Don’t Pay The Maximum Income Tax Rate

by James on January 6, 2013 · 2 comments

1040 HelpFolks,

It is Sunday, January 6th, 2013.  This posting is on income taxes and why minimizing them is an important part of your personal finances.

There seems to be an regrettable attitude among some members of the public and among the media that it’s cool to pay a lot of income tax. People frame this in terms of “patriotism” or “paying your fair share”. The thinking goes something like this: you shouldn’t focus on getting around taxes because taxes pay for a lot of good things, like police, social security, etc.  Thus, because you support America, you should pay the maximum amount of tax. Many people also feel the obligation is moral, e.g. you should be subject to the maximum pecuniary obligation because it is immoral that some people pay more of their income to support society than others.

Someone is going to pay the maximum tax rate, but it shouldn’t be you.  Why?

There are lots of reasons why this is the case, but since the ideological ones are tired and hackneyed at this point, lets just focus on the practical questions.

First, income taxes are likely to be one of your major expenses.  The median U.S. income in 2011 was $50,054 (1).  This puts the average American squarely in the 25% tax bracket if you’re filing single.  This means that Joe or Jane average is coughing up $12,514 dollars in income obligations.  Twelve thousand is enough to pay for rent for a year or enough to purchase a good quality car – its a significant expense.

Second, there are huge opportunity costs to high taxation.  By opportunity costs, I mean what you could have had if you weren’t paying taxes.  Take the example we’ve been discussing previously.  Lets say you were able to shave 10% off of your income tax bill – about $1,200.  Lets say you took that $1,200 and made a one time investment paying you 7% (which you can do easily in the stock market or with peer to peer lending).  After ten years, you’d have $2,360.58. Which is enough for a car down payment or several months worth of food for your household.  So, if you aren’t paying the maximum tax rate your purchasing power can be freed up for other things.

Basically, the bottom line is that tax avoidance is highly practical for most people because of the huge expenses and associated opportunity cost associated with the income tax.

Now, the issue becomes how you should avoid the government’s levy.  Obviously, anything illegal or even legally questionable should be avoided at all costs.  It is not worth the impact on your career, your family and your reputation to even consider getting involved with anything that has even a hit of impropriety.  Don’t jeopardize your good name and your family to try to save a few grand.

On the other hand, do maximize the use of legal tax shelters.  Some tried and true approaches include: starting a small business to take additional tax deductions, utilizing 401ks and ROTHs to avoid taxes, family income shifting (i.e. giving money to your kids or family), owning rather than renting – taking advantage of deductible interest on your mortgage, buying rental properties to deduct expenses related to that business (though this has limitations), putting money away for your child’s education (only after you are financially secure and maxing out your retirement), and funding retirement accounts for your children if they earn income.

Finally if you want to get the latest on taxation, consider checking out Getting Your Financial Ducks In A Row, which is an excellent blog dealing with basic income tax issues for individuals.

Best,

James

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{ 2 comments… read them below or add one }

1 James January 6, 2013 at 9:20 pm

You shouldn’t expect people to take your thoughts on taxes seriously when you don’t know how they work. If a single person makes 50,054, the first $8,700 is taxed at $870 (10%). The next $26,650 is taxed at 15% so that’s $3997 more. The earnings *above* $35,350 are taxed at 25%, another $3,676. That’s $8,543 in tax before standard or itemized deductions. With standard deduction the tax would be around $6,000.

2 James January 12, 2013 at 11:00 am

Hi James,

Thanks for taking the time to write. In point of fact you are correct about the graduated nature of income taxes. I went ahead and pulled the tax tables for 2011. If you take an individual who earns 50,054 married filing single then their Federal income tax obligation is about $8,644. Once you tack on other obligations like state income taxes, social security, etc. Then you are likely to easily be looking at a figure of $12,000.

So, while you are correct about the math, the main point still holds. People should be maximizing the use of legal income tax shelters as much as possible.

Thanks,

James

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