Understanding how taxes affect personal finance

I like to pay taxes. It is purchasing civilization–Oliver Wendell Holmes

Taxes are a big consideration in many financial decisions, including retirement accounts, tax-advantaged investments like municipal bonds, and renting versus buying a house. These financial decisions are so important that knowing basic tax information is critical. Here are four traits of the US Tax system to get you started:

1. The US income tax is progressive and has marginal tax brackets

A progressive tax code means that the more money you make, the higher your tax bracket is. What is sometimes confusing is that “tax bracket” refers to the last, or marginal, dollar that you made. Here is the US Federal Tax Rate Schedule from the IRS for the year 2007 for a single filer:

For instance, consider two single earners Alice and Bob in the year 2007. Let’s say that Bob had a taxable income of $7,800 and Alice had one of $7,900. Calculating Bob’s taxes is easy. According to the chart, Bob is in the 10% tax bracket, and therefore he owes $780 in taxes. Bob paid an average of $780/$7,800 = 10% in taxes.

Alice’s taxes are slightly more complicated. Alice is in the 15% marginal tax bracket. According to the chart, Alice owes 10% on the first $7,825 she earned, and then she owes 15% of income above $7,825. This means Alice owes $7,825 x 10% + ($7,900 – $7,825) x 15% = $793.75. Alice paid an average of $793.75 / $7,900 = 10.05% in taxes.

The example demonstrates a few key points. First, the tax code is “fair” in the sense that everyone pays the same taxes on the initial taxable income. Second, higher tax brackets only apply to the last dollar you made instead of your entire taxable income–this means your average tax liability is lower than your tax bracket.

Here is a chart that illustrates these points. The horizontal axis represents taxable income, the blue line represents the marginal tax brackets, and the orange line is the average tax. Notice that the average tax paid is quite a bit lower than the tax bracket.

2. The richer you are, the more incentives you have to reduce taxable income

The highest earners face a 35% tax on any additional taxable income. This gives the rich a huge incentive to invest in tax sheltered options. Many of these are legal–like municipal bonds and retirement accounts. But there are other aggressive, and some times illegal, tax shelters like offshore companies and structured finance agreements.

Because the rich participate in these tax shelters, it is often said that the “rich don’t pay taxes.” The cliche sounds nice, but I’m not too convinced because recent IRS data shows that the richest earners do in fact still pay most of the taxes.

3. It doesn’t matter if you get a tax refund or bill. You pay the same income tax.

It feels great to get a tax refund, but that doesn’t mean you’ve saved any money. Your yearly tax liability is always the same whether you get a refund or have taxes due. A tax refund means you’ve overpaid taxes through your paychecks and now you are getting your money back.

Most argue against a tax refund because it means that you (1) lost out on money that could have earned interest due to the time value of money (2) you lost cash flow each paycheck, and (3) you gave government an interest-free loan. I generally agree with this advice, but every thing does depend on your own preference. Some people explicitly like tax refunds despite the disadvantages so I can’t argue against that.

4. Taxes are secondary consideration to net return

Taxes are an important component of many decisions, but don’t let it get in the way of focusing on the take home return. It is financially better to get a 10% return and pay 20% in taxes for a net 8% return than to simply get a 7% tax-free return.

The decision obviously depends on your marginal tax bracket. Let’s compare a tax-free 3% municipal bond to a taxable 4% CD. In the lowest tax-bracket, the investor is choosing between an after-tax return of 3% on the bond and 3.6% on the CD–so the CD is better. In the highest income bracket, the investor is choosing between an after-tax return of 3% on the bond versus a 2.34% on the CD–making the bond better. This is an example of how the rich can benefit from tax-advantaged investments more than lower tax brackets.

This post is part 6 of a 7-part series on the most important lessons in personal finance. Here are links to all of the articles in the series:

1. Personal finance is not about money
2. Know your preferences
3. Consider opportunity costs
4. Calculate risk
5. Know the time value of money
6. Consider taxes
7. Know the value of your time