Your Effective Tax Rate Defined. How Much Tax Do You Really Pay Uncle Sam?

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You’ve seen me use the phrase effective tax rate quite a bit. What is an effective tax rate? What is yours? Why is it such an important topic for discussion and why should you know about it?

Here is how Wikipedia defines effective tax rate:

“An effective tax rate refers to the actual rate, i.e., the rateexisting in fact. Both average and marginal tax rates can be expressed as effective tax rates. The effective tax rate is the amount of tax an individual or firm pays when all other government tax offsets or payments are applied, divided by the tax base (total income or spending).  If certain groups have high degrees of tax offsets compared to other groups, their effective tax rate will be different, even where their official tax rates and marginal tax rates will be equal. The effective rate of tax can often be discussed in terms of the effective marginal rate of tax – namely the amount of effective tax paid as a percentage of the last dollar earned or spent.”

So what does this mean in English?

Knowing what your effective tax rate is important because this number tells you how much you are truly paying Uncle Sam in taxes each year. So while you think you are making $80,000 a year, you are not really keeping that entire amount.

Further, just because you think you are in the 25% tax bracket because the IRS website says so, you may assume that you are paying 25% of 80,000 (or $20,000) in taxes and taking home the remaining $60,000 (or 75%)?

The 25% in this case only refers to your Federal Tax liability. If you think about your tax liability using this perspective, you are significantly understating your tax obligation and misleading yourself in terms of your take home pay and how you should be preparing your budget (expenses).

Different components of your effective tax rate – The different taxes

While you are obligated to pay Federal Taxes on your earned income, you are also obligated to pay the following taxes:

• State tax – unless you live in one of the 11 states that do not tax your income, you are typically taxed anywhere between 1-4% depending where you live.
• City tax – if you are working in a city that administers its own income tax, this is an added tax liability you have to factor into your total tax obligation. For example, the city of Detroit taxes income at roughly 2%.
• Social Security tax – Everyone pays Social Security tax. It is made up of two components, which add to approximately 7.65% (you are only taxed up to a certain amount of income).

Each of these taxes individually are absolute tax rates, but collectively they contribute to your overall effective tax rate. So while some people think they only pay 25% in tax, they are really paying 25% + 4% (let’s assume for simplicity) + 2% + 7.65% = 38.65% before any adjustments and deductions to their taxable income.

This means for every dollar you earn, you have to pay 38.65 cents of it in taxes. That is almost 40%. To put things in another perspective, you are essentially working January through May just to pay your tax bill. You don’t really start earning the money you get to keep until May. Yes that sucks.

Your taxable income and allowable deductions

You pay tax on your taxable income (also known as your “tax base”), not your gross income. Your taxable income is calculated as your gross income, adjusted for any adjustments, minus the various kinds of allowable deductions by the Government. Your income, adjusted for the adjustments is referred to as your Adjusted Gross Income, most commonly referred to as your AGI.

If you don’t have a side business and all your income comes from employment, you cannot really lower your AGI (there are some exceptions such as stock trading losses – but that is beyond the scope of this discussion). You are however entitled to two basic types of deductions that every tax filer is entitled to, the Standard Deduction and a Personal Exemption amount.

Your overall taxable income is calculated by taking your AGI, and subtracting the above two mentioned deductions. In 2010 the Standard Deduction is $5,700k for singles and $11,400k for married couples. The exemption amount is $3,650 for each person that you claim as a dependent on your tax return. For simplicity, let’s assume the case of a single individual with no additional dependents:

• Gross Income: $80,000
• + or – Deductions (none)
• = AGI: $80,000
• – Standard Deduction: $5,400
• – Personal Exemption: $3,650
• = Taxable Income: $70,950
• Tax owed to uncle Sam assuming the percentages above:
• $70,950 X 38.65% = $27,422

The individual made $80,000 in gross income, but because of the tax bill, they only took home $52,578 ($80,000 – $27,422).

