Find out how income is really taxed and who pays the most.
Money Girl
253 MG Do the Rich Pay Less Income Tax?
In Colorado, our freedoms are everything. Gabe Evans would rip them away. Just like Lauren Boebert, he'd ban abortion without exceptions for rape or incest, and overturn the right to marry for same-sex couples. Don't let him take our freedoms. Paid for by DCCC, www.dccc.org, not authorized by any candidate or candidate's committee. "Is man up or here?" After investing billions to light up our network, T-Mobile is America's largest 5G network. Plus, right now, you can switch, keep your phone, and we'll pay it off up to $800. See how you can save on every plan for Verizon and AT&T at tmobile.com/keepandswitch. (upbeat music) Up to four lines via virtual prepaid card, a left 15 days qualifying unlocked device credit, service, ported, 90-plus days with device and eligible carrier and timely redemption required. Card has no cash access and expires in six months. (upbeat music) Hi, friends, this is Laura Adams, and you're listening to the Money Girl podcast. Since presidential candidate Mitt Romney revealed his tax return, which showed an effective tax rate of 15%, there's been a lot of talk about whether the rich get away with paying less income tax than ordinary folks. Today, I'll reveal how income is taxed and how much millionaires really do pay. (upbeat music) The first tax that we're all familiar with is income tax. It's a rite of passage to receive your first paycheck and be stunned by how much the government takes. There are four main types of taxes that employers are required to withhold from your paycheck. Number one, federal income taxes. Number two, state income taxes. Three, social security taxes, and four Medicare taxes. Additionally, depending on where you live and the industry you work in, you may also have unemployment, disability, and local income tax withheld. I'll summarize each of the four payroll taxes so you know what they are and how much you're paying for them. So let's start with federal income tax. It's collected by the Internal Revenue Service or IRS to fund the country's expenses for everything from education to the military. You pay federal taxes according to tax brackets, which are ranges of income that are subject to different tax rates. As your income goes up, the amount that falls into each of the six brackets is taxed at a progressively higher rate. In other words, federal income tax is staggered with part taxed at 10%, part at 15% and so on, up to the maximum tax bracket of 35% for 2011. To pay that top rate, you must have income that exceeds the highest threshold, which is $379,150 for single taxpayers. You don't typically pay tax on all your income. You're allowed to reduce your taxable income by certain amounts, including exemptions for the number of people you support, like yourself, a spouse, and dependents. You can also reduce your taxable income by claiming deductions for qualified expenses like medical care and charitable contributions. Additionally, the total amount of tax you have to pay is reduced if you qualify for a tax credit, such as the child tax credit. In addition to federal taxes, you may also pay income tax to your state, unless you live in one of the nine states that don't collect it like I do. They're Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming. State tax rates vary. However, they're generally treated as a deductible expense, which lowers your taxable income when you file your federal tax return. The last two payroll taxes, Social Security and Medicare, are collectively called FICA, which stands for the federal insurance contributions tax. If you're a fan of the TV show, Friends, you might remember the scene when Rachel opens her first paycheck and says, "I earned this, I wiped tables for it, "I steamed milk for it, and it was totally not worth it. "Who is FICA and why is he getting all my money?" I thought that was great. You're familiar with Social Security, a vast social program that provides income for the elderly, survivors, and the disabled. The Social Security tax rate is 6.2% for employers, and it's typically the same rate for employees. On income up to $110,100, there's no Social Security tax on income you earn above that amount. However, employees got a temporary 2% reduction in 2011, which has been extended into January and February of 2012. Right now, we don't know whether the reduced rate of 4.2% for employees will stick or go back up to 6.2%. Medicare is the federal health insurance program for those aged 65 or older. It also covers younger people with certain disabilities, but it doesn't pay all medical expenses or the cost of most long-term health care. The tax rate for Medicare is 1.45% for employers and employees, regardless of how much you earn. And by the way, if you're self-employed, you're required to pay both the employer and employee portions of Social Security and Medicare taxes. Now that we've covered taxes on your earned income, let's talk about how investment income is taxed. Let's say you earn interest on a bank savings account, a CD, or a bond. Even if you don't cash out the income, it's still subject to federal and state tax, but not Social Security or Medicare. Another type of investment income is stocks or funds that pay out a dividend. In some cases, the dividends are taxed as regular income, but in most cases, they're taxed as a capital gain. The capital gains tax is very different from ordinary tax on your income and interest that we've covered so far. - In Colorado, our