So, my accountant finally wrapped up my various tax documents and for the prominent Federal Tax Return, I was surprised once again to see just how low my Effective Tax Rate is – under 5%. That’s my net tax rate after all deductions, credits, etc. Not that I’m complaining, but the tax system is so convoluted that someone that makes what I make pays less than 5% in Federal Taxes. I mean, we are a single income household and I’m not raking in huge bucks, but we’re solidly upper-middle class and paying just a fraction of our actual “tax bracket” amount. This just further illustrates that if I’m paying this little in Federal taxes, people closer to the national average income are pretty much paying nothing.
Why Is My Tax Rate So Low?
There are so many deductions available that with relative ease, one can get down to a virtually non-existent tax rate. Here are a few financial drivers for our family:
- I’m a routine contributor to my company 401K plan. Any dollars contributed reduce your taxable income by an equivalent amount.
- We just had our third child. That’s a $1000 tax credit for each child until you start to get phased out based on income limits.
- We make various charitable contributions each year, which reduces taxable income.
- We have a decent sized mortgage since we live in a relatively high cost area. Mortgage interest is deductible, as are real estate and school taxes. Even though I have an incredibly low mortgage rate at 4.625% for a conventional 30 year, it’s still a 5-figure amount lopped off income each year.
- I established an LLC for my blogs. While I brought in a decent amount of money last year, it was still in the growth phase and I had expenses that were either fully or partially deductible.
- I utilized a Flex Spending Account for health and medical expenses.
- I took my lumps last year in my taxable trading account during the market meltdown. I had recognized some losses throughout the year (here’s my Current Portfolio which is doing remarkably well this year, even in the context of the 70% in the broad market from March last year).
- There are probably a few other considerations I missed as well.
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More Tax Tips and Deductions
- Cash for Caulkers $3000 Plan
- 7 Year End Tax Tips
- New Car Sales Tax Deduction
- Cash for Appliances Plan
- Deferred Compensation
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For my state taxes, I’m actually getting a refund if you can believe it, because in our state, 529 plan contributions are deductible as well. So, that’s like beating the market by a few points each year in that college plan account for the kids as well. Not only does it grow tax-deferred, but I also get a refund back from the state up to something like $15K per year (I have to check that).
Who’s Paying the Taxes?
Well, most of the country isn’t. It’s pretty much the top percentage of earners. I get the notion that a family of four making $40,000 in a medium cost part of the country would struggle with a $5000 tax bill on top of the myriad state taxes and cost of living. But shouldn’t most families at least pay something? 1%? I mean, we’re all sharing in the services and expenditures of the federal government from Defense to social programs to now, healthcare, but the full burden is being borne by such a small portion of our constituency. With more tax increases on the way, this equation will only become more lopsided. It just begs that question as to how far it goes and the fairness of the whole system.
So, with a rather large tax deduction, some may question why I don’t run and adjust my W-2 immediately to make sure I’m not giving the government one of those free loans all year, but the reality is that it’s really not a big deal to me – Here’s Why.
What Was Your Effective Tax Rate?
Do You Feel It’s Too Low or Too High?
Related posts:
- What’s wrong With THIS Health Care Reform
- 401K Loan Rules – Taxes, Interest, Pros and Cons
- Why Pay High Credit Card Interest Rates with Low Rate Alternatives Out There?
- 7 Year-End Tax Tips You Can’t Miss!
- Yes, You Can Deduct Your New Car Sales Tax This Year!
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I have had the same quandry each year as I compute my taxes and find that I owe very little in Federal income taxes. I wrote a post on it last year that goes through the math of how a family making $100,000 pays no federal income tax (and actually gets a refund of more than the amount that was withheld). When you have a country that is addicted to deductions and credits, it is only the high income earners that pay ANY federal income tax. And we keep on changing what a high income earner is (hint: it’s more than $100,000).
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Financial Samurai Reply:
April 5th, 2010 at 3:46 pm
@Reputo,
Amazing ain’t it?
We should have a regressive tax, since there are so many people in America who make less than $250,000 than those who make more than $250k!
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I don’t know my effective tax rate off hand, but I do know that the top 1% of earners pay upwards of 70% of the total tax taken in. That is simply ridiculous and unsustainable in the long run.
If you are in NY, and I think you are the 529 is deductible up to 5k per spouse.
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Investor Junkie Reply:
April 5th, 2010 at 12:14 pm
@Evan,
Yup the NYS 529 is actually decent. If have children and not contributing, you might as well burn the money then.
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Well done if you can get away with paying only 5% of your income in federal tax! I agree with you that everybody should pay a little income tax, even if it is only 1%. I think whenever you pay something into any organization, it gives you a different sense of belonging. If we look at taxes as a membership fee, it would not sounds so outrageous if everybody paid a little bit, right? I also agree with you that $5,000 or 12.5% is a lot of money for a family that brings in only $40,000 while $30,000 or 20% is not that as bad for a family who earns $150,000. Having said that, I can see how progressive taxes can easily be viewed as “unfair” just like like anything else can be viewed as “unfair”.
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Man, you are SO LUCKY! I do all those things as well… and my effective is looking like 30 freaking percent! Can I shoot you a private e-mail, or do a G-chat so you can help a brother out? Seriously…. i haven’t submitted my taxes yet this yr b/c I’m aghast at my effective tax percentage.
