Make more, pay less

June 15, 2011

Look closely - especially if you're at work - and you can actually see her soul leaving her body.

Dissatisfied in your job? Here’s the time-tested solution: tough it out, be thankful you have one, and come in next weekend just to emphasize the latter point.

Or you can tell The Man which orifice he can shove his company picnic and break-room coffee into, and go out on your own. Incorporate.

There are several volumes’ worth of reasons to do this. We can’t go into all of them now, but one of the best-kept secrets of incorporating is the regressive Social Security tax.

You might not be familiar with the concept of a regressive tax, but it’s easy to grasp. There are 3 species of tax:

-A proportional tax is one levied at a fixed rate. Sales tax, for instance. If your jurisdiction charges 7% sales tax, then any item subject to the tax costs 7% more than the list price whether the item goes for $1 or $100,000.

-A progressive tax means the higher the base amount, the higher the rate. Income tax in the United States (and most everywhere else, as far as we know) is an example.

That leaves the rarest bird in the aviary, regressive taxes.

You mean there are taxes where the greater the amount subject to the tax, the less you pay? That’s absurd. And illegal, right?

It’s cute that you think that. Not only do regressive taxes exist, they’re authorized by the same federal government that you entrust to have your best interests at heart. To fund the 2 biggest and least tenable programs in its tentacles – Social Security and Medicare.

Out of all the confusing, capricious, seemingly arbitrary taxes we pay, Social Security and Medicare taxes might be the most senseless.

The federal tax collectors (sorry, we don’t know most of their names, but Doug Shulman is the Internal Revenue Commissioner) take about 15.3% of your salary in the form of Social Security and Medicare “contributions”. Collectively, these are dubbed FICA – after the Federal Insurance Contributions Act. Remember, Social Security was invented because federal officials of a bygone generation decided that Americans were too stupid to save for retirement. Therefore it would take a benevolent government populated by financial geniuses to make those critical investment decisions for our grandparents, our parents, you, me, and our descendants. Medicare is essentially the same thing, but earmarked for a different purpose.

If you never look at anything but the net pay amount on your paychecks, take some time to read the other numbers. Just once. That 15.3% breaks down like this:

-6.2% employee’s Social Security taxes
-1.45% employee’s Medicare taxes
-6.2% employer’s Social Security taxes
-1.45% employer’s Medicare taxes.

Hopefully this is obvious, but you’re wrong if you think your employer pays its share of these taxes as a necessary cost of keeping so wonderful a worker as you on the payroll. She doesn’t pay these taxes, she merely collects them. You pay them. Your employer factors these taxes into your salary when she hires you. If your employer wasn’t required to pour 7.65% of your income into the subterranean trench that is the federal government, she wouldn’t. Instead, she’d much rather attract you and other employees with wage levels that are 7.65% higher than what you think you’re currently making.

How is this regressive? Sounds proportional to me.

The Social Security portion of your FICA taxes is capped once your annual income exceeds $106,800. You pay the 2.9% in Medicare taxes no matter how much you make, but the Social Security portion can’t go above $13,243.20. (Half of that levied directly on you, the other half levied on you via your employer.)

So the higher your salary – past $106,800, anyway – the smaller the proportion of it you pay in Social Security taxes. On the one hand, this gives you incentive to work hard and earn money. On the other, it’s the kind of inequality that French revolutionaries chopped off people’s heads for.

If you’re an independent businessperson, and you structure as an S corporation or a limited liability company, you can run around the system instead of through it. Incorporate, and you can pay out part of your company’s profits to yourself as salary while paying out the remainder as dividends. The former is subject to FICA, the latter isn’t.

What’s the downside?

You’d be surrendering the “certainty” of a regular, constant paycheck. As if there exists an employer who could guarantee such a thing in perpetuity anyway.

Still, it sounds promising. So why doesn’t everyone do this?

The usual reasons: fear of the unknown, lack of faith in themselves, etc. The same negative thinking that’s been holding most human ingenuity back since we figured out fire and the wheel.

