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How Much Are You Really Taxed?
Here's something an older friend quipped the other day: If your wife wants you to buy her an expensive item, tell her, "Why yes of course dear, but only if you pay the taxes on it". (This clearly wasn't marriage advice and this friend is no longer married.) If she really wants said item, she might calculate the tax liability as the cost of the sales tax - let's call it 10% for easy math - and agree to pay it. That's $300 on the likely overpriced $3,000 item. But that $300 would not be accurate my friend says.
Also, let me preface this with a disclosure that this is an oversimplification of tax liability. There are several exceptions and nuances which cause too much complexity if they were included in this illustration. Therefore, this scenario is to give a general portrayal of tax liabilities, not specifics.
For him to pay for that $3,000 item- actually, it just became $3,300 because of the sales tax - he would have to have an income of $5,196 (assumptions below*****, using taxable income of $418,850). So, his wife would really "owe" $1,896. After all, they would owe 22.84% ($1,187) in federal taxes (22.84% effective fed tax rate and 32% marginal tax bracket) and income taxes to the state of Missouri of 6% ($312). And, since he is a W2 employee, he has to pay 7.65% ($397) in payroll taxes^. The payor of this 7.65% tax is going to get this back via social security and Medicare when he is older (supposedly). But, when and if he does get that back, he'll most likely have to report it again for taxes.
So, again, the husband would only have available $3,300 in cash for the said item once he has earned $5,196. Then, after amounts owed to the federal government, to the state of Missouri, and for payroll taxes, he would have available the cash for the item. That's a total tax rate of around 36%, and does not include the 10% sales tax.
We can use this same framework for thinking about how much we pay for items taxed differently than goods and services. Let's take for example stocks. Thankfully, there is no sales tax on stocks. Unfortunately, though, the alternate tax is sometimes higher: the capital gains tax. You pay the capital gains tax when you sell the stock and realize a gain. The long-term capital gains tax rate for this couple is 15%. So, let's say they buy $10,000 worth of stock. First, to get this $10,000 cash in the bank they need to earn around $15,746 (using the aforementioned assumptions for federal, state, and payroll taxes). So, they have to make $15,746 to get $10,000. Then, they invest that in a stock for 366 days (to ensure long-term gains) that appreciates 10%. So, his $10,000 has become $11,000. He has a long-term realized gain of $1,000, of which he owes $150 (15%) in taxes to the feds. The $1,000 becomes $850. Also, this does not include state capital gains taxes or the 3.8% NII tax.
Now, let's say they wanted to buy a car for $30,000. If the sales tax is 10%, that car just became $33,000. For them to have the $33,000 cash to pay for the car, they need to earn $51,960. Then, after they buy the car, they owe personal property taxes. Let's just call it 8% (St. Louis County*). The assessed value is around 1/3 of the real value. So, for the first year, they will be taxed 8% on 1/3 of $30,000. That's about $800. Don't forget, in order for them to have that $800 to pay those taxes, they need to have earned $1,260 in income.
Now, real estate taxes. Let's say they are going to buy a home for $600,000. They are going to put down 30%, $180,000, and mortgage the rest. To have that $180,000, they need to have earned $283,420 (or have appreciated real estate, stock, etc. But, for the sake of this let’s assume it’s from income.) Then, each year, they need to pay real estate taxes on that home’s value. A $600,000 home in St. Louis County might have around $5,700 in real estate taxes each year*** (this of course varies by municipality). And again, to pay that $5,700, they'll need to make $8,975.
And, in the end, if after all these taxes they are fortunate enough to have a certain high dollar amount of assets, then there are death taxes of 40% on your estate over a certain limit. That is 40% taxes on their bank accounts, investment accounts, businesses, etc. Being from St. Louis, we can blame the death tax for us ultimately losing the Rams to LA. Georgia Frontiere’s children, who inherited the team, had to come up with cash to pay the estate taxes (AKA death taxes) on the value of the team. While NFL franchises aren’t all that liquid, the IRS demands it be paid in cash. Frontiere’s kids had to sell their ownership in the Rams so they could raise the cash to pay the 40% taxes on her estate. They probably wish she would have had an estate attorney and financial planner. The estate of course sold the team to Stan Kroenke, who moved the team to LA.****
So, after all this, who cares, right? This is unavoidable and exhausting. Plus, these taxes provide us with vital infrastructure and other services. So, what should we do with this information? The whole point of this post is to encourage you to try to be as tax-efficient as you can with your investments. While you can’t really control the aforementioned taxes, there are things you can control. Check out our page here for more information. Research it yourself, hire us for tax-efficiency, or hire a CPA for more specifics, so you can use the tax code to your advantage.
On the other hand, and in another post, there is more you might be able to do, which is to try to get paid in different ways or to form a business. All the above applies mostly to a W2 employee. But what about 1099 employees and contract workers? What are the benefits and pitfalls? What about starting your own LLC or corporation and being a business owner? Most wealthy people build their wealth not from their W2 income, but from their equity investments. How can you structure your income and your assets so that your wealth might accumulate more efficiently? We'll try to address that in a post down the road.
And finally, to answer the original question and in case you aren’t yet aware, what is tax liability?
Tax liability is how much you have to pay in taxes. It is what you are liable for. Many times, this just refers to your tax liabilities to the IRS, i.e. federal income taxes. Whatever you owe that was not withheld from your paycheck throughout the year is close to what you will need to pay after you file your taxes. If more was withheld than what you owe, then you will receive a tax refund check. But tax liability, in general, extends further than your income tax return showing what you owe the Internal Revenue Service. There is also state government tax, sales tax, and capital gains tax. Here is a list of some of the main types of taxes:
Types of Taxes:
- Federal Income Tax
- State Income Tax
- Payroll Tax
- Sales Tax
- Capital Gains Tax
- Personal Property Tax
- Real Estate Property Tax
- Estate Taxes AKA Death Taxes
*****Calculations and Assumptions
Assuming married file jointly with taxable income of $418,850.
Effective Federal Income Taxes: $67,206 + (0.32 * ($418,850 - $329,850)) = $95,686
$95,686 / $418,850 = 22.84% Effective Tax Rate
Effective State Income Taxes: 6% = $25,131
Payroll Taxes: 7.65% = $32,042 (not accurate because this is applied on gross pay - not taxable income. So, the amount given here is smaller than in reality.)
Total Effective Taxes: $152,859 / $418,850 = 36.49%
Cost of item with 10% sales tax = $1,100
$3,300 / (1 - 0.3649)
$3,300 / 0.6351 = $5,196.03
Sources & Notes
^ payroll taxes are assessed on gross pay, not taxable income, so this would like be higher than stated. https://smartasset.com/taxes/all-about-the-fica-tax