Understanding the American Tax Code #2

Income vs Capital Gains

“Just because you do not take an interest in politics doesn’t mean politics won’t take an interest in you.” – Pericles

In part one we discussed how America’s marginal tax code works, and the most common incorrect assumptions American’s make about the tax code. Check it out here if you missed it. Now that we understand basic income tax, let’s move on to Capital Gains and how wealthy people who understand the tax code can pay a smaller percentage of taxes than you and your plumber. 

For math’s sake let’s say you make $500,000 and Warren Buffett(can’t seem to stop using him) makes $500,000, he will pay a maximum of $100,000 in capital gains taxes while you will pay $149,457 in income taxes. Check out part one for this how to calculate this. 

Now let’s bring this down to reality, Warren Buffett can make that with one mouse click selling a stock. A doctor or surgeon might earn a large salary like that, but is still clocking in many hours of actual life saving work. 

How does this happen, why would a doctor have to pay more taxes than a stock trader? Capital Gains. Capital Gains are any profit made from the sale of an asset, like property, stocks and bonds. Side note: You probably noticed, your average working man or woman doesn’t have any of those. The extraordinarily wealthy do not earn income. They put all of their money into assets that rise in value, like land, and sell them later for more money and pay a lower tax rate. 

Wealthy people don’t make large salaries, they operate in the realm of assets and capital. They are paid in stock options. They buy and sell property, and when they die their fortune goes untaxed into the hands of their children, staying out of the system. 

How could this be? Well, wealthy individuals started lobbying to change the tax code and they succeeded with the Bush Tax cuts. It is really a brilliant strategy, they know the tax code is convoluted and hard to understand, a perfect place to change the laws for your benefit. We know today that companies like Intuit spend massive amounts of money lobbying to stop efforts to simplify the tax code. This forces people to file with TurboTax, they then criminally charge you to file taxes after committing to the government that the service is free. Do you ever wonder why ideas like Ted Cruz’s simple tax postcard don’t happen? 

Understanding the American Tax Code

Part #1 Marginal vs Effective Tax Rate. 

Have you ever wondered why we were not taught about taxes in school?  It is safe to assume that the overwhelming majority of Americans have no idea what tax rate they pay. Below are the Marginal Tax rates in America, this is how we actually pay taxes. Marginal Tax means what percentage of tax you will pay on your next dollar earned. Effective tax rate is what percentage of taxes did you pay relative to all of your income. 

Let’s walk through this math, most people assume if you are the person making over $518,400 your taxes look like this-

Income $518,400

Tax rate x     .37

Equals $191,808 

This is NOT how our tax system works. The next dollar earned, marginal tax means that all people are taxed the same at each income level. You can’t pay 37% on your first $10,000  earned. The math works as following-

First $9,875 x .10 = $987

Next $30,250 x .12 = $3,630

Next $45,400 x .22 = $9,988

Next $77,775 x .24 = $18,666

Next $44,050 x .32 = $14,096

Next $311,049 x .35 = $108,897

Total taxes paid = $156,265 with an Effective rate of- 30% (156,265/518,400 = .30)

You might notice this misunderstanding is where you hear the line “If I make more I will go into the next tax bracket!” Only your next individual dollar will be taxed more. Imagine that, you make one more dollar and immediately the government takes and extra $10k, ridiculous! 

The key to remember is that everyone pays the exact same rate on their money, a billionaire pays the same taxes on their first $50,000 as you do, well unless they have a way to avoid taxes somehow…. Oh wait they do! 
The tax aversion conversation is for part #2, however let’s talk about effective tax rate. If you remember when Warren Buffett said he should have to pay more in taxes he made the claim that his effective tax rate was only 19% or less. How could this happen, isn’t the top tax rate 37%? Correct, however that is the top Income tax rate, billionaires don’t make income. They use the system to avoid fair taxation. Most of the ultra wealthy pay less of their total income as a percentage in taxes than the majority of working people. On part #2 we will dissect how billionaires avoid income tax.