As you can see, because of the deductions, the individual was taxed on a lower taxable income rather than the full $80,000. Therefore, this individual’s effective tax rate is only 34.28% (which is the tax $27,422 divided by the gross income $80,000). This means that instead of paying 38.65 cents out of every dollar earned, this individual is only paying 34.28 cents and pocketing the rest.

So back to the definition of the effective tax rate – it is basically the amount of total tax paid divided by the gross income. Because adjustments and deductions to income lower the taxable income, your goal should be to accumulate as many adjustments and deductions you legally can to bring your tax liability down. The lower your tax liability, the lower your effective tax rate becomes. This is how you get ahead of the game, and a side business certainly helps you accumulate those deductions.

If you want to know my definition, your effective tax rate is the percentage of your earned money that you owe in taxes. Therefore, the lower this number is, the more money you get to keep in your pocket.

Note: The Government introduces several new adjustments and deductions to arrive at your taxable income depending on certain initiatives and agendas. These vary every year.

Another thing to note is that individuals in certain situations are allowed to “itemize” their deductions (this is beyond the scope of this discussion). When you itemize deductions, you cannot take the standard deduction. It’s one or the other. Majority of tax payers select the standard deduction option for either ease of tax filing or because they do not qualify to itemize.

Key lesson learned

What is the key lesson you should take away from all the jibberish above? Simple – lower your taxable income as much as possible to lower your effective tax rate.

And how can you reduce your effective tax rate? By reducing your tax base, which is achieved through adjustments and deductions to your gross income. Put in another way, your taxable income is the driver of your effective tax rate. Your adjustments and deductions to your gross income drives your AGI and taxable income.

In addition, when you lower your AGI, you have a good chance of lowering your federal tax bracket. So while we used the assumption of 25% in the example above, this percentage can be reduced to 20%, 15% and even 10% depending on where your AGI falls. You can view a complete tax rate table on the IRS.GOV website.

If you want to see a more detailed example of how your effective tax rate can be managed, read my post titled Why pursue a Side Business when you already have a full time career where you can see how just a 1% difference in your effective tax rate can mean thousands of extra dollars in your pocket each year. This means tens of thousands over few years. What would you do today with tens of thousands of extra dollars in your pocket?

How does the effective tax rate apply to companies?

If you are wondering how a company is treated for tax purposes, it is really treated not much different from an individual. A company, or a C – corporation more specifically is treated as its own living and breathing entity.

All its profits are taxed by the Federal Government, as well as the various other jurisdictions it operates under. Because larger companies operate in multiple states, they end up paying taxes everywhere they do business.

Corporations, just like individuals, are allowed to take certain deductions to their profits to reduce their taxable income. So when companies file their tax returns each year, they take advantage of these deductions to reduce their taxes as much as possible.

Companies, because of the nature of their business, are entitled to all kinds of adjustments and deductions to their income. For tax purposes, they are allowed to expedite some deductions (reversible deductions), which means they pay less tax today and more in the future (also called a deferred tax liability or DTL).

Alternative, for various purposes including tax planning, companies may decide not to expedite tax deductions, which means paying more tax now and less later (also called a deferred tax asset or DTA). In the world of CPAs, they refer to these deductions as timing differences, reversible or temporary deductions.

There are other deductions to income that companies are allowed to take which they do not have to reverse in the future. These are called permanent deductions. It is the permanent deductions which lower the company’s overall effective tax rate by putting more money back into the company coffers.

These mechanics also applies to individuals with certain types of businesses and operations. For example, an individual who has a real estate rental business can benefit from the depreciation of the property (a non cash expense on the tax return) and therefore reduce their tax liability in the current year.

However, the individual will have to recapture the depreciation upon time of sale and pay taxes at that point. In this case, the individual manages to delay the tax payment by a few years (similar to a temporary deduction for a company). I will not go too deep into this because it is beyond the scope of this article. Suffice it to know that individuals can also engage in effective tax planning, but only when they have side gigs outside their normal employment.

How can a Side Gig lower your effective tax rate?

