as vastly more stringent record keeping requirements. Since there’s no federal tax withholding on self employment, you’re required to make quarterly estimated tax payments (or pay a penalty for not doing so), and keep records to explain things like expenses, cost of goods sold (COGS) and other elements that define your net income. You face vastly more significant tax liabilities in the case of exam issues where the IRS disagrees with your records (i.e. paying tax on gross income, instead of your income less expenses) which can create seemingly insurmountable tax liabilities on income that didn’t even end up in your pocket.
Warren Buffett could be treating his Secretary as Self-Employed to get to that 25% figure he cites, but that adds very relevant specifics to the debate other than simply “I pay a smaller percentage than my secretary.” I don’t intend to be pejorative here either, but WB would be doing this to avoid paying payroll taxes and paying the employers portion of Social Security, Medicare and FICA Tax for his secretary – Which could be beneficial for his business, but is pretty poor treatment of your employees. (It’s also questionably legal.)
I’ve said before that any politician that claims to support small businesses, needs to first fight for changes in social security tax law, as well as how it’s administered. I’ll stand behind that. Our tax code and politicians almost universally want to crush small business.
The point here is that if you have a good accountant and/or understand the tax code, there are a number of perfectly legal ways to minimize your tax liability, simply based on how you organize your finances. Even a circuit judge of appeals (who I quoted earlier) stated there’s nothing wrong with managing your financial situation in such a manner as to pay the lowest amount of tax possible. When you’re working on maximizing your investments, paying 15% tax is like only making 4.25% on an investment that was promised at 5%.
The 17.4% or How People With Money Become Subject to Lower Rates
For the record, I have every intent of mocking Warren Buffett in this post. The particular article I’m citing (“Stop Coddling the Super Rich”, NY Times, 08/15/2011) highlighted a few glaring misunderstandings about our tax code and tax law that I felt necessary to elucidate here.
I’m going to start with a basic overview of our tax system, and a breakdown of a tax return. This post may get a bit lengthy, but I’d hope that by the end of it many of you who read it will be able to understand your own tax returns and review them without fear. I’m going to cover the Tax Return it’s self, how tax is calculated and what different tax rates there are, and I’ll go into exam, collection and appeals at the end. For the record, ALL of this is publicly available info, and if you need a citation somewhere just ask.
Our Tax System
We have what’s called a “progressive” income tax. That is, as you make more money, you’re taxed at progressively higher and higher rates. This is as opposed to a flat tax, where everyone pays the same percentage. This is intended to cause people who make more money to pay more tax however, I’ll be discussing why that’s not always the case, and how some people can end up getting more back than what they paid in during the year!
Of course, the whole tax return would be simple if it was just a matter of totaling up your income, then figuring the tax on that income. However, Congress and the President enact laws that complicate the code for the sake of incentivizing certain things in our economy, like buying a new home, going to college or adopting a child. This is the social engineering aspect of the tax return. The tax code is often manipulated to provide incentives for specific groups or actions, and to remedy other problems like double-taxation between your state and the federal government.
The Tax Return
I’m going to cover a little bit about the tax return and its structure to explain what terms like “tentative tax,” “taxable income” and “adjusted gross income” mean. I would highly recommend pulling up the IRS website and the 2011 form 1040 to follow along. We won’t go into any special schedules, but the form guides much of this explanation.
Your tax return is broken down into five primary sections (six, including your name/address/SSN and filing status) which are identified on the left side of the 1040.
1. Income
These first lines (7-22) go about totaling up all of your income. From wages, interest and dividends to capital gains, business and rental income. Line 22 is what we call your “Total Income.” You could call it gross income, but that’s not to be confused with the next total after…
2. Adjustments
This section simply adjusts your income through various “deductions” that don’t require you to itemize. Certain deductions (such as the self employment tax deduction) don’t have to be itemized to take advantage of. These are almost always reductions to your income. After we adjust your gross income in this section we get to line 37 – your “Adjusted Gross Income.” As I’ve implied here, your Adjusted Gross Income may be less than the total we came up with before.
3. Tax
Lines 38 – 44 go through the process of determining the amount of your income subject to tax, and the total tax on that income. In this section we would start reducing the amount of your income with things like your Itemized or Standard Deduction (itemized deductions are just that; listing deductions like state taxes paid, mortgage interest, medical expenses, etc. The Standard Deduction is a pre-calculated standardized amount that everyone can use. You take whichever is most beneficial.) We’re also reducing your income by your personal and spousal exemptions, as well as dependency exemptions.
This section is perhaps the single most important point on a tax return, as it’s where we initially calculate how much tax you’re liable for.
