3 Case Studies in Taxes
We’ve got some brief stories to tell you about three different types of people and how they are affected by taxes during the course of their lives.
And just so you know, here’s a peek at what an IRS tax form for an individual actually looks like. Looks like your math textbook threw up all over your computer monitor, right? However, it’s worth taking some time to understand all of this gobbledygook, as it can really change your life.
Fred Frugal: Low-Wage Earner
We first meet our good friend Fred Frugal at age 25; Fred recently graduated from a local university and has begun working at a non-profit for a salary of $36,000 per year. Fred receives his salary in the form of two $1,500 checks per month – well, sort of. Those 1,500 dollars are before taxes, and because the government requires it, Fred’s employer will withhold 7.65% from his paycheck for Social Security and Medicare. This bumps Fred down to only 1,385.25 every payday. Hey, at least that quarter will come in handy for laundry money. But wait - the government isn’t done yet.
Fred’s employer will also withhold money for federal income taxes. At 36,000 dollars per year, Fred will be giving up an additional $135 every paycheck for federal income taxes. Now Fred is lucky - he lives in a state which doesn’t tax income, but if he did he would have even more money withheld for the payment of his state income taxes.
This means that, in total, Fred only walks home with $1,250.25, even though he thought he would be receiving $1,500. Aw, and he really had his heart set on that $1,500 antique sewing machine.
15 years later and our friend Fred is still living life as a bachelor. He just hasn’t found the right one yet (i.e., someone who won’t nag him about never changing out his toothbrush). Fred has been promoted multiple times at the non-profit he began his career with and now earns $54,000 dollars per year. For a non-profit, that’s non-bad. This means he now takes home $1,766.16 twice each month after FICA tax (Social Security and Medicare) and federal income taxes.
Now at $1,766.16 every payday, it may seem like good ol’ Fred is paying quite a bit in tax, but you know what? It could have been worse. If Fred had not used a key deduction he would be paying even more. Fred, being the responsible guy that he is, has decided to start planning for his retirement and, this year, he contributed $4,000 to his IRA. Not only are IRA contributions smart planning for your future, they are also tax deductible, which means Fred was able to lower his taxable income from $54,000 down to $50,000, resulting in a tax savings of $42 per paycheck, or over $1,000 per year! Soon, that sewing machine will be his!
Fred, forever the bachelor, is still living the single life in retirement. He doesn’t need anyone (other than his fourteen cats and three turtles) to be happy. He now collects social security, receives Medicare benefits, and withdraws money from his IRA.
In retirement, those FICA taxes his employer had taken out of his paychecks don’t seem so bad; they are now coming back to him in the form of monthly checks and medical visits.
In addition to his social security benefits, Fred is also withdrawing money from his IRA, which, as you may remember (it wasn’t that long ago that we mentioned it), he had contributed into for most of his working career. Being the frugal guy that Fred is, he knows that social security benefits are untaxed, and that as long as he withdraws less than $25,000 per year from his IRA, he won’t have to pay taxes on that income either. Smart guy. And on top of that, now he’s only paying expenses for his turtles. Turns out they last longer than cats.
Bob the Scientist: Middle-Class Job/Income Range
Although 25 years old, Bob the Scientist is still in school. Okay, so right now he’s Bob the Future Scientist. He is completing a graduate degree so he will be prepared to tackle the world’s more complex scientific problems (and be prepared to get a job) once he leaves college. Bob, the hard worker that he is, has a part-time job as a consultant for a local biotech firm, Curing Cancer Co. Hm… wonder what they do.
Bob only works a few hours a week and, over the course of the year, earns $5,000 for his efforts.
At first, Bob thinks that because he earned less than the minimum amount required to file for single individuals he is off the hook. Unfortunately, upon further review Bob realizes that he is still required to pay income taxes. Because Bob was paid as a consultant and not an employee, his employer was not required to withhold money from his paycheck. So now Bob must pay the employer’s share of the taxes on his consultant income.
Staying for graduate school really paid off well for Bob, as he now makes $100,000 per year. Bob has also started a family (he did it the old-fashioned way, rather than creating them in his lab); he has a wife who is a school teacher and makes $50,000 per year, and together they have two young children.
Not only do Bob’s children bring joy into his life, they also bring tax savings into his wallet. For each child, Bob and his wife (jointly) get to deduct $3,500 from their gross income. But Bob doesn’t stop there. He also gets a deduction for the interest payments on the new house the family has just purchased, and he gets a deduction for both his and his wife’s IRA contributions. With all of these deductions Bob is able to lower the taxable income on himself and his wife’s joint return by around $25,000, which equals a tax savings of close to $8,000. That’s more than he made in a single year during graduate school. You’ve come a long way, Bobby boy.
