Mitt Romney’s federal tax rate has come under a lot of scrutiny with the battle for the republican primaries heating up. He released statements that showed his effective tax rate was around 15%. This number has come under attack from the White House and critics alike, pointing out that Romney, whose estimated net worth is over $250 million, is out of touch with the concerns and day to day life of the average American.
No doubt, it seems outrageous that a multi-millionaire who earned around $20 million dollars each of the last two years pays federal taxes at a rate of 15%. However, everything that Romney has done is perfectly legal. His effective tax rate of 15% is due mainly to the fact that most of his income is derived from capital gains. Whether this is fair or not, a lot of people like to compare their tax rate to this. The average worker making 50k is outraged that he pays 25% while Romney only pays 15%. But let’s dig a little deeper into these numbers.
Effective vs. Marginal Tax Rate
The United States has a progressive tax system in which the more income you make, the larger percentage of taxes you pay. The highest marginal tax bracket an individual can pay is 35% for those making $379,151 or more. But don’t be fooled by this number. As we see with Mitt Romney, the 35% tax rate on ordinary income does not apply to capital gains, it only applies to ordinary W-2 type income that you would receive from your employer.
The effective tax rate you pay is a more accurate representation of your taxes. It essentially calculates the true percentage of taxes you paid where as marginal is the tax rate the last and next dollar you make will be taxed at. A simple example:
Jerry makes $100,000 a year. Assuming no deductions, Jerry’s marginal tax rate will be 28%. But he doesn’t have to pay $28,000 in taxes. He pays 10%, 15%, 25% and 28% based on the tax brackets.
The bottom line is instead of paying $28,000, Jerry only pays $17,025. His effective tax rate is only 17%.
Keep this in mind when comparing your tax rate to Mitt Romney, you always want to calculate your effective tax rate when making comparisons.
How Can I Get Capital Gains
So let’s say you calculated your effective tax rate, and it’s still higher than 15%! Many savvy investors and high income earners invest in stocks due to the fact that capital gains are only taxed at 15%.
While you may not be able to get bonuses in the form of stock options like the big boys, you can always participate in employee stock purchase plans. These plans usually allow you to buy company stock at a discount and if you hold onto it for a year, you are able to claim long term capital gains and pay taxes at 15%. Essentially, you are trading your ordinary taxable income, which would be taxed at 25%, 28% etc. for capital gains income which will now be taxed at the favorable rate.
You can also earn capital gains the old fashioned way by purchasing stocks on the open market. Although this is a riskier strategy, it can work out well over a medium to long term time-frame. I would recommend low cost index funds that correlate well with the entire market. With this method, you are able to safely diversify and when you sell your shares you will only pay 15% taxes on your gains. It also allows you to tax harvest losses in down markets, effectively deferring your tax bill.
So, does it bother you that you pay more taxes than Mitt Romney or would you do the same thing in his shoes? I think all income should be taxed at a flat rate for those above a certain level(ie poverty line). What about you?
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Ah, if only the politicians and the talking heads on tv would calmly think about taxes as you just did in this post. But of course the whole Romney tax thing is not really about taxes, but about politics.
Personally, I don’t think raising taxes is the solution(my basic rule of personal finance: spend less than you earn). But in Obama’s defense, at least he is willing to raise taxes on himself unlike these other guys!
This is a great post. It shows that there is some logic to taxes, and the little guy doesn’t just get screwed!
I think taxing capital gains and dividend-income at a lower rate makes perfect sense. It provides an incentive to pur your money to work, which is good for the economy. Plus, anyone who says that long-term capital gains should be taxed just like income: are you willing to wait a year for your paycheck?
However, I’d like to see no taxes at all on income. I think we should only be taxed on the money we spend. That would provide an incentive to work and save, and a disincentive to spend. We know that saving is good for the economy (it builds capital for further expansion), and spending is bad (it depletes capital and leaves less room for expansion and error). If we were only taxed on what we spend, we may think twice about buying something we don’t need, and we may be a bit more willing to work a little extra if it means you get to keep more of what you earn.
*I stole the “tax the spending and not income” idea from Peter Schiff. And, not all spending is bad, provided it’s on something more efficient than that which already exists, and will result in more capital in the future (from a purely economic sense).
Thanks for the comment Matt. I really like your idea of taxation only on spending. Though, it would be hard to find that sweet spot between not spending enough(and hurting the economy) and spending too much(and hurting your own savings).
Either way, I like that capital gains/dividends are taxed at a lower rate now, however I think there should be some laws to prevent companies from giving out bonuses in the form of shares. This should be taxed as income. Actual investments into a company should be given the preferential treatment.
I agree. They are earned based on your work, ipso facto it should be considered wage income.