I feel like I’m doing something wrong…. ……………
Sam
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Investor Junkie Reply:
April 5th, 2010 at 12:16 pm
@Financial Samurai,
Yea you:
- work for someone else
- don’t have corp. Get one for your blog.
- don’t have a pro do your taxes.
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Financial Samurai Reply:
April 5th, 2010 at 3:45 pm
@Investor Junkie, What is your effective tax rate?
After you make a certain amount, I think it’s $150-200k, basically EVERYTHING gets phased out.
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Evan Reply:
April 5th, 2010 at 3:50 pm
@Financial Samurai,
I think IJ’s point is that YOU don’t have to make $150k – $200k. There are situations when your S-Corp can pay you $60K and then you have non-taxable profit of the remaining amount. That is just one technique.
My effective tax rate has been ridiculously low too for years, but it is not starting to creep up as child tax credits begin to get phased out, my mortgage interest deduction wanes, and my income steadily rises.
It was 7% last year and 9.4% this year. Next year it will probably be even higher – but it is still very very reasonable!
The truly wealthy really do already shoulder most of the tax burden in this country. Anybody that thinks otherwise needs a bit of a reality check.
All the best,
Len
Len Penzo dot Com
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OK Evan, I’ll look into it.
Dang Len, only 9.7%?! Maybe I’m the only loser here. What about you E-dog? What’s your effective tax rate?
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Investor Junkie Reply:
April 5th, 2010 at 6:18 pm
@Financial Samurai,
Hey FS,
I don’t remember last year’s (2008 taxes) but I believe around 18% effective rate. That’s personally, If I included my biz would add approx 5-8% more. My 2009 taxes are not done yet and have been filed an extension (my accountant is slow). As of this year I’m creating metrics to monitor our family procession (total salary – before deductions, taxes paid, effective tax rate, net worth increase, passive income, etc). I’ve started to go back in my old Quicken files and so far it’s pretty interesting what I’ve learned.
Repeat after me, it’s not how much you make it’s how much you keep. Someone like Lyndon on your blog is getting royally screwed. Single wage earner with no house, and lives in NYC. 45% effective tax rate Ouch!
Owning a business is really the only last method to legally defer, or reduce tax of any significance. If the government starts reducing deductions for businesses, it’s game over for our economy.
I’m not saying create a biz for the sole sake of the taxes (which could get you in hot water with the IRS) I’m saying put as much through your business. You have a blog, which I would consider a legit business. As Evan has mentioned there are many more options (including your salary and distributions) that can be adjusted that also affect your tax rate. Same goes for rental properties. If they are not Inced already (usually LLC) then more than likely you are missing many legal deductions.
The amount it costs per year, should outweigh your tax savings, especially in your 35% bracket. Remember Flexo saved 10k from adjusting his business from a LLC to an Inc. Keep in mind our damn tax code is 880,000+ pages, so to say it’s complex is an understatement. Also to those who own a biz like me, expect an increase in audits in the coming years. I’m not saying my accountant or I do anything illegal, but since this code is so complex and can be interpreted differently, they will leave no stone unturned. Count on this, especially the people who pay less than their peers (red flag).
Of course I’m not a tax professional (but play one on TV). Speak to someone that can help you. Hope this helps…
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Financial Samurai Reply:
April 5th, 2010 at 9:03 pm
@Investor Junkie, Good points. Should I suggest Lyndon go get married, make some babies, and save some tax money?
I did my calculation of effective rate wrong. I was guestimating and including 10% California tax.
My Federal effective is lower but still above 20% unfortunately.
I’ll start a business in due time. Can’t wait to minimize taxes like you guys!
$35,000 in internet and computer expense deductions here I come! j/k, but hopefully one day! I mean, don’t I need a new laptop in each bedroom as well as a nice Audi S5 to keep up my image?
Best,
Sam
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Investor Junkie Reply:
April 12th, 2010 at 11:00 am
@Financial Samurai,
I just looked up my effective tax rate for 2008 was 6.8%. This includes state and federal, but does not include corporate taxes paid. That would bump it to 10%
Keep in mind I calculate total income for the year (no AGI crap) So that includes rental income, salary, 401k matching, etc… total income for the year.
If I use the AGI the rate is 13%.
Again the reason for the low rate is what Darwin mentions as I’m in a similar situation.
Investor Junkie Reply:
April 12th, 2010 at 11:20 am
@Financial Samurai,
Also it should be noted, that are you including SS and medicare tax? I didn’t to my calculations, which they should since that’s something you have to pay and typically cannot deducted, nor included in your tax form submissions.
I’m looking at my taxes as how much I’m paying to the government, the smaller the number the better
We make about $80,000 a year jointly and have about an 8% effective tax rate normally. We don’t have kids, I only contribute 6% to my 401k (we fund a Roth IRA as well), and we take the standard deduction since our mortgage interest is so low (about $3000-$4000 a year).
This year our effective tax rate was about 5% since we received a large college credit for my husband’s graduate school expenses.
I’m one of those people who cringes at how much is taken out of my paychecks. So, yes, I feel like we pay enough to taxes. I feel worse for the people who really get hit hard…
I don’t want to get rid of road work or some entitlement programs, but I think the problem is mismanagement of funds, not the lack of them. I see how much is wasted in city construction and it makes me gag.
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Great article here and great comments from everyone. Taxes are painful and whatever insight I can gain here to limit the amount I have to pay, the better.
Thanks Darwin for the great info!
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