tax muleIn the spirit of tax season, I figured I would spend some time updating my post on taxes. I always seem to need a bit of perspective after forking over a considerable amount of money to Uncle Sam, so here goes.

Please keep in mind that this is not a political post nor a reflection of my views on social issues. This is simply an objective look at taxes from a purely analytical point of view, along with my perspective.

For my international readers, please bear with me, as this will be a fairly US centric post. Although I'm sure many elements will be similar to your region.

Federal Income Tax Brackets

The US has a progressive tax system, where the average tax rate of a household/individual is often lower than the marginal tax rate. The table below shows the tax brackets for 2017, based on marginal tax rates, courtesy of Bankrate.

2017 tax brackets

This doesn't mean that everyone will pay those exact percentages based on the incomes shown. If only it were that simple! Often the average tax or effective tax paid is lower since you get taxed on the portion of your income in a given threshold against the applicable rate.

The income thresholds shown are also based on Adjusted Gross Incomes (AGI) which are often lower than real incomes for wealthier individuals or business owners who have many deductions available.

Effective Tax Rates

So how much taxes do people actually pay? Here's a chart showing effective tax rates at different AGI thresholds for the latest available tax year from the Tax Policy Center.

Effective tax rates 2018

I like this table because it gives a more granular view of the income thresholds. I also like it because it includes payroll taxes, so it shows a more holistic view of tax burdens. I'm excluding sales, state income, and property taxes from this analysis, since the variations are too great.

According to this information, the average tax unit (think an individual or household), paid an effective tax rate of 19.8%.

A few observations from the table:

  • About 92% of tax units had incomes <$200K, the remaining 8% had incomes >$200K.
  • 43% of tax units paid less than half the average, while 8% of tax units paid more than the average.
  • That same 43% had incomes <$40K.
  • To be considered in the top 1% tax unit, roughly speaking, you would need an income of >$500K.

As a point of reference, the MYF household recently paid an effective 26% tax rate. That's about 30% higher than what the average tax unit paid.

The Real Tax Burden

Talking about effective tax rates only tells part of the story. If you want to get a true sense of the real share of income taxes paid, you have to look at the total amount of individual income taxes we all paid to operate the country. In 2017, that number was expected to be $1.66 Trillion, according to the Tax Foundation.

The chart below from the same source, visually shows who shouldered the highest burden by income bracket based on 2014 data. I don't expect this distribution to be materially different in 2017, although 2018 and beyond may be a different story with the new Trump Tax plan.

real income tax burden

As you can see, 97.3% of all income taxes were paid by 50% of taxpayers.

If your tax unit income is roughly >$40K, you're considered to be in the top 50% of income earners in the country.

Which Tax Mule Are You?

Imagine you were one of six mules, representing the six brackets in the chart above. The blue bars in the chart represent your AGI as a percent of the total ($1.66 Trillion). They are also figuratively speaking, a representation of your muscle mass relative to the other mules.

Now imagine that the share of income taxes paid, the red bars in the chart above, were supplies you had to carry around for the benefit of your entire mule pack. Logic would follow that each mule should carry a burden that matches its ability, or muscle mass.

In the case of the distribution shown in the chart, it's clear that some mules are carrying more than their fair share. In fact, if you're in the 5% or greater income bracket, you may be feeling a little bit like this…

via GIPHY

I must admit, I felt more like donkey from Shrek after I signed over my virtual check to Uncle Sam. We used to get refunds every year, but that recently changed. Of course I recognize this is a good problem to have.

In the past 3 -4 years, the MYF household crossed into the top 5% bracket, which is something to be thankful for, and a big reason for our increase in net worth. We may even be able to barely squeak into the top 1% bracket in the next few years, which should hopefully buy us more freedom years.

There is however a real price to pay, in the form of stress/health, a heavier burden, and overall happiness.

The Optimal Mule

Seems to me that the best bracket to be in, based purely on ‘burden/muscle' ratio, is the 10-5% bracket. That roughly corresponds to a tax unit income between $100k-$200K. It also happens to be taxed at an effective rate of 18.7%, which is pretty close to the average.

I believe this is the optimal mule to be in the pack, for the following reasons:

  • No one can argue that this mule isn't carrying its fair share.
  • You still have a shot at millionaire status and financial independence.
  • You don't have the psychological burden/stigma of feeling like the other mules are carrying your load.
  • You avoid the stress and additional effort associated with the more burdened mules.

Of course if you're still carrying a lot of debt, such as mortgage debt or student loan debt, you're still better off chasing the higher incomes until those debts are eliminated.

Final Thoughts

If you're wondering how all that money is spent, check out the graphic below from the National Priorities Project.

how taxes are spent

In keeping with my promise of not getting political with this post, I will simply leave you with that image.

But I do have one other point…

If I continue to work for the next 5 years, my household would have paid in excess of $1 Million in federal income and payroll taxes during the course of our 25 year careers.

In fact, if we assumed that the average tax burden a year is $9,400 (based on the national burden of $1.66 Trillion, and the 176K tax units). A typical 50 year journey should carry a $485K lifetime burden per tax unit.

Since we're considered one tax unit, we would have contributed at over 2X the expected burden, in half the time.

Should I opt to retire early, I can rest assured that we carried more than our fair share for the pack.

Of course there will be plenty of haters that will accuse us of living off the system, even though we chose to “front-load” our tax contribution. If the graphic above is any indication, I'll attribute that phenomena to our minuscule spend on education/science.

PS:  Shout out to the Need2Save household who originally inspired me to run my lifetime tax calculation.

Readers, are you surprised by any of the statistics on taxes? Do the numbers match the popular rhetoric on the subject? Do you feel like a tax mule? Do you think early retirees should be criticized if they paid their bill early? Share your thoughts and comments below! – Max