We do this by taking your taxable income (line 43) which is the figure we’ve arrived at after subtracting all the previous adjustments out, and then using that amount to find out how much tax you owe via the tax tables, based on your filing status (single, married filing jointly/separately, head of household.)
4. Credits
The credits section of the tax return are special sections of the tax code that allow you to reduce your tax dollar for dollar. In this section we have things like the Child Tax Credit and Education Credits. Unlike deductions, they don’t reduce the amount of your income subject to tax, but rather the actual tax.
As a matter of mention, there is a small section between this one and the next that deals with special taxes that cannot be offset by credits under the law. These are special taxes like the Alternative Minimum Tax and Self Employment Tax (which we’ll talk about later) and certain penalties.
5. Payments
This is where your federal income tax that you have withheld gets credited to you. A payment is some sort of pre-paid credit toward tax, but can also include certain credits (called refundable credits) that can be refunded to you, in excess of your tax. So, if you only have $1000 in tax liability, but have $2000 in withholding, and you qualify for a special refundable credit called the Earned Income Credit, you could actually get back more than what you paid in!
So the tax return, despite how disorganized it appears, is actually set up in such a way to determine what your income is, how much you’re legally liable for, how much of that liability you can mitigate and then what you owe or are getting back, in that order.
Now that we’ve very basically covered the tax return…
The Progressive Tax
The first thing to discuss here is the tax brackets and tax rates. The traditional income tax is set up such that you pay tax based on how far your income progresses into that bracket. So the first few dollars are taxed at the 10% rate, then the next amount above that at the 15% rate and so on. This is why we call it a progressive tax rate. I’ve included the 2011 tax rate schedules for the next example.
If this makes sense so far, the first thing you’ll notice is there is no 17.4% tax rate.
To illustrate this with example;
You’re a single filer with no dependents and just wages. We’ve figured out all your income on your tax return totals up to $40,500, and we figure that your taxable income is $31,000. Looking at the tax brackets, we see that your income falls just below the 25th percentile bracket. This means that the first $8,500 of income is taxed at 10%, the next $22,500 is taxed at 15% (just the amount that falls within that bracket.) You would pay $4,221.00 in tax. (Note: This is calculated with the tables, not the rate schedules because the marginal rate is rounded in that table.)
The 17.4% (effective tax)...
The reason we hear strange percentages quoted (like 17.4%), is that many OpEd articles and other sources will use an “effective” tax rate amount. In my previous example, while that person would fall into the 15% bracket, the effective tax rate on all their income would be 10.42%. (4221/40500)
When people like Warren Buffett tell you they only pay 17.4% while his secretary pays 25%, it’s likely because the difference between his adjusted gross income and his taxable income is larger than the difference in his secretary’s, or he has income that’s subject to special tax rates.
“So you’re telling me that I just need to reduce my taxable income more and find a way to have income that’s taxed at a special rate?”
Yep.
“How do I do that?”
Well that’s the whole point of this post isn’t it?!
At this point, things are going to get pretty gray and potentially confusing, if they weren’t already. We’re going to start talking about capital gains rates, depreciation and deductions. I mentioned “reducing your taxable income” and for most of us that boils down to things like mortgage interest and charitable contributions, but there are other things that can have substantial impacts on your tax liability, if you organize your finances properly.
“There is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible.” – Judge Learned Hand, 1947, United States Court of Appeals
Capital Gains Rates and Investment Income
In the law there is a special provision that allows for reduced tax rates on Capital Gains and other types of income. A Capital Gain is the money made on the difference between the sale price and the purchase price of a capital asset (such as your home, stocks, bonds, mutual funds, real property etc.) A capital gain is positive, loss is negative.
Now, despite what is often said, there are actually FOUR(!) capital gain tax rates. Five, beginning 2014.
28% - Collectibles Rate – This applies to capital gains on “collectibles” that is your stamp collection, that pristine 1958 Chevy Belair that you inherited from your father, precious metals etc.
Note: There’s another 28% rate that deals with qualified small business stock and IRC 1202. I’m not going into it here.
25% - Unrecaptured Section 1250 gains – This one is important (and we’ll talk about it later,) but deals with gain on depreciated property and special stock.
15% - This applies if your capital gain is anything OTHER THAN what I just mentioned, and you fall into a tax bracket of 25% or higher.
0% - Same as above, but it applies if your income is below that 25% rate.
