Planning

Do the Wealthy Really Pay Lower Taxes Than the Average American?

Tax Bill

As tax season comes to an end, many Americans grumble about the rates they pay and where their money goes.

In the past few years, the Occupy movement, presidential election and tax talk had many raising questions about who pays what in taxes.

Stories of teachers and plumbers paying higher tax rates than millionaire hedge fund managers have many taking a closer look at their tax returns.

While wealthy investors do take advantage of lower capital gains tax rates, few workers pay the percentages in their tax brackets due to deductions and exemptions.

Experts say the reality is that you likely pay less in taxes than you think, but there are some long-term moves you can make to reduce your tax burden even further.

Confusion about tax brackets

There’s often a large misconception about what tax rates people truly pay, says Adam Koos, Founder and President of Libertas Wealth Management in Dublin, Ohio.

He says very few people pay the actual percentage of their tax bracket, a problem that causes many tax payers to think they’re paying more in taxes than they do.

First, that’s because different portions of the income are taxed at different rates as they work their way up the scale. A single person earning $65,000 in 2012 would fall into the 25% tax bracket, but would have an effective tax rate much lower than that.

That’s because only the portion of the income over $35,351 is taxed at 25%, while the rest is taxed at 10% and 15%, as per the laddering schedule designed by the IRS. Throw in deductions and exemptions and the rate drops even further.

“By the time you take out standard deductions, exemptions and other things, you’re going to pay a lot less than your actual tax bracket. Most people pay a lot less than the number of their actual bracket,” says Koos.

Koos says many people don’t understand the concept of “effective tax rates,” the rate which for individuals is the total tax divided by taxable income. Mike Piershale, President of Piershale Financial Group in Crystal Lake, Ill., says tax rates “can be all over the place” depending on so many factors related to deductions and credits.

Two taxpayers with the same income could have drastically different effective tax rates depending on factors such as family size, the amount of mortgage interest they pay and investment losses.

Consider that a married breadwinner of a family of 4 who earned $65,000 in 2012 would have a federal tax liability of $2,815, or 4.3%. For a single earner with no dependents, that federal tax liability would be $9,843, a rate of 15%.

“You need to look at all the person’s taxes divided by their personal income. That is their income minus their deductions and exemptions. [Tax rates] can vary dramatically,” says Piershale.

Investment income versus earned income

The wealthy can sometimes pay lower tax rates than ordinary Americans because they often derive much of their income from investment income. This can come in the form of capital gains, dividends or both.

Capital gains and dividends are not taxed as ordinary income and are taxed at lower rates. Prior to 2013, the maximum long term (assets held more than one year) capital gains rate was only 15%.

Starting this year, the long term capital gains rate is 20%. There are also rates of 25% and 38% that can apply to other special types of net capital gains.

Koos says top capital gains rates have gone down over time from around 40% in the 1970s. The idea is that if capital gains rates are lower, investors will be more inclined to invest their money rather than sit on it or seek out other alternatives.

Regardless, many wealthy Americans often intentionally structure their income so that it comes from long-term capital gains in order to enjoy lower tax rates.

In any case, most capital gains and investment income is taxed at a lower rate than earned, ordinary income. That can technically put many investors in lower tax brackets than middle class working Americans, at least before the middle-class taxpayer factors in deductions and exemptions.

Consider that a single worker earning $75,000 in 2012 fell into the 25% tax bracket while an investor who earned $300,000 in dividends or long-term capital gains may have only paid 15%.

Another reason why workers often pay higher tax rates than investors and the wealthy is because their income is subject to FICA (Federal Insurance Contributions Act) taxes.

This is a federally imposed tax on both employers and employees that covers contributions to Social Security and Medicare. Investment income is not subject to FICA taxes.

Furthermore, FICA taxes phase out and max out at certain income levels. As of 2013, Social Security taxes are only taken out of the first $113,700 of income, for a maximum tax of $7,050.

So while a worker earning $50,000 per year is taxed at a rate of 6.2%, a worker earning $190,000 will essentially only pay 3.7% of their income towards Social Security taxes.

Piershale says that while it may seem distorted at times, it’s really only the “ultra wealthy” that may skirt away with lower taxes.

The moderately wealthy, doctors, attorneys or small business owners that may have household incomes of $250,000 or more per year, certainly pay a large share of taxes.

“They pay a lot more as a percentage of every dollar than the average person making $40,000 per year. Working people at upper income levels certainly pay a lot of taxes,” says Piershale.

Piershale notes that the self-employed, including high-level professionals and small business owners, are hit with more taxes because they have to pay the full share of FICA taxes.

“The self employed are hit with essentially double the rate of FICA taxes because they have to pay the employee and employer portions. Instead of 7.65%, it’s 15.3%,” says Piershale.

Think like the rich

As a worker, there may be little you can do to escape FICA taxes but there are some things you can do to minimize your federal income taxes.

Talk to your tax professional or use a home-based software program to ensure you’re taking full advantage of all of the tax credits and deductions you are entitled to.

There are also some moves you can make to minimize your tax burden later down the line. Koos says one of the biggest is to take full advantage of your 401(k) plan at work if your employer offers a match.

Contribute enough to take full advantage of the match which is essentially “free money.” After that, he recommends contributing as much as possible, or maxing out a Roth IRA.

While a Roth IRA will not save money on any taxes in the current year, it can pay off tremendously later down the line.

“Tax rates are near historic lows and we know that they’re probably going to go up over time. I’d say take the [tax hit] now and you won’t have to worry about it when you start yanking out money in retirement,” says Koos.

The Roth IRA is one of the best tax advantages for ordinary Americans because it lets your earnings grow tax free and when you reach retirement age you can make withdrawals tax-free as well.

Contribution limits are $5,000 for 2012, or $6,000 if you’re over 50. They’re likely to rise in the future but if you contributed $5,000 per year and your money grew at 7%, you’d have over $500,000 in 30 years. That could provide at least $20,000 per year in tax-free income.

“If you planned ahead, at least you could pay very little taxes in retirement. But you have to plan now,” says Koos.

Craig Guillot is a business and personal finance writer from New Orleans. He covers insurance, investing, real estate, retirement and debt. His work has appeared in such publications and web sites as Entrepreneur, CNNMoney.com, CNBC.com, Bankrate.com and Investor’s Business Daily. He is the author of “Stuff About Money: No BS Financial Advice for Regular People.”