Note: Some people blather that sales taxes aren’t proportional because the less you earn, the higher a ratio of your income you pay in sales taxes.
First off, sales taxes aren’t levied on income, they’re levied on sales. See “income tax”, above. Second, there’s no way around this. Unless you think state legislatures and municipal governments should mandate that merchants ask people how much money they make before determining how much tax to collect.

**This article is featured in the Carnival of Wealth #43**

Filed Under: Entrepreneurship, Finance, Healthy Living, Personal Finance Tagged With: , , , , ,

6 out of 8 people reading this are idiots

April 15, 2011

Come on, make his job easier

And hopefully, 8 out of 8 noticed that that headline is mathematically inelegant.

It’s Recycle Friday! And under normal circumstances, it’d also be tax day. Instead, you’ve got an extra 72 hours to mail your check this year.

What’s that? You’re not mailing a check? You’re getting a refund? Oh, you poor impressionable thing. Let us set you straight. Come with us back into the archives: a dimly lit corner with a table for two. You and us. We’ve got absinthe on ice (it was a gift from a sponsor) and Sade crooning on the Bose system. Now spend a little quality time with us as we break out a post from last February. Enjoy.

That means you, who’s looking forward to getting a tax refund on April 15. It might not be the dumbest thing you can do with your money, but it’s in the top 8.

Congratulations, getting that check means you let the government (definitely federal, probably state) enjoy your money all year long, as your employer dutifully paid the IRS every two weeks before you got your share. Of what you earned.

Remember that packet of papers the HR wench gave you when you started your current job? They included IRS Form W-4, which orders your employer to withhold some minimum amount of income tax from your paycheck. The implicit message from the government is you’re too stupid to budget, Citizen.

(You also can’t handle saving for retirement, and we don’t want you making too many decisions about your health care either. But those are issues for future posts.)

Many people, 75% of you according to some estimates, gladly choose to have their employers withhold more than enough to cover their taxes from each paycheck, thinking of this as “forced saving” in a gross misinterpretation of the term. The logic goes that rather than come up short on April 15, you can spend the whole year not thinking twice about your eventual tax bill. Best of all, when all those other suckers are lining up at the post office on Tax Day, not only will you not have to, you’ll be “receiving” money from the IRS. You outsmarted the system!

You didn’t.

You don’t want to get a big check from the IRS on April 15. You want to incorporate as a business, and send the IRS small checks on April 15, July 15, October 15 and January 15.

If you’re not an entrepreneur – i.e., if most of your income is still tabulated on W-2 forms rather than 1099 forms – you still don’t want to get a big check from the IRS on April 15. If anything, you want to cut them as big a check as possible.

“As big as possible” meaning not that you should give them all your money minus your living expenses, but as much of your tax bill as you can save until the last possible moment.

Look at it this way. Lots of merchants give cash discounts. The auto repair shop would rather have your money immediately than wait until the end of the month to receive it from MasterCard (after they subtract their cut, of course.) Continuing in that vein, the longer the merchant has to wait for your money, the more they expect. That’s why most invoices call for increased payments after 30, 60, 90 or 120 days, which is obvious.

The IRS has the second part of that down, being only too happy to assess penalties if you’re late.

So does that mean the IRS reduces your tax bill if you pay early?

(Sorry, broke a blood vessel from laughing too hard.)

If there’s no benefit to paying early, why on earth would you do it? Let the time value of money do its work. The longer you can hold on to it, the better it is for you.

Retailers use the annual ritual of receiving a check as a seasonal mating call. Come to our car lot, and we’ll double your IRS refund on the purchase of a new Camry! Turn your refund into a plasma screen!

A million years of human evolution, and our brains still haven’t developed to the point where they can instinctively appreciate the wisdom of deferring things beyond the obvious benefit.

Get the minimum deducted from each biweekly paycheck. (You don’t have to wait until the anniversary of your hire date. You can do this at work today if you want.) Take the difference between that and what you would have had deducted otherwise, and invest it in your 401(k). When it comes time to pay your taxes you’ll have enough to buy that plasma screen or Costa Rican vacation and then some.

