Could you be a 15-percenter?
New York • Millionaires can be just like everyone else. At least when it comes to paying taxes.
Mitt Romney released records this week that show he pays a tax rate of about 15 percent of his income. The relatively low figure is raising eyebrows because it's on par with the rate paid by many middle-class households. That's despite the Republican presidential candidate's impressive income of $45 million over the past two years.
Even if investment income doesn't play a big role in your finances, understanding the basics of how tax rates work can help even the average wage earner save hundreds, if not thousands of dollars a year.
Here's an overview:
Tax rate basics • An essential starting point is to look at how tax rates are applied.
Taxpayers can currently fall into one of six federal tax brackets depending on their taxable income. This amount includes items such as wages and distributions from retirement accounts. The tax rate for each bracket ranges from 10 percent to 35 percent. This is the most basic building block of tax planning because your taxable income can be reduced considerably by credits, exemptions and deductions.
Here's the breakdown of how much single filers would pay in federal income taxes depending on their taxable income for 2011:
10 percent • income up to $8,500
15 percent • more than $8,500 up to $34,500
25 percent • more than $34,500 up to $83,600
28 percent • more than $83,600 up to $174,000
33 percent • more than $174,400 up to $379,150
35 percent • amount more than $379,150
Keep in mind that these are marginal rates, meaning your income is taxed in tiers. The first $10,000 you earn, for example, is taxed at a lower rate than the next $10,000.
The current federal rates are set to expire at the end of this year. If Congress doesn't act by then, the rates would revert to levels from before the Bush-era tax cuts, which ranged from 15 percent to 39.6 percent.
For now, federal income tax rates overall are near historic lows, says Joseph Rosenberg, a research associate at the Tax Policy Center in Washington, D.C. He also said that nearly half of Americans do not pay any federal income taxes because of exemptions given to those with dependents and limited incomes.
Federal income taxes are only a piece of the larger tax picture, however. Payroll taxes, which go toward Social Security and Medicare, eat up another 5.65 percent of wages. That rate returns to 7.65 percent if the payroll tax cut pushed by President Barack Obama isn't extended past February.
State taxes are another factor and can vary widely, with rates ranging from as low as 3.4 percent in Indiana to 11 percent in Hawaii and Oregon, according to H&R Block's Tax Institute. A handful of states, including Alaska and Florida, do not have an income tax.
The exceptions • Not all income is taxed at the rates outlined above. A key exception is any money earned from long-term investments, such as stocks, mutual funds and real estate held for at least a year. This income is classified as capital gains and is taxed at a flat 15 percent. That's regardless of whether it's $100 or $1 million.
"This is why someone who's a millionaire might have an effective tax rate that's lower," said Gil Charney, a tax analyst with H&R Block's Tax Institute. "A higher percentage of their income is going to be from long-term investment income."
In Romney's case, a chunk of his income in 2010 and 2011 came from Bain Capital, the private equity firm he founded and managed between 1984 and 1999.
Bain still pays Romney "carried interest," which is a classification of pay for managers of hedge fund and private equity firms. Critics say this type of compensation should be taxed as salary at ordinary rates. But as it stands, carried interest is considered capital gains because it's profit in excess of what investors paid into the fund, Charney said.
The tax rate for capital gains wasn't always 15 percent. The rate has moved up and down through the years. In the 1970s, for example, the figure was close to 40 percent. And if Congress doesn't act by the end of the year, the capital gains tax rate will revert back to 20 percent.
Reducing taxes • Tax rates are subject to political influences. But there are a few standby strategies taxpayers can use for reducing their tax bill.
A key tactic is to reduce taxable income; this is why financial planners are such advocates of maximizing contributions to 401(k) accounts. Workers can reduce their taxable income by as much as $17,000 a year. For traditional individual retirement accounts, the maximum contribution is $5,000 a year.
Most large employers also let workers set aside up to $5,000 of pre-tax wages in a health care flexible spending account. This money can be used for a variety of medical costs, including co-pays, prescription drugs and supplies such as cold packs.
There are also tax breaks for donations and education and health care costs that you may incur anyway.
An example of how taxes are calculated
A person's taxes are not calculated solely on his or her salary. Lots of things come into play. But here's a simplified version of how someone's taxes might be calculated:
A single man in his early 30s working as a midlevel executive makes $98,650.
Gross income $98,650
Personal exemption for 2011 $3,700
Standard deduction for 2011 $5,800
Taxable income $89,150
Tax on the first $8,500 (at 10%) $ 850
Tax on the next $25,999 (at 15%) $3,900
Tax on the next $49,099 (at 25%) $12,275
Tax on the next $5,549 (at 28%) $1,554
Total federal tax bill $18,579
Tax rate, compared with his gross income 18.8%
Sources: The Associated Press, The IRS
See more about comments here.