When has talking about your income tax bracket ever been more in vogue? It is center stage in the Presidential election, and, for the first time in history, the President's guest at the State of the Union address, Warren Buffett's secretary Debbie Bosanek, was invited simply because of her tax rate! Even though Warren Buffett says he would like to pay taxes at a higher rate, in my 24 years of being an advisor I have NEVER met a client that shares that view.
In fact, now that we know that millioniare Mitt Romney pays tax at an effective rate of just under 15%, that threshold has become a kind of new fashion statement. It proves that you are doing your duty as a citizen, but also that you are rich enough afford the kind of tax advisors who make sure you are nobody's fool, least of all Uncle Sam's.
So, let’s look at just a few ways you could qualify for that 15% clip. It's actually easier than you think:
- Be poor. Earn no more than $70,700 as a married couple and you'll be taxed at the 15% rate.
- Be average. According to the Bureau of Labor Statistics, the median earnings of the American worker is about $37,000, which after standard deductions puts that income in the 15% bracket.
- Be a struggling small business owner. Or at least appear to the IRS to be one. If you have show little net profit, you could easily find yourself in the 15% bracket.
- Be generous. A couple that makes over $75,000 but tithes to charity can reduce their taxable income to the 15% bracket.
- Be a saver. If you save a great deal by contributing to IRAs, SEPs or 401k plans, and invest in tax-free municipal bonds, you may be able to lower taxable income enough to hit the 15% rate.
- Sell your business, invest the proceeds and live off the returns. Succeeding as an entrepreneur and living off the fruits of that success is clearly the most desirable of all the alternatives. You owe only a 15% capital gains tax on realized gains for the sale of your business (assuming you've owned the business more than a year) and any long-term investments you own, and the qualified dividends your portfolio throws off are likewise subject to just a 15% haircut. That's essentially the secret to Mitt Romney's low tax rate (although his income qualifies for capital gains treatment for a different reason, which we don't need to get into.)
Now, according to President Obama, being wealthy and paying a 15% tax rate is unfair. But let's think about that more deeply.
Start by comparing the capital gains tax to the ordinary variety. To do so, think of the person that earns income, pays ordinary income tax on that sum and is THEN able to save some of what is left over. Those savings are invested in stocks, bonds or other business investments. When the investments are sold at a gain, a tax must be paid.
The capital gains tax is the only “second layer” tax listed above. You paid ordinary income tax to accumulate the capital you invested. So isn't it reasonable that Uncle Sam gets a smaller share when he comes back for a second helping? Further, the government sets capital gains tax at lower level to encourage business investments and turnover of capital. Is that unfair or good policy?
And if it's good policy, then paying a 15% rate isn't necessarily a sign of villany. It may well be a sign of being just as good a citizen as you are required to be. As Arthur Godfrey quipped: "I am proud to be paying taxes in America. The only thing is, I could be just as proud for half the money."
Mike Foltz JD, CPA, CFP contibuted to this article