Those special rates apply to different types of capital gains. The vast majority of what we deal with will be the bottom two, 15% and 0% respectively. If you sell common stock you bought through E-Trade, or TDAmeritrade, you’ll likely fall into the 15% or 0% bracket. Same goes with mutual funds and most types of gains we regularly encounter. These special tax rates are also beneficial rates, so if you sell some gold you inherited, but your income isn’t even in the 28% bracket, they’re still going to tax it at the most beneficial rate (your regular income tax rate) instead of 28%
In addition, these rates apply only to LONG TERM gains; Assets you’ve held for more than 1 year. They also apply to special dividends called “qualified dividends.”
The Bush Cuts – I need to take a moment and explain these cuts. These cuts were enacted in 2008, and reduced the bottom two rates I mentioned (the “any other gain rates”) from 20% and 10% to 15% and 0% respectively. For clarification – 10% drop for the lower incomes, 5% drop for the higher incomes. The 15/0% rates are scheduled to sunset (expire) on December 31, 2012 unless renewed.
For the sake of perspective; Tax cuts for the lower incomes were reduced by over twice what the higher rates were. However, because percentages create scaling effects (think back to your college algebra class and coefficients) the dollar for dollar tax savings for the wealthy is higher, though the difference in the decrease in rate was double for the lower income bracket. (I.e. 5% of 1000. Is more than 10% of 100.)
In summary, most gains are subject to a 15% or 0% rate, some are taxed at higher rates.
NOTE: DO NOT DO NOT DO NOT APPLY THESE CONCEPTS TO YOUR HOUSE. There’s more detail there than I will explain in this post. If you have questions about gains on the sale of your main home, ASK ME DIRECTLY! (There’s special rules, and an exclusion from the gain on the sale.)
Basis and figuring gain.
Your Basis in a piece of property is generally the purchase price plus the costs of purchase and includes any increases or decreases to the basis while the property is held.
We determine capital gain or loss by subtracting your adjusted basis from the amount realized on the sale of property.
The tricky part here is with “increases or decreases while you held the property.” Certain things can increase your basis (like capital improvements you make) while others can decrease your basis (like depreciation and easements you grant.)
The 25% rate and depreciation.
This is one of the important parts of how to reduce your tax liability.
I mentioned before, reducing your taxable income. Depreciation is an itemized deduction for the rental or business use of property. Depreciation is simply the loss in the value of property over the time the property is being used. Through depreciation it’s possible to take substantial deductions from your income, and in many cases it may even reduce your taxable income to zero.
The depreciation deduction allows individuals to deduct the reduction in value of property over time due to the business or rental (income producing) use of the property. Just to throw around some numbers, if you had 4 rental condos that cost you $80,000 per unit, that would amount to at least $11,000 as a depreciation deduction for ONE YEAR. Depending on your tax liability, that could save you between $1,000 and $3,500 in tax in one year. Not to mention the potential rental income. Even if you maintained a mortgage on those units, you’re still developing equity and reducing your tax liability.
Note: I am using the straight-line method, with a class life of 30 years for the sake of example. It’s likely that the actual depreciation would be vastly greater using the “modified accelerated cost recovery system” which could result in a massively higher deduction.”
The end result?
If you’re able to buy and maintain depreciable property you can reduce your income substantially over the course of decades. The catch to it is in your basis.
I mentioned basis and calculating it because that depreciation deduction then reduces the basis of your property. When you sell, the gain that’s equal to the reduction in your basis as a result of depreciation becomes subject to that “Unrecaptured Section 1250 Gains” tax rate of 25% instead of 15%.
The thing is, paying 25% beats any higher rate when your income is going to be subject to it. Moreover, just hold on to the property until you die, then transfer it in trust to your kids so you can dodge the 25% rate… as long as you can hold on to it until you die.
The point in all of this, is that there are many investment strategies that revolve around minimizing tax liability. Capital will always go where it sees the highest return, and tax liability reduces that return. Some investment strategies involve buying high dividend yield stocks that (after a period of time) yield quarterly “Qualified Dividends” which are only subject to the 15% rate, with no strings attached. Some are more real property based, such as what I explained. There’s also means of setting up businesses to write off expenses and hold property in trust to avoid having to deal with the tax liability directly, while still maintaining legal use of the property (ownership held by the business but you’re seeing all the perks.)
Chances are, most of us can’t afford to buy and maintain rental property, but we can buy stocks, mutual funds, ETF Shares and Gold, and deal with transactions on a much smaller level to the same effect; Reducing your tax liability in a very legitimate manner established by the tax code. None of this stuff I mentioned is illegal (or immoral.) The only real question is “to what degree?” Warren Buffett can afford to wrap up millions in investment strategies that minimize his tax liability because he has the resources to do it.
Warren Buffet’s Secretary – Credit phase outs difference in effective tax rates
Hopefully the direction this is heading is clear. “Why then does Warren Buffett’s secretary pay so much?”