Unfortunately, by buying a house and making some other more sophisticated investments, Bob has brought some new tax burdens into his life. Bob lives in State X (check your map… it’s probably one of those states that’s all bunched up in the Northeast), and like all other states, State X has a property tax. Bob purchased his home right at the median value for State X, which is $360,000. On this home value, Bob pays 0.82% in tax every year to his local government, which equals around $3,000 in property taxes.
In order to fund the down payment for his recently purchased home, Bob sold some stock he purchased many years ago in his old company, Curing Cancer Co. Shortly after graduate school, Bob used a $1,000 graduation gift to buy stock in the company. Since that time, the price of the stock has doubled. Unfortunately for Bob, he does not get to keep all of that thousand dollars ($2,000 sale price – $1,000 purchase price = $1,000 profit) he just made by selling the stock. Good ol’ Uncle Sam still wants a piece, but this time in a slightly different form. Because Bob has owned the stock for more than 1 year, the gains from the sale fall under capital gains tax. In 2008, the capital gains tax was 15%, so Bob will have to give $150 ($1,000*15%) in cold hard cash to the government, which just adds more to his tax burden.
At his age, Bob and his wife are ready to kick back, take it easy, and ride off into the sunset. That is, if the hemorrhoids don’t hold them back.
Having constantly contributed to their IRA’s over their working lives, Bob and his wife are taking ample opportunity to draw down those funds to live out their golden years. The couple each receives social security and draws down a combined $50,000 from their IRA’s.
All social security payments go untaxed. However, withdrawals above $25,000 for IRA accounts are taxed at the rate of regular income. This tax treatment would mean that Bob and his wife would be paying a little over $4,000 dollars per year in taxes, even though they had no earned income at all! That is one pricey sunset.
Richard Rich: High-Income Entrepreneur/Wage Earner
Richard Rich was smart…. and we mean wicked smart. This guy graduated top of his class at one of the toughest universities in the country, and at 25 was working at Smart Tech Co., developing the best thing since the internet. (For blessing Smart Tech with his genius, Richard was paid a salary of $125,000, and yeah that’s per year.) Kinda makes you want to go out and invent something better than the internet, doesn’t it?
Richard wasn’t one for aesthetics so he didn’t go out and buy any fancy cars. He just threw his money into a savings account and let it sit there. But even though he wasn’t out shopping, he still had to pay taxes on the money he earned. Being in such a high tax bracket means that, over the course of the year, Richard ends up paying over $25,700 in federal income taxes and over $9,000 in FICA taxes. You’d think the government might let it slide, considering what a huge debt society now owes him for his patent, but nah.
At 30, Richard was tired of working for someone else and decided to start his own company, making whatever it is that people as smart as Richard make. We would make something up, but A) it probably won’t sound that impressive, and B) we don’t want you stealing our ideas.
Over the past 10 years, Richard’s business had grown substantially and is now making a profit of $1 million a year. Richard still owns 100% of his business and is interested in taking some money out of the company in order to purchase a home for him and his fiancée.
Because Richard’s business is incorporated, its profits are subject to corporate tax. With profits as high as a $1 million per year, Richard’s company is solidly in the highest federal corporate tax bracket of 35%, and adding on any state corporate taxes means Richard’s company must pay close to $400,000 in taxes before it is able to pass any money on to investors. That’s a chunk of change, but Richard has an awfully big piggy bank.
Wanting to pay cash for his new house, he decides to take out all $600,000 remaining after corporate taxes. To do this, Richard instructs his company to pay out a dividend, which means Richard receives the $600,000 as a one-time payment from the company.
Dividends, unlike the sale of stock, are taxed as regular income, meaning that smart guy Richard must report $600,000 as income for the year. The federal income tax on that money alone is over $180,000 (you could have bought a house with just the tax money!) not to mention the state taxes on top of that. Needless to say, Richard is doing his part to improve government revenues. What a patriot.
Even into old age Richard is working, but now he works to enlighten others as a professor at a prestigious university. Being well regarded in the academic community, Richard is paid well at $125,000 per year for his insights. He’s made more in the past, but now that he’s on Easy Street (he has asked that we not disclose the exact address), he doesn’t have to work for the money as much anymore. Now, it’s about opening minds more than opening Swiss bank accounts.
Last tax year, Richard sold his business for $10 million after all taxes were paid. Richard decided after his bad tax experience at age 40 that he wanted to avoid taxes as much as possible, so he invested the entire $10 million into municipal bonds issued by his home state. These bonds paid interest of 5% or $500,000 to Richard every year, and the best part is that the interest of municipal bonds from his home state is tax-free from both state and federal taxation. That means that Richard gets the entire $500,000 TAX FREE.
Of course, Richard still must pay tax on the $125,000 he earns as a professor, but given that it is such a small percentage of his real income, we doubt he will even notice.