Find out how income and investments are really taxed and whether the rich pay less tax compared to ordinary folks.
Since presidential candidate Mitt Romney revealed his tax return which showed an effective tax rate of 15%, there’s been a lot of talk about whether the rich get away with paying less income tax than ordinary folks. Today, I’ll reveal how income is taxed and how much millionaires really do pay.
What is Payroll Tax Withholding?
The first tax that we’re all familiar with is income tax. It’s a rite of passage to receive your first paycheck and be stunned by how much the government takes.
There are 4 main types of taxes that employers are required to withhold from your paycheck:
- Federal income taxes
- State income taxes
- Social Security taxes
- Medicare taxes
Additionally, depending on where you live and the industry you work in, you may also have unemployment, disability, and local income tax withheld.
I’ll summarize each of the 4 payroll taxes so you know what they are and how much you’re paying for them.
What is Federal Income Tax?
Federal income tax is collected by the Internal Revenue Service (IRS) to fund the country’s expenses for everything from education to the military. You pay federal taxes according to tax brackets, which are ranges of income that are subject to different tax rates. As your income goes up, the amount that falls into each of the 6 brackets is taxed at a progressively higher rate.
In other words, federal income tax is staggered, with part taxed at 10%, part at 15%, and so on up to the maximum tax bracket of 35% for 2011. To pay the top tax rate, you must have income that exceeds the highest threshold, which is $379,150 for single taxpayers.
How to Reduce Your Taxes
You don’t typically pay tax on all your income. You’re allowed to reduce your taxable income by certain amounts, including “exemptions” for the number of people you support, like yourself, a spouse, and dependents.
You can also reduce your taxable income by claiming deductions for qualified expenses like medical care and charitable contributions. Additionally, the total amount of tax you have to pay is reduced if you qualify for a tax credit, such as the child tax credit.