Tax Rates

published October, 2014

How does this help you? Short term, you have little choice of the tax rate you fall into. But you should not be “surprised” at how much tax you owe. Too many people are. In the long term, you may want to see what you can do to move “down” this list. Be sure to read the caveat in the last paragraph.

As you know, money pulled early from retirement is “expensive” money, both in terms of taxes, and also beause it will not be there when you retire. Hopefully, you won’t need to draw money from retirement funds early to meet living expenses. If you do, know that the tax rate is closer to 40% than 10%. The federal penalty for early withdrawal is 10%, plus the state adds a penalty also. And, you have to pay income tax on the money. The retirement fund people may offer to withhold federal (and state) tax, but they default to just withholding the penalty amount, not the penalty plus the income tax.

The self-employment income tax rate is closer to 50%. This includes federal and state income taxes, plus 15.3% for Social Security and Medicare. This includes income to partners in a partnership or members of an LLC who are performing services.

Income from wage jobs can be more like 30%. You pay income tax on this money, and they withhold half of the Social Security and Medicare from your check before you even get it. I think of this withholding as a tax. The benefit here is that the income tax is withheld before you ever see it, in hopefully the correct amounts.

Ordinary income is not earned by services, so there is no Social Security nor Medicare to pay. This would include things like interest—but with current interest rates you’d have to have a LOT of money to make any substantial amount of interest, and S Corporation earnings. There is still income tax on this, but it is taxed at a lower rate.

Capital gains rates are lower, closer to 15%, but you have to first buy an asset, and then sell an asset. See the definition of assets in a later issue.

Even better is cash flow without income tax recognition. I’m not suggesting you don’t report your income! Always report all your income in full. The tax code, however, allows you to take a depreciation expense against income from some capital assets. So it is possible to have cash flow that does not get taxed at all. The tax rate on this money is 0%.

Income tax rates are “progressive”—that is to say, the more money you make, the higher the rate is on your income, so the rates above are not only for a specific income level, they will also change as the rates get changed each year. Also, Social Security has an upper limit (this is a component of SE tax). This is a very broad illustration of tax rates and there are many nuances, adjustments, rules and limitations. I’ve spent 15+ years on this topic. Your actual results may vary.