Pictures Your Taxes Differently
This article is the first in a series of seven conversations we’ll be having on the topic “Perfect Your Tax Savings”.
I don’t know about you, but I don’t like wasting money. As an entrepreneur, I appreciate the expression “it takes money to make money.” If I need to spend money to make something happen, I’ll do it. But I expect value to be there, especially since I am responsible for running my company like a smart business owner. If the value is there, I spend the money. The moment that the value is not there, I stop spending the money. Like most people, I can’t think of a greater waste of money than overpaying in taxes. A key in stopping this pattern is to change the way we think about our taxes. Let’s begin with some background in tax rates.
TAX RATE BACKGROUND
The federal income tax code in the United States is based on tax brackets. We can actually picture these brackets and their corresponding tax rates like a staircase. Starting at the bottom we have the lowest tax bracket rising all the way to the top where the highest tax bracket exists. The rate you are paying at any point in time depends on the step you are standing on. Most people concern themselves with a couple of ideas. Which step on the tax rate staircase am I standing on now? This is my marginal tax rate. Every dollar I earn while standing on this step will have federal income tax applied to it at this rate.
There is another concern that actually begins to fool us a little. What is the impact of all the steps I have traveled? That average is essentially how much federal income tax I have paid on the money I’ve earned.
problem is that using those two measurement criteria, we’re only looking at a fraction of the tax picture! We haven’t considered taxes such as Social Security, Medicare, unemployment, even sales and excise taxes.
WHAT IS TAX EFFICIENCY?
When I work with clients on taxes, we use a concept known as tax efficiency. Tax efficiency is essentially the measure of the total taxes that you’re paying against the total income you make. The reason tax efficiency is so important is because it tells us how much money we have to make to take home the money we want. Let me give you an example.
Let’s say Tom and Judy have a tax efficiency rate of 65%. That means they pay 35% of their income to taxes of all varieties. Tom and Judy need to take home an additional $1,000 for a purchase they been planning to make. With a tax efficiency rate of 65%, Tom and Judy will actually have to earn over $1,500 to be able to take home that $1,000.
That actually sounds a little bleak. But it can be even worse if Tom and Judy are small business owners. In that case, they would be responsible for not only the employee taxes on their income but also the employer side. That can lower that 65% tax efficiency rate. Now take into account that Tom and Judy may have certain business expenses they incur when they sell a product. Those necessary business costs would force Tom and Judy to earn a greater amount to get to that extra $1,000 of take home money. So let’s say that to earn $1,500 in their business,
and Judy have to incur another $500 of business expenses. We would have to add that $500 to the $1,500. Now Tom and Judy need to earn over $2,000 to take home $1,000. Yikes!
Clearly this is a topic that has lots of moving parts and is unique to each individual situation. The important thing is to begin to picture your taxes differently. That’s the purpose of our conversation today. Do you have a better focus now about your real tax rate?
If the subject has you worried or a little bit down, don’t fret. There is good news! If you find a professional to work with who understands the concept of tax efficiency, there are lots of available techniques to improve your tax efficency percentage. The net result will be you keeping more of your hard-earned dollars. That will be our focus over the next six articles of this series, “Perfect Your Tax Planning”.