If you’re not convinced by this point, then you have no willpower and will have to wait until we release a book called Let Someone Else Control Your Cash. Even worse, in the last few months we’ve seen just how hollow the phrase “full faith and credit of the (United States) government” goes.

For instance, the state of Hawai’i recently announced it was delaying its tax refunds until July 1. This isn’t to commemorate Canadian independence day, we’re guessing.

UPDATE: It isn’t. Make that August. Late August.

That leaves 49 solvent states. Well, except for Virginia. Oh, and Georgia, which kept its citizens waiting until mid-July and beyond last year. You knew New York would be a part of this too, right? How about Alabama? And North Carolina, you can step right up too. Etc.

States routinely budget in billions of dollars, making it easy to assume they have giant reservoirs of cash. They don’t. Californians pride themselves on having an economy that would be the world’s 8th largest were California a nation, but their state government doesn’t even temper the news when it announces it’ll be paying its creditors with IOUs.

America’s largest corporations by revenue are ExxonMobil, Wal-Mart, Chevron, ConocoPhillips, Ford and General Electric. Imagine what would happen if any of them decided to pay vendors or employees with postdated checks. Somewhere between the customer boycotts and class-action suits, the state attorneys general would be among the first to publicly call these companies out.

But remember, it’s businessmen who are evil.

Hmmm…if the state, or IRS, doesn’t owe you money (that was yours to begin with) in the first place, you’ve denied the taxing authority the chance to defraud you or make you wait.

Chances are pretty good that in the next year, your municipality will float a bond issue for more money for your neighborhood firemen. Or initiate a ¼% sales surtax. You’ll vote yes, probably because of the residual effects of 9/11. A few months later, when the firemen have spent all the money on lasagna and mustache grooming and matching blue shirts for their daily trips to the gym, try not to draw a correlation to your delayed tax return. Which you shouldn’t be getting anyway, if you learn how to Control Your Cash.

**This article is featured in the Carnival of Wealth #35**

**This article is featured in the Yakezie Carnival Easter Sunday Edition**

Filed Under: Consumer Debt, Economics, Taxes Tagged With: , , , , , ,

Read this and watch your taxes fall

January 17, 2011

U.S. Commissioner of Internal Revenue Doug Shulman. Never mind that this is apparently his Bar Mitzvah photo, nor that he opted for the festive ultraviolet at Sears Portrait Studio that day. Get a load of this actual quote: "I use a preparer...I've used one for years. I find it convenient. I find the tax code complex, so I use a preparer.”

Taxes are too high, but not necessarily as high as you think.

This post isn’t going to argue about the merits or weaknesses of our tax system, nor about the obscene amounts of our money that our elected officials spend on our behalf – spending that’s inseparably tied to the taxation and that shows zero signs of abating or even decelerating.

Stop 100 people on the street and ask them the difference between an effective tax rate and a marginal tax rate. 97 of them will stare at you and drool. The remaining 3 will know the answer, but won’t give it to you because they’ll be too busy wondering why you’re stopping random people and asking them finance questions.

The concept of marginality shows up in freshman college economics courses but rarely thereafter, even though it’s critical and often misunderstood. Let’s see if we can explain it without charts. Not that they wouldn’t help, but I can write several paragraphs in the time it takes to create a chart. Besides, dropping one in would create at least the semblance of a dreary academic lecture.

“The highest tax rate in this country is 35%! Why should I bother making money, when 35¢ of every dollar goes to taxes?”

3 reasons, in increasing order of importance:

1. That’s tax on income, i.e. wages and salaries. If you get paid in cash, how much of it you declare is your business. Just don’t get stupid and declare none of it. At least not under your real name. Or at least not under your real Social Security number.

2. There are other ways to earn money, namely capital gains. The IRS calls this “unearned income”, as if you were just walking down the street nonchalantly when a giant cartoon bag of money with a dollar sign on it fell out of the sky and hit you on the head. Capital gains are taxed at their own rate, typically lower than income and in some cases, zero.

