Monday, February 8, 2010

What is your effective tax rate?

Assorted international currency notes.Image via Wikipedia
Most people know their income tax rate, but have they considered their EFFECTIVE tax rate?

For people who are single, their effective tax rate is probably nearly the same as their real tax rate. However, for families, esp. those with children, the effective tax rate can be MUCH higher than the real tax rate. Why? It's because of our strange tax system and various income-based incentives in life, such as financial aid for schools, and in recent years, loan modification.

For example, here's a family. Father is working and earning a nice chunk of salary, and as kids are heading for college mother is contemplating going back to work. If she lands a local part-time teacher's position, which pays 35000, she will have to pay 15000 in taxes (income and payroll), lose 10000 of need-based financial aid of her kids (husband earns a lot), leaving her only 10000 ahead. In other words, her effective tax rate is not 35%, not 43%, but actually 71%.

No, the numbers are NOT made up. These are real numbers as published in a Forbes Magazine article (October 5, 2009) called "When Work Doesn't Pay". And this is hardly an anomoly.



Most financial aid are need-based, which is just another way of saying: the more your parents make and/or own, the less we'll give you in financial aid. Or restated for the parents: own little, earn little, and you'll get a lot of financial aid for your kids. And we're talking 10000 to 20000 (or more) PER YEAR PER CHILD in financial aid. That's not chump change. And you thought there's no free money in life? Sure there is... If you are "not rich".

Then there are the tax breaks, and there are several, most of which start disappearing after you go above 60000 per year income. You also lose eligibility for Federal Pell Grants, plus some tax deductions. This makes the effective tax rate higher than the 35% max bracket, without even counting "payroll tax" (i.e. Medicare and Social Security).

Or take the current Obama loan relief program "Making House Affordable" or something like that, which is a huge grant to pay for the loan modifications for mortgages from Fannie Mae and Freddie Mac and so on. In other words, it's okay to owe money; if enough of you owe a lot of money, government will help pay for some of it. Can you imagine some home owners with mortgages would purposely pay late a few payments, and wrangle a rate cut? No need to imagine it, as it has already happened... If your income is "low" enough. if you have higher income than that, you don't qualify for the loan mod, which is more "effective tax" on you.

While the details on the Obama health care reform is still sketchy, there would HAVE to some sort of income-based government subsidy, which will cut off at a certain point. If your income is above that, you are out of luck. Those subsidies you do NOT get are effetively a tax on you: for being not poor.

There's also the "marriage penalty", which I will not discuss here. It's well documented. Suffice to say, it makes NO SENSE for a couple to be married tax-wise in many instances.

A list of the problems with our current tax system will take much longer than I have space here. Suffice to say, the current tax system is seriously flawed. It has gotten away from its purpose to raise revenue to run the government, but has gone into attempt to legislate behavior. Want to discourage smoking? Tax tobacco products. Want to discourage driving? Tax gasoline. Want to encourage retirement savings? Eliminate taxes on retirement savings accounts. Want to help the poor? Give the poor lots of incentives and tax cuts and whatnot. The list goes on and on.

However, it is not my intent to rant about taxes, but rather, to remind you that just having the tax deducted out of your paycheck is not the end of taxation. Remember Rich Dad's lesson... "It's not about how much you earn, but how much you keep". You need to understand all aspects of where money can be saved, in order to make your decisions. You need to know how much of that dollar you can actually keep. If you end up keeping only 30 cents of every dollar you earn, you may want to consider some OTHER forms of income, such as investing in real-estate and stock market or even a business.

The long term solution is to get OUT of the middle class and become RICH. The middle class is under attack. The various tax laws are telling us either become rich (at which point you don't really worry about taxes any more), or don't work so hard (there's various incentives telling us NOT to work so hard). One more reason you need financial education ASAP.

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