Taxes and Lifestyle – Competing Forces
With tax season behind us, I figured now is a great time to write an article related to taxes. Writing about tax strategies is always topical, but we’ve done that before (visit our blog for awesome posts), plus we cover all applicable strategies in our client meetings. Rather, I want to take a big picture look at how taxes and consumption intersect, and how increases in income can actually cause financial plans to go awry.
Disclaimer: I beg forgiveness from all my CPA friends who are reading this and cringing at my basic tax math and over generalization to the tax code. In reality, there are more moving parts to a tax projection than what I’m showing below. Tax software was NOT used in my example below. I simplified my example for the sake of communicating my main points. This is not meant to be a political article, so please grant me any leeway in interpretation.
Federal Income Tax:
From the time of your first job, whether you were delivering newspapers, waitressing in the local restaurant, working at McDonald’s, or serving as a golf caddie, you had the long arm of Uncle Sam reaching into your pocket to extract money. Ironically, the government doesn’t even reach into your pocket to extract money. They withhold it from your paycheck before you even touch it. It’s interesting to me that all of us accept this, but we do.
With a simplified tax code, everyone would be subject to the same percentage of income tax, a flat tax. As our income goes up, we would pay more tax than the next person, but the same percentage. The reality is we pay a higher percentage as our income goes up. Just as we think we’re succeeding financially and we earn that last extra dollar, the percentage of tax increases. This is what is known as a Regressive Tax. Let’s take a look at an example below.
Suppose you’re a married couple and collectively your taxable income is $78,950. For the first $19,400, you’re taxed at 10% and for income between $19,400 and $78,950 you’re taxed at 12%. For this income level, your total federal tax is $9,086. From a big picture perspective, that’s a lot of money to be pulling out of anyone’s pocket and this has already damaged your financial plan because that’s money not available to support you and your family. If you’re planning on spending all $78,950 of your income, you’re going to find yourself in a financial hole.
Now suppose you received a bonus near year-end of $20,000. This bumps your taxable income into the 22% bracket. Instead of paying federal income tax on this bonus of $2,400 ($20,000 * 12%), your actual tax is $4,400 ($20,000 * 22%), plus additional payroll and state income taxes. That’s $2,200 of extra income tax you’re not accustomed to paying for. Just as you were thinking your lifestyle could increase by $17,800 ($20,000 – $2,200), the reality is it can only increase by $15,600, not counting payroll taxes and state income taxes.
State Income Tax:
Based on Shakespeare’s domicile in Wisconsin, you are also paying state income taxes. Once a married couple has taxable income over $29,960, you’re paying 6.27% in State income taxes. Focusing on the example of the $20,000 bonus, you would pay $1,254 in Wisconsin Taxes on this bonus. Your $20,000 bonus is now down to $14,346.
One of the most stealth taxes in the tax code are payroll taxes. For anyone with wages below $132,900 you pay 6.2% in taxes to Social Security and 1.45% to Medicare. These taxes come out of your paycheck automatically. This results in added taxes of $1,530 for the above example. Your bonus is now down to $12,816.
Retirement Plan Withdrawals:
The discussion above focused on the impact of a $20,000 bonus to your wages but the same concept applies if you’re taking money out of your 401k or IRA, although those withdrawals are not subject to payroll taxes. As a result, having $1,000,000 in a retirement account really isn’t $1,000,000. It’s a smaller amount of spendable dollars, based on your federal and state income tax brackets at the time of withdrawal.
As your income goes up, you’re subject to other taxes. These may include a 0.9% added Medicare tax, a 3.8% net investment income tax, a Medicare surtax, and higher taxation of your Social Security benefits to name a few. In addition, if you’ve saved money in bank and brokerage accounts, interest, dividends and capital gains are also subject to tax; and the tax rate goes up as your income goes up.
Many of us base our lifestyle decisions on gross income numbers, whether it be wages or retirement balances. This approach is deeply flawed, as we know that the impact of taxes to our spendable dollars is dramatic. Using our $20,000 bonus example above, if we’re prudent and save at least 10% of our windfall ($2,000), there is approximately $10,000 left to spend. In real-world examples, a $20,000 bonus can frequently lead to an increase in spending of $25,000, as people figure they will only need to finance a smaller percentage of a purchase than they otherwise would have. They would actually harmed by $15,000 in this example.
In addition, our brains are wired a certain way to believe that events that have occurred in the past will continue occurring in the future. We begin to think we’ll get at least a $20,000 bonus each year and we adjust our spending higher in anticipation of this. Ironically, that $20,000 bonus could be negatively impacting us in several different ways.
Just as ‘objects in the mirror are closer than they appear,’ income and assets may also be larger than they appear. It’s important to fully understand your net-income and assets, net of taxes, when calibrating your spending decisions. If you would like to have an in-depth conversation about your situation net of taxes, give us a call for further discussion.