I think it’s fair to assume that Warren Buffett’s secretary makes a decent sum of money. I’m going to use $125,000 as her adjusted gross income, and I’m going to assume she’s single and has 2 kids, both in college. I don’t know that these are facts, but it should illustrate my point about how this kind of thing occurs.
At $125,000 Adjusted Gross Income (102,500 taxable), Buffett’s Secretary falls into the 25% income tax bracket (which means her capital gains are taxed at 15%.) Her income is all wages, and we’ll assume she doesn’t have the resources to go out and buy a bunch of property to offset her income through depreciation. She’s pretty average, with a solid salary.
For those of us with much smaller salaries, we qualify for a number of tax breaks, like the Earned Income Credit, Child Tax Credit, First-Time Homebuyer Credit just to name a few. At $100k, she won’t qualify for anything. The Child Tax Credit phases out at $75k. That means she simply doesn’t qualify for the credit because she makes too much money. The American Opportunity Credit that most of us would qualify for, for sending two kids to college phases out at $90k. Basically, she has no breaks because $150k qualifies as “too much money” for most of these tax breaks.
“Phase Outs” are provisions built into the tax code to prevent high income earners from taking advantage of special tax credits – To keep them paying “their fair share.”
So here’s the numbers.
Head of Household filing status
2 Dependents, 3 total exemptions including herself.
$125k Adjusted Gross Income becomes $105,500 taxable income.
Her tax liability is $21,142.50
Effectively, her tax rate is 16.91%
Wait! I thought Buffett said she paid 25%! Why, with high income and almost no benefits because of phase outs and intentionally skewing the numbers out of her favor, does she only pay 17%?! (I used the standard deduction instead of estimating itemized deductions, and included no other potential tax breaks that would have resulted in a lower tax.)
In order to reach a figure that would reflect an effective tax rate of 25%, we’d have to inflate the figures to well over $250k worth of compensation with no itemized deductions, no investments, no tax breaks of any kind through financial management and the like. If we used her taxable income instead of adjusted gross, we would need to inflate the numbers to about 175k, to reach 25% effectively. Unless she was subject to special taxes depending on her situation, or WB is including State and other Taxes in his estimation of 25%, there's no way she's paying 25% without some seriously substantial compensation.
Paying their fair share, other taxes and legal pigeonholing
There are a number of special provisions like phase outs in the tax code, that ensure high income taxpayers can’t avoid paying the tax rates they’re subject to. I mentioned earlier the Alternative Minimum Tax. This tax applies to people who have a large income and large amount of deductions that cause a significant difference between their gross income and taxable income. It could apply in some situations, to that depreciation model I explained earlier. The Alternative Minimum Tax (AMT) was designed to ensure that people with incredibly high deduction totals pay some tax. But again as I’ve mentioned, there’s ways to plan properly and avoid encountering that tax. (If you’re able to use Straight Line Depreciation as I did in my rental property example, it’s not a factor in determining if you’re liable for AMT. Using MACRS is, however.)
The other (and more important) is the Self Employment Tax.
The self employment tax is a compilation of Social Security, Medicare and FICA taxes. Under the law, if you earn a wage, you pay half of these taxes, and your employer pays the other half. The total is a 15.3% (on income up to $105k or so, in 2012.) If you’re self employed however, you pay the entire 15.3%, instead of 7.65%.
This 15.3% is called the Self Employment tax when you pay it without an employer.
I’m just going to abridge this, but the simple version is that if you’re self employed, the tax code views you as a special class of citizen, subject to higher tax rates (your half of the SE tax) as well as vastly more stringent record keeping requirements. Since there’s no federal tax withholding on self employment, you’re required to make quarterly estimated tax payments (or pay a penalty for not doing so), and keep records to explain things like expenses, cost of goods sold (COGS) and other elements that define your net income. You face vastly more significant tax liabilities in the case of exam issues where the IRS disagrees with your records (i.e. paying tax on gross income, instead of your income less expenses) which can create seemingly insurmountable tax liabilities on income that didn’t even end up in your pocket.
Warren Buffett could be treating his Secretary as Self-Employed to get to that 25% figure he cites, but that adds very relevant specifics to the debate other than simply “I pay a smaller percentage than my secretary.” I don’t intend to be pejorative here either, but WB would be doing this to avoid paying payroll taxes and paying the employers portion of Social Security, Medicare and FICA Tax for his secretary – Which could be beneficial for his business, but is pretty poor treatment of your employees. (It’s also questionably legal.)
I’ve said before that any politician that claims to support small businesses, needs to first fight for changes in social security tax law, as well as how it’s administered. I’ll stand behind that. Our tax code and politicians almost universally want to crush small business.
