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Case Studies in Taxes

Who do taxes hurt and who do they help?

Come tax time, everyone's feeling the pinch, but let's take a look at three case studies to see how IRS rules can actually affect tax payers.

Victim #1: Frank Frugale, The Lower Income Earner

Frank started in the working world earning $36,000 per year at a non-profit. He makes $1,500/month before taxes, but his employer needs to withhold money for Medicare and Social security—about 7.65%, plus about $135 for federal income taxes—leaving Frank to live on about $1,250.25 each month.

We hope he has roommates.

Frank is comparatively lucky: he lives in a state that doesn't charge income tax. If he did, he'd have even more carved out of his tiny paycheck.

By age 40, let's say that Frank is still single (online dating has been unkind to him), but he's poured his love-sick heart into work, so now he's earning $54,000 dollars/year. After taxes, he gets two paychecks of $1,766.16 each month.

He may not be lucky in love, but he is smart in money: Frank has opened up an IRA and contributes about $4,000 a year. He's saving cash for his retirement, and since the IRA contributions are tax deductible, he's only being taxed for $50,000 rather than $54,000, so he's saving about $42 in taxes every payday. That's about $1,000 less he's paying each year. Aw yeah, stickin' it to the man.

By 65, Frank is living in a little apartment and is still single except for his goldfish named Frankenstein. Since he's worked all his life, he collects social security, thanks to all those payments he's made. He can also take out up to $25,000 per year on his IRA without being taxed on that income. A lifetime of not earning a ton has made him enjoy the little things and his goldfish has a small appetite, so he can stretch his pennies.

Victim #2: Marketing Mike

Mike is 25 and he's still in school, getting a professional degree after staying undeclared and hitting up one too many parties in his first go through college. He doesn't mind, though, because he has his sights set on a good job at a PR firm.

He's working part time at a web design company. He only makes $5,000 per year, but that doesn't mean he doesn't pay taxes. Since he freelances for the company, nothing is held out of his paycheck and he still has to file taxes.

By 40, Mike is making $100,000 a year after working his way up the ladder at the PR firm and catering to celebrities with big egos. At his last college party, Mike met Donna. They're now married with two kids, and Donna is adding $50,000 to the household from her job.

Mike and Donna file taxes jointly, and for each child, they get to deduct $3,500. They also get deductions on their house and IRA contributions. Together, they lower the amount of income they can get taxed on by about $25,000, saving about $8,000 on taxes.

The house is proving a bit of a liability, though. Mike fell from the roof trying to fix a leak, and he lives in a state that charges property taxes. The house is worth $360,000, and the property tax in the state is 0.82%, which means Mike and Donna have to find about $3,000 to pay for those taxes.

To even buy the house, Mike had to sell the stocks he had bought during his 20s with his first paycheck. The stock in Acme Company doubled in value from $1,000 to $2,000, but when Mike sells, he has to pay taxes on the gains. Capital gains taxes are 15% when Mike sold those stocks, so he'll have to pay $150 from his $2,000 ($1,000 x 0.15).

By 65, Mike still has all his hair. Equally lucky, he's still married to Donna, and they've been saving for retirement from the start, so they have $50,000 together from their IRAs and social security now that they're getting grey and want to stop work. They don't pay taxes on social security, but any withdrawals over $25,000 on those IRAs are taxed, just as they would be if Donna and Mike were working. Donna and Mike are paying about $4,000 on those IRA withdrawals, which is pricey.

Victim #3: Richard, the Entrepreneur

Richard knew he was going to go into business ever since third grade, when he charged $5 for kids who wanted to come to his birthday parties. He wasn't the most popular kid, but he could always afford candy (and birthday cakes shaped like Monopoly money). By 25, Richard had fast-tracked through business school and was hired to work in Silicon Valley for $175,000/year.

Richard could have spent money on a condo, fancy clothes, and a Bugatti. But he kind of loved his rusty Honda and always wore sneakers and jeans to fit in with the tech crowd. A lot of his money went into a savings account. Since he's earning a lot, though, he's taking a big hit from the IRS. He's paying about $9,000 for FICA taxes (Social Security taxes) and about $25,700 in income taxes. It might not be lonely at the top, but it's expensive.

By 30, Richard decides to show those guys in Silicon Valley a thing or two and starts his own business. He makes extra-important gadgets for tech guys (we have no idea what the gadgets do because it was all explained by an engineer).

By 40, the business is making $1 million in profits a year and Richard wants to take some of that money out of the company because he just got engaged. He's got a big Star Wars-themed wedding to plan (because he's very comfortable with tech stereotypes) and a house to buy.

Richard's business is a corporation (his lawyer recommended that, and so did his accountant) and that means he has to pay corporate tax. Profits of $1 million a year make the IRS very happy because it puts the company into the highest federal corporate tax bracket (35%). On top of that, Richard's company has to pay state corporate taxes. Together, those eat up $400,000.

To pay for his house and wedding, Richard decides to take out the $600,000 that's left after paying his taxes. Since his company is a corporation and he's the only owner, he can pay the money to himself as a dividend. If his company was public and he had lots of investors, he'd have to spread the wealth around.

The $600,000 dividend is taxed like regular income, and on income that high, Richard is paying $180,000 in federal income taxes plus state income taxes. Richard is rich, but…ouch.

By 65, Richard has decided he has had enough of the cutthroat world of business. He becomes a university professor, teaching students how to launch their own hugely successful gadget companies. The university pays him $125,000 per year and he works much shorter hours than he ever did, so it's a good deal. He now has time to stop and smell the roses (literally—he put in rose bushes in his garden last year).

Last year, Richard decided to sell his business. After all taxes were paid, Richard got $10 million for the company he spent years building. Not bad. After that time in his 40s when the government dinged him, Richard wanted to be smarter about taxes. He invested the $10 million in municipal bonds, which are sold by his state.

Here's the exciting part: Interest on municipal bonds in his state is free of taxes both from the federal and state government. The bonds pay 5% interest and are very stable, which means that Richard gets $500,000 each year without paying a cent in taxes. Take that, IRS. Sure, he has to pay taxes on the $125,000 he gets from the university, but that's peanuts to the money he's hauling in.

Bottom line: everyone pays the piper (er, IRS) in one way or another.

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