3. Alluded to above, the difference between “marginal” and “effective”.

We have these things called “tax brackets” in the United States. Make $34,000 a year*, you’re in one bracket. Make $34,001 and that moves you into a higher bracket, meaning one in which you pay a higher percentage of your income in taxes. Make $373,651, that puts you in the highest bracket of all.

There are 6 brackets. The 3 referred to here are the 15%, 25%, and 35% brackets respectively.

Are we going too fast?

So if I make $34,000, I’ll pay 15% of it in federal income taxes, or $5100. If I make $34,001, I’ll pay 25%, or $8500.25. I make $1 more, but it costs me $3400.25. What a rip.

Alright, apparently we are going too fast.

No. One bracket starts where the previous one stops. If you make $34,001, the IRS treats you like someone in the 15% bracket for the first $34,000 of your income. And treats you like a mid-level tycoon for the remaining dollar, one that they charge you 25% to keep.

This is what a marginal tax rate means. You pay 25% only on the marginal income – i.e., the part of your income that gets you in that particular bracket. There, you just dodged a $3400 bullet.

It’s not even that bad. The 15% bracket also refers to a marginal rate. That bracket starts at $8375, which means that if you make $34,000 (or anything greater), you’re not paying 15% on $34,000 of it. You’re only paying 15% on $25,625 of it. The lowest tax bracket is the 10% bracket, which is for any salary or part of a salary under $8375.

So at $373,651, in the 35% bracket, you’re paying the following:

10% on $8350$       835
15% on the part between $8350 and $34,0003843.75
25% on the part between $34,000 and $82,40012,100
28% on the part between $82,400 and $171,85025,046
33% on the part between $171,850 and $372,65066,629
35% on the remaining dollar.35
Total 108,452.10

Is this a big deal? Sure it is. If you were paying 35% on all your income, your tax bill would be $22,000 higher. This total tax bill above represents an effective tax rate of 29% – your total tax as a ratio of your income.

But even the numbers in this example are unduly liberal, because they don’t account for the tax credits and deductions we’re all entitled to – for everything from making mortgage payments to saving receipts for charitable donations. (That’s not even counting the tax benefits available to someone who registers as a corporation rather than as a regular wage earner, instead of merely drawing a salary and letting her boss enjoy said benefits.)

The Beatles wrote a song about marginal rates, “Taxman”. Opening line:

Let me tell you how it will be/
There’s 1 for you, 19 for me.

That’s right – at the time, the highest marginal tax rate in the UK was 95%.

The government set such an absurdly high rate to make “the rich” pay “their fair share”, two subjective phrases that mean nothing. Apparently, whomever thought up such a rate (and its cousin, the 77% marginal rate the United States imposed in the late ‘60s) thought that there existed taxpayers who were

-smart enough to earn lots of money, yet
-too dumb to devise a way around those taxes.

The imposing authorities forget that taxpayers are ambulatory, and that work is voluntary. Why pay 77% in the US when you can pay a lot less by moving to Switzerland or Antigua? Or if you don’t want to pack up and move, then why even bother working beyond a certain point? What incentive is there to contribute anything extra to the nation’s output when you get to keep almost none of that contribution?

Beyond that, plenty of high-income earners put their money in shelters. You know what tax shelters are in theory, but keep in mind that they exist for non-economic reasons. If you’re making good money, you likely don’t put it in a tax shelter to help that money grow, to invest in a new product, or to employ people. You often do it for completely antithetical, defensive reasons – setting up a third party to funnel money through, channeling it offshore, etc. It doesn’t help the economy grow, it just keeps it out of the hands of the IRS. Which is a laudable goal, but a secondary one.

*Assuming you’re single. If you’re married, or recently widowed, or something called “head of household” (long story, and a topic for another day), the cutoff incomes differ.

Filed Under: Taxes Tagged With: , , , , ,