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Could you be a 15-percenter? Decoding tax rates

Wednesday - 1/25/2012, 12:44pm  ET

By CANDICE CHOI
AP Personal Finance Writer

NEW YORK (AP) - Millionaires can be just like everyone else. At least when it comes to paying taxes.

Mitt Romney released records this week that show he pays a tax rate of about 15 percent of his income. The relatively low figure is raising eyebrows because it's on par with the rate paid by many middle-class households. That's despite the Republican presidential candidate's impressive income of $45 million over the past two years.

The disparity seems to fly in the face of the basic rule that tax rates move in tandem with wages; the more you earn, the more you pay. So Romney's disclosure may stir suspicions that the system is tilted toward the rich.

In his State of the Union speech Tuesday night, President Barack Obama focused on the issue by noting that a quarter of all millionaires pay lower tax rates than millions of middle-class households.

"We need to change our tax code so that people like me, and an awful lot of members of Congress, pay our fair share of taxes," Obama said in a speech that repeatedly touched on the gap between the rich and poor.

On average, the wealthy pay taxes at a much higher rate than the middle-class individuals. But the primary reason that many pay a lower tax rate is that more of their income comes from investments, which is generally taxed at a far lower rate than wages.

Even if investment income doesn't play a big role in your finances, understanding the basics of how tax rates work can help even the average wage earner save hundreds, if not thousands of dollars a year.

Here's an overview of what you need to know:

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TAX RATE BASICS

Although it's common to grumble about taxes, taxpayers often don't know precisely what percentage of their income goes to the government. So an essential starting point is to look at how tax rates are applied.

Taxpayers can currently fall into one of six federal tax brackets depending on their taxable income. This amount includes items such as wages and distributions from retirement accounts. The tax rate for each bracket ranges from 10 percent to 35 percent. This is the most basic building block of tax planning because your taxable income can be reduced considerably by various credits, exemptions and deductions.

Here's the breakdown of how much single filers would pay in federal income taxes depending on their taxable income for 2011:

1. 10 percent - income up to $8,500

2. 15 percent - over $8,500 up to $34,500

3. 25 percent - over $34,500 up to $83,600

4. 28 percent - over $83,600 up to $174,000

5. 33 percent - over $174,400 up to $379,150

6. 35 percent - amount over $379,150

Keep in mind that these are marginal rates, meaning your income is taxed in tiers. The first $10,000 you earn, for example, is taxed at a lower rate than the next $10,000.

So let's say you earned $100,000, putting you in the 28 percent tax bracket. This doesn't mean you'd fork over $28,000 in federal income taxes. It means that the amount you earn above a certain threshold is taxed at 28 percent. Your federal income taxes would actually be closer to about 22 percent of your income.

The current federal rates are set to expire at the end of this year. If Congress doesn't act by then, the rates would revert to levels from before the Bush-era tax cuts, which ranged from 15 percent to 39.6 percent.

For now, federal income tax rates overall are near historic lows, says Joseph Rosenberg, a research associate at the Tax Policy Center in Washington, D.C. He also said that nearly half of Americans do not pay any federal income taxes as a result of various exemptions given to those with dependents and limited incomes.

Federal income taxes are only a piece of the larger tax picture, however. Payroll taxes, which go toward Social Security and Medicare, eat up another 5.65 percent of wages. That rate returns to 7.65 percent if the payroll tax cut pushed by Obama isn't extended past February.

State taxes are another factor and can vary widely, with rates ranging from as low as 3.4 percent in Indiana to 11 percent in Hawaii and Oregon, according to H&R Block's Tax Institute. A handful of states, including Alaska and Florida, do not have an income tax.

THE EXCEPTIONS

Not all income is taxed at the rates outlined above. A key exception is any money earned from long-term investments, such as stocks, mutual funds and real estate held for at least a year. This income is classified as capital gains and is taxed at a flat 15 percent. That's regardless of whether it's $100 or $1 million.

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