The point here is that if you have a good accountant and/or understand the tax code, there are a number of perfectly legal ways to minimize your tax liability, simply based on how you organize your finances. Even a circuit judge of appeals (who I quoted earlier) stated there’s nothing wrong with managing your financial situation in such a manner as to pay the lowest amount of tax possible. When you’re working on maximizing your investments, paying 15% tax is like only making 4.25% on an investment that was promised at 5%.
Capital will always go where it finds the greatest return. If at any point the market is changed or the potential gain is affected by law, the capital will go wherever else it can find substantial gain – people will simply change their investment strategies. This isn’t one or two, or even a handful of investors acting to move all the money in an economy, its intelligent investment planning, retirement savings, business management, et cetera, among almost every participant in the economy. It is human nature to try and maximize gains while minimizing cost, and it will happen regardless of how we structure our economy or law. – Folks are just trying to make money through investment and trying to put their money where they’ll get the most back. What you pay in taxes is a normal part of the analysis of what you expect to get back. The only issue here is a matter of scale – Wealthy people have a much greater capacity to invest and the only way you will ever pay 25% is if you’re self employed or you’re rich and investing poorly.
In Conclusion
Paying less is a matter of decreasing your taxable income relative to your adjusted gross income. You can do it through capital gains tax reductions, depreciation and just careful and proper financial planning with the goal of minimizing tax liability. For most of us though, we're working with small money amounts, so the potential gains are small.
Comparisons like “I’m rich and I only pay 17.4% while my secretary pays 25% are grossly inappropriate. There is vastly more involved with the cause of that discrepancy other than simply, “I’m rich.” Moreover the issue with tax rate discrepancies based on income is appropriate to arguments about the complexity and equity of our tax code as it applies to specialized taxes like the Self Employment Tax. NOT as an argument for increased tax rates on the rich. Those arguments need to be based on socio-economic and/or moral factors.
I must admit, that I started this post with the idea of demonizing Buffett pretty hard, seeing the opinion conveyed by his article (as I did initially) as a wealth protection goal, assuming that he knows that income tax rate increases (including Capital Gains Tax rates) primarily affect people that make between 175k and 325k. Vastly more than an increase would affect people that make as much as the richest man in the world. At this point, it occurs to me that Buffett just doesn’t understand why the numbers could turn out such that someone who makes more pays a smaller effective percentage of their income. For the record, however... of the people who file a tax return, the wealthiest 1%, pay almost 49% of the total income tax revenues.
Our tax code doesn’t like the self employed, or people that make enough to fall into a higher tax bracket but not enough to offset substantial amounts through investment and business development. The solution here isn’t to tax the rich more but to resolve the gap by changing the tax code. Getting the super-rich to pay more is a vastly more difficult issue than simply increasing the tax rates on the highest brackets. The proper way to resolve issues in effective tax rates as Buffett pined, is to engage in productive discussion about how to work out those “holes” in the code that cost certain people a great deal of money, as well as simplifying the code to make understanding it easier. The problem, is that both the tax preparation industry as well as the government profit through complexity and ambiguity, when talking about the tax code.
In the end, paying less is a matter of managing your finances well to maximize returns – Anyone can do these things, even if it’s just a matter of buying stocks, CD’s or other investments. Admittedly however, the ability for those of us that make lower incomes is on a vastly smaller scale than Warren Buffett. Ultimately though, this term "effective tax rate" is moot. If we really want to talk about effective tax rates, we ought to include sales tax, state tax, excise tax and other taxes, at which point, most of us probably pay near 60% after we spend our paychecks on necessities. (I'm still compiling the data about that.)
At anyrate, I hope this was clear and to the point. I was hoping to keep it concise but I think that was lost in the subject matter. If you’re reading this and don’t already know, I do free federal and state income tax preparation, and will always research and answer tax law questions if asked.
Informal Sources! (I may write an 8 page essay for fun, but not a bibliography.)
Tax Tables were derived from the 2011 Publication 17, “Your Federal Income Tax Return.”
Information on Depreciation can be found in Pub 17 as well as Pub 946.
Information on Capital Gains Tax Rates can be found in Pub 17 as well as Pub 550 and 544.
Information on the Self Employment Tax can be found in Circular E (Pub 15), Pub 334, and Pub 4591.
Information on Your Rights as a Taxpayer can be found in the publication by the same name, Pub 1.
All these publications can be found at the IRS's website, www.irs.gov
Please feel free to contact me for info on changes to Capital Gains Taxes as a result of PL 110-289, HR3200 and PPACA; The Health Care changes.
