Think You Know Your Tax Rate? Think Again

Do you know how much you really pay in taxes? I’m talking about all your taxes: income, capital gains, property and sales taxes. Most people I ask tell me they pay about 30 percent. That may sound high, but it turns out to be right. And part of it has to do with living in Georgia.

When I gauge a client’s approximate overall effective tax rate, I often go to moneychimp.com. Check it out. You may be surprised to see how low your “effective” federal tax rate is.

But it’s probably not your actual tax rate. Most tax calculators don’t show all the areas that take a hefty chunk out of your paycheck. FICA and state income taxes are two of the big eaters at the paycheck buffet. Here’s what I mean:

Let’s say the Joneses earn $110,000 a year. Although their overall effective rate is only about 18 percent, the moneychimp tax calculator more accurately indicates their tax bracket is 25 percent. That’s because our tax system is progressive; you pay a higher percentage on your earnings as they go up and pass certain thresholds.

So 18 percent now seems like a pretty good deal. And, for most of you lucky retirees, 18 percent is pretty representative of what you pay overall. But for us working folks, 18 percent is just the tip of the iceberg.

Enter FICA, the 1935 Federal Insurance Contributions Act that established the tax-funded funding Social Security program. For 2013, the FICA tax is 6.2 percent on the first $113,700 you earn as an individual. So for the Joneses, making $110,000 and in the 25 percent bracket, we have to factor in an additional 6.2 percent tax burden. And, we pay another 1.45 percent tax on everything we earn for Medicare.

Let’s do the math

We started at 18 percent, then added 6.2 percent for FICA and then added another 1.45 percent to reach a grand total of 25.65 percent. That means 25.65 cents of every dollar the Joneses earn go toward taxes.

I love living in Georgia — as I’m sure the Joneses do, too — but it’s not a cheap state. Georgians pay 6 percent income tax. (Georgians older than 62 likely pay less, as some state income tax exemptions begin to phase in).

OK, back to our calculators. Let’s add that 6 percent to the 25.65 percent we came up with earlier. We’re now at more than 31 percent.

That means nearly one-third of every dollar you earn goes toward taxes.

Taxes are inevitable. But there is a simple methodology to keep you sane and on the path to retirement freedom. Come back next Monday and we’ll discuss that.

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