Making Cents: How much tax do you pay?

There seems to be a lot of confusion in the popular press about how much tax is paid by the wealthiest Americans versus the hard-working earners without much accumulated wealth.

 To truly understand this political football, there are a few basic issues that need to be discussed.

Marginal tax bracket and average tax rate are two completely different terms.

The easiest to understand is your average tax rate. That is simply your total taxes paid divided by your total gross income.

Yet even here the numbers can get fuzzy. Are we talking about gross income, adjusted gross income or next taxable income? This number, as you’ve been hearing in the popular press, gets pretty low for all Americans.

How does the average tax rate calculate to be lower for wealthy Americans versus those with modest or no wealth? That happens because of a few items, such as capital gains taxes, tax-free income and deductions from state income taxes to charitable contributions that are significantly larger than most taxpayers.

Long-term capital gains are currently federally taxed at 15 percent, and they may go to 20 percent on Jan. 1. This 33 percent increase will be painful for those who generate much of their income through capital gains.

Tax-free income comes from investments in municipal bonds. With today’s low rates in other guaranteed-income-driven holdings, muni bonds still hold a place in a high bracket taxpayer’s portfolio. But the wealthy are also smart enough to do a before and after tax comparison to evaluate whether they may be better off investing in muni’s or taxable bonds.

The last item that impacts an average tax bracket is deductions. Most high-income taxpayers own a home, pay state income taxes and make charitable contributions. All of these deductible items combine to reduce one’s overall federal tax burden and, therefore, lower the average tax rate. Some or all of these deductions may disappear in the future, which could cause its own set of ripple effects in the not-for-profit or mending communities.

Now let’s explore marginal tax bracket. We all have heard that the fiscal cliff of expiring Bush era tax cuts will cause top income tax rates to reach 39.6 percent in 2013. What this means is that once your income exceeds the highest taxable income limit of $372,950 for married taxpayers in 2012, your next dollar of ordinary income will be subjected to the highest marginal bracket.

Remember this: Much of the preferentially-taxed items on a personal tax form, such as gains and muni bond interest, came from ordinary income that may have been taxed at the highest marginal tax bracket in the first place. Even those who built major businesses that were eventually sold and taxed as a capital gain paid a lot of ordinary income tax both personally and corporately.

 

John P. Napolitano is CEO of U.S. Wealth Managementin Braintree, Mass., and 2012 president of the Financial Planning Association of Massachusetts. He may be reached at jnap@uswealthcompanies.com or on Facebook as JohnPNapolitano and US Wealth
Securities offered through LPL Financial, Member FINRA/SIPC.

Investment advice offered through U.S. Financial Advisors, a registered investment advisor and separate entity from LPL Financial. The LPL Financial Registered Representatives associated with this site may only discuss and/or transact securities business with resident of the following states: AL, AR, AZ, CA, CO, CT, DC, FL, GA, HI, IA, ID, IL, IN, KS, KY, LA, MA, MD, ME, MN, NC, ND, NH, NJ, NM, NV, NY, OH, OK, OR, PA, RI, SC, TN, TX, UT, VA, VT, WA, WV. USFA, and U.S. Insurance Brokers, LLC are wholly-owned subsidiaries of U.S. Wealth Management. U.S. Wealth Management companies are not affiliated with LPL Financial.

The information being provided is strictly as a courtesy. When you link to any of the web sites provided here, you are leaving this web site. We make no representation as to the completeness or accuracy of information provided at these web sites. Nor is the company liable for any direct or indirect technical or system issues or any consequences arising out of your access to or your use of third-party technologies, web sites, information and programs made available through this web site. When you access one of these web sites, you are leaving our web site and assume total responsibility and risk for your use of the web sites you are linking to.