My brother-in-law is an experienced businessman. Intelligent guy, college-educated, etc. We were talking about Bill Gates and Warren Buffett, and he said something like: “Well, those guys give money to charity to save on their taxes.”
This wasn’t the first time that I’ve heard someone who should know better make this mistake. It’s been said about me – to my face and, I’m sure, many more times behind my back. The idea is that when you are wealthy and give money to charity, you come out ahead – i.e., it is a net benefit to you.
But as I explained to my brother-in-law, that’s not how it works. Anyone that cares only about maximizing his wealth would never give a cent to charity. People give to charity for charitable reasons.
Let’s say you earned $2 million and your tax rate for the year (counting state taxes) is 50%. You do not give anything to charity and your tax bill is $1 million (50% of $2 million). You are left with $1 million to spend.
Now let’s say you give away $1 million of that $2 million to an approved (501-C-3) charity and get a “write off” for it. Your taxable income is reduced from $2 million to $1 million. You pay 50% of that in taxes. You are left with $500,000 to spend.
So you see, after the tax deduction is figured in, giving money to charity is not a net positive. You pay less in taxes – but you end up with less money that is yours.
This is one of many myths about “rich people” and taxes. Here are some others:
The 8 Most Common Myths about Wealth and Taxes
Myth: The rich get all sorts of income tax breaks that are not available to ordinary people.
This is simply not true. There are no schemes or strategies to NOT pay the taxes you owe based on your tax bracket. The only way a wealthy person (or anyone) can pay less in income taxes is to make less.
Myth: The rich pay less in income taxes than the middle class does.
Again, this is NOT true. When it comes to the tax code, the IRS does not distinguish between rich and poor. If you make more, you pay more. This misconception arose when Warren Buffett once commented that his housekeeper paid more in taxes than he did. What he meant to do was make a distinction between capital gains tax and ordinary income tax. Ordinary income is taxed according to a scale ranging from nothing to about 38% (on the federal level). Capital gains tax is only 20%. Since more than 95% of Buffett’s income comes as capital gains, his rate, at 20%, is less than the rate at which his housekeeper was charged.
Myth: The rich do not pay their “fair share” of taxes.
Putting aside the question of what “fair share” means… No, wait. Let’s not put that aside. Every time I hear someone say that the rich do not pay their fair share, I ask them, “What would be their fair share?” And the answers I get indicate little to no understanding of the facts. When I tell them the facts, interestingly, they stick to their position. Unless, of course, I ask if they would be willing to pay that percentage of their own income to the government. No, they say, they wouldn’t. It’s “different” for them because they don’t make as much money. So “fair share” turns out to mean: “I don’t know what the rich are paying – but whatever it is, it is not enough.”
Here are the facts:
* The top 20% of income earners pay about 85% of all income taxes and more than 70% of all federal taxes, according to the Congressional Budget Office.
* The top 1% pay, on average, an effective tax rate of 33.4%. The bottom 20% pay, on average, an effective tax rate of 3.6%. The top 1% pay 37% of all taxes, which is more than 25% of all federal income tax revenue.
* The bottom 50% pay only 3% of all tax revenue.
Myth: The rich paid more in taxes in the 1950s than they do now.
During most of the 1950s, the highest federal income tax rate was 92%. But nobody paid it. There were many exclusions, exceptions, and shelters back then that don’t exist today. The average effective income tax rate for the top 1% was very low – only 16.9%. The top 1% did pay more taxes in other areas, so their total share of all taxes – 42% – was considerably higher. Still, 42% is only a few points higher than it is now.
Myth: The tax system favors the rich over the poor and the working-class poor.
The bottom 40% of all income earners benefit greatly from the income tax code. They actually pay negative income tax rates because refundable credits, such as the Child Tax Credit and the Earned Income Tax Credit (EITC), wipe out their tax liability and pay out more money to them than they ever paid in.
Because of refundable credits, a family of four in the bottom 20% paid an effective income tax rate of -6.6% in 2006. As a result, such a family received $1,300 through the tax code. A family of four in the second-lowest 20% paid an effective tax rate of -0.8% and received $408 of income through the tax code.
Myth: Illegal activity is not taxable.
Income acquired through illegal activity is still taxable. From a tax compliance perspective, the IRS doesn’t care if you’re selling drugs, robbing banks, or defrauding investors of millions. As long as you’re making money, the government is still entitled to its piece of the pie. Remember, no matter how well you cover you tracks when it comes to illegal activities, cheating on your taxes can come back to bite you. (Just ask Al Capone.)
Myth: Your tax bracket is your tax rate.
The United States has a progressive tax system. In other words, the more income you make, the more tax you pay on that higher income.
Using theoretical numbers, if you had taxable income of $30,000 last year, you would pay 10% on the first $15,000 and 15% on the 15,001st dollar through the 30,000th dollar. If you earned $30,001, you’d pay only 25% tax on that one dollar over $30,000. You wouldn’t pay 25% in taxes on all $30,001.
Your marginal tax bracket is the highest bracket that you’re in – or the one that you are in for the next dollar of income. Unless, of course, you have completely filled a bracket to the last dollar. In that case, the next dollar goes into the next tax bracket.
Myth: You shouldn’t pay off loans that have tax-deductible interest
I’ve heard people argue that you shouldn’t pay off student loans or mortgages early because the interest is tax-deductible. But while there could be other legitimate arguments for not paying off these types of loans quickly, tax-deductibility isn’t one of them.
As discussed above, a tax deduction lowers only your taxable income, not your tax due. So for every dollar in interest you pay, you save just a small portion. It usually comes out to 22 cents or less per dollar of interest you pay. While paying 78 cents is better than paying $1, paying nothing is best in my book. Paying off your loan saves you 100% of the interest you were paying.