freedoms are everything. Gabe Evans would rip them away. Just like Lauren Bobert, he'd ban abortion without exceptions for rape or incest, and overturn the right to marry for same-sex couples. Don't let him take our freedoms. Paid for by DCCC, www.dccc.org, not authorized by any candidate or candidate's committee. ♪ He's been up over here ♪ After investing billions to light up our network, T-Mobile is America's largest 5G network. Plus, right now, you can switch, keep your phone, and we'll pay it off up to $800. You can see how you can save on every plan for Verizon AT&T at tmobile.com/keepandswitch. (upbeat music) - Up to four lines via virtual prepaid card, a left 15 days qualifying unlocked device, credit, service, board, and 90-plus days with device and eligible carrier and timely redemption required. Card has no cash access and expires in six months. - I love learning and anything that makes learning easier. If you're a parent and your child needs some homework help, then IXL is a right for your family. IXL is an online learning program for kids covering math, language arts, science, and social studies. IXL has interactive practice problems for topics from pre-K to 12th grade, and everything is organized by grade and subject. As kids practice, they get positive feedback, awards, and explanations for wrong answers. IXL figures out what your kids need more help with and recommends more topics to practice. Their videos, lessons, sample problems, and learning games too. One subscription to IXL gets you all subjects and all grade levels. Membership started just $9.95 a month. It's no wonder IXL is used in 95 of the top 100 school districts. I think the positive feedback that IXL gives is really crucial when it comes to learning. So make an impact on your child's learning. Get IXL now, and money girl listeners can get an exclusive 20% off IXL membership when they sign up today at IXL.com/moneygirl. Visit IXL.com/moneygirl to get the most effective learning program out there at the best price. Okay, back to the capital gains tax. It's not levied on an ongoing or annual basis, like other taxes. It only applies when you sell a capital asset, like a stock or an exchange traded fund for a profit. If you've owned the capital asset for a year or less, that's called a short-term gain, and it doesn't get any favorable treatment. You pay the same tax rate as for ordinary income, which as I mentioned, ranges from 10% up to 35%. However, when you've owned a capital asset for more than a year before selling it, the very favorable long-term capital gains tax rate applies, which is capped at 15%. For instance, if you sell a stock that you own for more than a year and make a profit, no matter how much you earn or how wealthy you are, you don't pay more than 15% tax on that income. That's obviously much lower than the 35% maximum tax rate on ordinary income. Additionally, capital gains are not subject to Social Security or Medicare taxes. This should shed some light on why a multimillionaire, like Mitt Romney, had an effective tax rate of 15%, most of his income comes from long-term capital gains and dividends on his investments. Recent IRS data shows that the average tax rate for all American taxpayers is 11%. Here's how the average tax rate breaks down by earnings. If you earn less than $100,000, you're paying an average tax rate anywhere from 0 up to 8%. If you earn 100,000 up to half a million, the data show you're paying an average tax rate from 12 to 19%. If you earn half a million up to a million, you're paying an average tax rate of 24%. And if you earn a million up to 10 million, you're paying an average tax rate from 25 to 26%. So the data shows that even with the very preferential tax rate on capital gains, those earning half a million or more still pay at least twice that of the nation as a whole. Romney's rate of 15% is higher than the average of 11%, but is considerably less than other multimillionaires who are shelling out around 25%. You can use the marginal tax rate calculator at dinkytown.com to find out what your average tax rate is and see how you stack up against Romney. I'll put a link to the calculator, the IRS data, and other resources on the MoneyGirl page at quickanddirtytips.com. Just look for episode number 253 titled, "Do the Rich Pay Less Income Tax." If you have tax questions, post them on the MoneyGirl Facebook page. If you're on Twitter, be sure to follow me under username @LaraAdams. It's L-A-U-R-A-A-D-A-M-S with no space. And you can learn much more about taxes in easy-to-understand language. When you read my book, MoneyGirl's Smart Moves to Grow Rich. It's available at your favorite bookstore in print or as an e-book for your Kindle, Nook, iPad, PC, Mac, or smartphone. Why don't you download two free book chapters at smartmoves2growrich.com. I'm glad you're listening to change. That's all for now. Courtesy of MoneyGirl, your guide to a richer life. [MUSIC PLAYING] In Colorado, our freedoms are everything. Gabe Evans would rip them away. Just like Lauren Boebert, he'd ban abortion without exceptions for rape or incest and overturn the right to marry for same-sex couples. Don't let him take our freedoms. Paid for by DCCC, www.dccc.org, not authorized by any candidate or candidate's committee. Imagine earning a degree that prepares you with real skills for the real world. Capella University's programs teach skills relevant to your career so you can apply what you learn right away. Learn how Capella can make a difference in your life at capella.edu. See you. [BLANK_AUDIO]