As a lawyer, estate planning consultant, and writer, I talk to a lot of parents about planning for their family’s financial future. And I’ve noticed that certain questions come up over and over again, regardless of how many children you have, how much you make, or where you live. With that in mind, I’m excited to share some of them with Mainstream Mom readers over the next few months. I hope that they will help inspire you to think and talk about these important issues, because the Happiest Parent is the one who plans for their child’s long-term well-being, no matter how hard it may seem today. – Jacoba Urist
Tax season is right around the corner, and I’m getting lots of tax law questions from all the different moms I run into. With that in mind, I’m going to be sharing the most important ones I hear (and the ones I’m asked over and over) with Mainstream Mom readers in a special series of tax-related questions and answers leading up to April.
The President mentioned in the State of the Union that an assistant can pay more taxes than a billionaire. Can you explain how this could possibly be true?
This issue has been a political flashpoint since September, due largely to the famous billionaire Warren Buffett who’s been saying that the government should tax wealthier people (like him) more than it currently does. And everyone, from my family finance clients to the mom getting a manicure next to me has questions about it. How on earth, can one of the richest men in the country pay less in taxes than his secretary?
Let’s start at the beginning. The United States has a progressive tax system, which means that people who make more generally pay a higher percentage of their income to the federal treasury than those who make less. Under a progressive system, the first dollar you earn is usually taxed at a lower percentage than the last dollar. (We also have FICA taxes, which finance Social Security, but, for now, let’s stick to the income tax).
When it comes to figuring out your personal tax rate, it helps to think about two different numbers. First up: your marginal tax rate. This is the highest tax bracket you fall into, or the rate at which the last dollar you make is taxed. The other is your overall tax rate, which — true to its name — is the overall percentage of taxes you pay out of your income to the IRS every spring. For example, if you make $100 but “bring home” $80 after taxes, you’re overall tax rate is 20%.
Okay, you say: so far, so good. But that still doesn’t explain why a major player in the world economy pays less than the person who answers his phone. Well, nobody is saying that she pays more than Buffet dollar-for-dollar. The overall number she gives the IRS is smaller than his tax bill. Politicians are talking about the overall percentage of her income that she forks over to the US government every year: and that can be higher than her boss’s for several reasons.
And here’s where people get super confused. The tax law treats different kinds of income differently, so not all the money you take in over a year is taxed at the same rate. For instance, the wages you earn from your employer (or you earn for yourself if you’re self-employed) are taxed as “ordinary income.” Traditionally, these are the highest rates in the tax code. But the profit you receive from the sale of an investment, like your home or stock in your portfolio, is called a “capital gain” – and is taxed at a much better, lower rate than your paycheck.
You may have also heard about something called carried interest, which has generated quite the stir in the press and the policy world because it’s taxed extremely favorably (like capital gains) and is usually earned by people who already have considerable wealth. Most recently, presidential hopeful Mitt Romney has come under fire for having a super low 14% tax rate because so much of his income falls into this category.
So what is carried interest and why so controversial? Well, carried interest is a type of income earned by certain investors of private equity and hedge funds that can start to look a lot like the ordinary compensation the rest of us pay a higher tax percentage on.
On the flip side, people who defend the lower rate argue that carried interest represents a return on the fund’s underlying investment, which they say looks more like a gain from the sale of a profitable chunk of stock.
Now back to Buffett. Much of his annual income comes from the tax-favored forms we talked about – capital gains, carried interest – and not the straight-up paycheck you and I are used to seeing in our checking account every few weeks. His assistant’s, on the other hand, is good, old-fashioned, ordinary income. So, yes, at the end of the day, Warren Buffett’s overall tax rate can be lower than the woman who gets his coffee every morning.
Remember: whether you think the system is fair as it is, or you feel the tax laws need a complete makeover, the most important thing every financially savvy mom can do is pay attention to what the candidates say about this issue, and make time in your busy schedule to vote next November- no if, and’s or but’s.
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