Notice that in the example above, the individual had no adjustments to gross income and therefore their AGI was the same as their gross ($80,000). Now let’s assume this individual had a part time gig. Let’s also assume that the individual’s part time gig is profitable, but because business owners are allowed significantly more tax deductions, let’s assume the individual is showing a net business loss on paper. A loss on paper does not mean that the business did not make money. This just means that for tax purposes, the business generated a loss. Let’s assume this loss amounts to $5,000.

Note: There are several business related expenses that may overlap your personal expenses such as your cell phone, mortgage or rent payment, gasoline, utility bills, etc. If you did not own a business, you would spend money on these expenses anyway in due course of life. But when you have a business, you are allowed to deduct part of these expenses as business related.

In addition, there are several “non-cash” business expenses such as depreciation of equipment or your vehicle. Non cash means that you can benefit from these expenses on paper (when filing taxes) without really having to spend any money and incurring “actual cash expenses”.

So let’s plug-in the individual’s loss into our tax formula:

• Gross Income: $80,000
• + or – Deductions: -$5,000 (business loss)
• = AGI: $75,000
• – Standard Deduction: $5,400
• – Personal Exemption: $3,650
• = Taxable Income: $65,950
• Tax owed to uncle Sam assuming the percentages above:
• $65,950 X 38.65% = $25,490
• Effective tax rate = $25,490 / $80,000 = 31.8%

What just happened here? Initially, the individual’s tax rate was supposed to be 38.65%. The because uncle SAM pretends to be nice sometimes, the effective tax rate was lowered to 34.28% (see above). But because this individual is smart and decided to start a part time business on the side, they were able to reduce their effective tax rate further down to only 31.8%.

What does this mean in terms of real money? Assuming you make $80,000 a year, a difference of 6.85% (38.65% – 31.8%) in your effective tax rate translates to $5,480 extra dollars in your pocket each year. That is over $54,000 over 10 years! The more your income increases over time due to promotions, bonuses and such, the bigger the actual tax benefit will be to you. So is it worth it? You bet?

Do you see why starting a part time business on the side is the best proactive approach to effective tax planning and getting ahead financially? Not only are you reducing your tax liability, but you are also doing it legally as allowed by the tax code. You are legally avoiding paying a large tax amount. There is a huge difference in tax avoidance and tax evasion.

I’m assuming you either already have a part time business or are interested in starting one, otherwise you wouldn’t be reading my blog. In order to execute this strategy effectively, education and awareness of the subject matter is your first step. I highly recommend familiarizing yourself with the tax advantages of starting your own business. A few highly recommended resources are: IRS.GOV, Wayne Davie’s The Ultimate Small Business Tax Reduction Guide and Greg Watson’s Internet Marketing Tax Guide.

After you have digested the material, go get yourself a smart CPA or financial planner who knows what they are doing. They will be able to guide you further on how you can take advantage of the single best thing you can do for your personal finances. I have helped a ton of my friends and family get on this path. Once you are on it, ongoing maintenance is very simple. A CPA will also be able to tell you about the latest tax credits which may apply to your situation. Tax credits directly impact your tax liability and lower your effective tax rate.

I will leave you with one caution – unless you are a CPA yourself, or just really good and confident, I do not recommend experimenting with this kinda thing. One mistake can cause the IRS cops to line up outside your doorsteps. While online tax software may be alright for a relatively new entrepreneur, A CPA will be able to guide you more thoroughly on how you can take advantage of the single best thing you can do for your personal finances.

It’s worth shelling out a few hundred dollars each year to get a professional to:

1. Set up / incorporate your small business legally and the right way
2. Bring you awareness of the latest and greatest adjustments and deductions each year and
3. Help you with tax compliance (filing taxes)

Although this discussion was purely in context of the US tax system, most tax systems around the world generally follow similar theory.  A few hundred dollars invested today can mean tens of thousands of extra dollars in your pocket in the coming years. You know what you need to do, so go do the right thing.

What about you? Do you know what your effective tax rate is? What are you doing to reduce it?

Here are some of my tax planning articles you might enjoy, some of these help reduce your effective tax rate.

Sunil
Pocketing More