The Top Tax Rate is Higher Than You Think

I heard a story. The person was trying to figure out a tax question for a friend of a friend, so I don’t know any actual details, and, like a good game of Telephone, what I did hear was probably altered beyond recognition (oh, you sell plants and seeds, not sex and weed!).

Even though it’s all probably wrong, it got my boss and I talking about the top tax rates in the United States.

The basic tenant of the story was that some guy got a notice from the IRS claiming he owed an additional $90,000 for 2014. The guy agrees to the bill and pays it.

“Wait a minute,” I interrupted before the storyteller could even get to the question, “the IRS claimed he underpaid $90,000 for just one year of taxes. And he just paid it? Just like that? Did he have that much cash hidden in the walls of his banana stand or something?”

“He makes a lot of money.”

Apparently.

I’ve worked with plenty of clients that make a lot of money and have paid a lot of taxes–much more than a measly $90k–but they’ve never been in my social circles, or the social circles of the people in my social circles. I was so hung up on that amount of money as an UNDERPAYMENT for the year that I couldn’t even get to the actual question.

So I dug into the story. The guy was making a lot of money in his business, and he paid taxes on that. His wife was making about $60k a year as a contractor, and she wasn’t paying any taxes on that. So all the underpayment was related to her work.

“She has a 150% tax rate?” I asked.

“No, the guy told me she was making $60k at first, but it turned out she was making more. And some of the taxes were for him, too.”

 

That’s where the fun began. We sat down and decided to back into the least amount of money she could be making and still pay $90k. It was an exercise on figuring out the top tax rate in the United States.

Yes, I know. Calling something like this fun is why accountants don’t have any friends.

Anyway, let’s assume her husband’s income puts them in the top marginal income tax bracket, which is currently 39.6%. Fiddling around with my fractions skills, it would mean she could make $227,000 and pay $90,000 in taxes.

But that’s way more than she was actually making. We had to get it lower.

She’s working as a consultant, which means none of her wages have any payroll tax withholdings. That tacks on an additional 15.3% (yes, it’s not a straight 15.3%, since it partially cuts off at a certain level, plus there’s a partial deduction, but this is just for fun, so let’s roll with it).

Combining 15.3% with 39.6% gets us up to a 54.9% tax rate. That’d take her income down to around $164k.

But wait, we have to include state income taxes. Colorado’s tax rate is a relatively low 4.63%, taking our total to 59.53%, bringing her income down to around $151,000.

 

Let’s say it was in California, which has the top marginal tax rate in the country.  Her tax rate could be as high as 68.2%, which means she’d be paying $90,000 in taxes on as little as $132k.

Well, not really. My back of the napkin calculation puts it closer to $140k, estimating for the Social Security Tax limitation and Self Employment Tax deduction.

Still, doing $140,000 of work and coming home with only $50,000 is a little crazy.

I don’t feel too bad for the person in this hypothetical situation, and not just because she’s only hypothetical. Her income, combined with her spouse’s, would still be over a million, and they’d get a decent amount of take home pay on that. Still probably not enough to own a house in the Bay Area, but they’d be doing fine.

The example should give us pause. Politicians–typically Democrats, but sometimes Republicans–harp on our low relative tax rates of our rich vs. our European counterparts, citing the 39.6% top tax rate. But the 39.6% tax rate is an illusion, about as accurate as throwing darts at a board of percentages.

Looks like Spain and the US will be sharing a tax rate this week.

Looks like Spain and the US will be sharing a tax rate this week.

Our real top tax rate is, well, complicated. It varies from state to state, type of income, and a whole host of other things. Politicians hate complicated, though, so they don’t talk about it.

Here’s a real world example. Bernie Sanders waxed longingly for the 90% tax rate of the 50’s. Imma get technical for a minute, so feel free to let your eyes glaze over until we get to the final rate. The 90% rate is just Federal income tax, which you’d have to layer on the 2.9% Medicare Tax and the state income tax of up to 13.3%. Taking into account the Self Employment deduction and the State Tax deduction, the effective marginal tax rate would be about 92.93%.

If you then remove the limitation on the Social Security Tax, an idea that has been tossed around quite a bit, it’d take the effective marginal tax rate to up to 99.75%.

Whatever you think about income inequality or “the rich,” having a 99.75% marginal income tax rate is not good economic policy. Better than 150%, sure, but nobody’s going to want to have to earn $100 just to put a quarter in a gumball machine.

My point in all of this is just to say that any time you hear a politician taking about a tax rate–and most likely any reporter covering the story–they’ll be throwing out totally meaningless percentages. I can’t really blame them too much, since the truth is much harder to get to. But when we are proposing changes to our 39.6% tax rate, we have to realize that for some people that tax rate is closer to 68.2%.

It could be that 68.2% is totally the rate we need. I don’t personally think so, but it’s possible. If we’re claiming that someone is paying 39.6%, though, when the real rate is 68.2%, then we’re never going to come up with the right answer.