The 3 Most Common Income Tax Myths That Just Won't Die
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Statistically speaking, most people don't like preparing, or even thinking about, their income tax returns.
A survey from Pew Research Center in 2013 showed that 56% of Americans either "hate" or "dislike" doing their taxes each year, compared to 34% who either "love" or "like" it. Despite the general contempt toward tax preparation, about 80% of taxpayers receive refunds, making Tax Day something of a payday for most tax-paying individuals and families.
Yet, in spite of taxes being part of the American culture, there are quite a few myths floating around regarding income taxes. Today, we're going to put three of the most common income tax myths to bed -- hopefully for good!
Income tax myth No. 1: The wealthy don't pay their fair share
One of the longest-standing myths is that the rich aren't paying their fair share come tax time.
On one hand, the rich do get an extraordinary number of benefits that allow them to keep more of their wealth and take advantage of tax breaks at a particularly high level compared to lower quintiles of income earners. For instance, Social Security caps its payroll tax at $118,500 in 2016, meaning anyone with earned income above this amount won't be paying the 12.4% payroll tax into the program (typically this tax is split down the middle between you and your employer). Most Americans make less than this amount, meaning they're paying into the Social Security program with every cent they earn.
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Additionally, the rich tend to generate a good chunk of their wealth from investments. Long-term capital gains taxes of 20% are a far cry from the top-tier ordinary income tax bracket of 39.6%, which means the well-to-do are able to keep most of their gains and reinvest them.
Let's also not forget that charitable deductions are taken as a percentage of your ordinary income tax bracket, meaning those in the highest bracket (39.6%) can receive a $0.396 deduction for every $1 donated. Donations made by lower-income quintiles will net smaller deductions.
Despite the Congressional Budget Office estimating that the highest quintile of taxpayers net 51% ($445 billion) of all major tax deductions compared to just 8% for the lowest-earning 20% of the population, the top 1% of income earners still pay an average effective tax rate of 33.4%. This compares to the average effective tax rate of 3.6% for the bottom 20% of the population. The wealthy typically owe more when it comes to estate taxes, corporate taxes, and individual income taxes than the lower quintiles according to Tax Policy Center data from 2015.
When all is said and done, the top 1% are responsible for more than 25% of all federal income tax revenue collected by the Internal Revenue Service.
Income tax myth No. 2: Lower-income workers aren't paying any tax
Another common income tax myth is the exact opposite of the above: that the lowest quintile of the population isn't paying any tax.
Just as we saw with the first myth, there's a small shred of evidence to back this up: the bottom 40% of income earners don't pay any individual income taxes. Lower-income individuals and families often qualify for a bevy of deductions that can potentially lower their taxable income to $0.
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However, just because low-income taxpayers manage to avoid paying individual income taxes, it doesn't mean they escape without paying taxes at all. As mentioned above, if you work you're paying into the Social Security and Medicare programs via payroll taxes. If you're employed by someone, this means paying 6.2% of your earned income into the Social Security program, and 1.45% of your income toward Medicare. In fact, it's not uncommon for payroll tax rates to be higher than individual income tax rates for all but the top 10% of income earners.
In addition to payroll taxes, lower-earning quintiles are more susceptible to excise taxes, which are indirect taxes paid for gasoline, alcohol, gambling, cigarettes, and other goods and activities. The bottom two quintiles may only pay an effective tax rate of 3.6% and 7.8%, respectively, but they're definitely contributing to the pot.
Income tax myth No. 3: Getting a tax refund should be my goal
Lastly, most taxpayers do everything in their power to ensure they get a fat refund come tax time. According to IRS data from late February 2016, the average refund issued to the roughly 80% of Americans owed refunds was a healthy $3,053.
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In one respect, a big refund can make a lot of sense. For those taxpayers who have a really hard time sticking to a budget and resisting the impulse to spend, paying tax is a way of forcing themselves to save, with the refund being their reward.
However, getting a refund is an admission that you've poorly managed your own money. You see, the IRS can possess your money for months, or perhaps even more than a year, without giving you a single red cent in interest. Of course, if you owe money and don't pay, you can expect to owe fees and interest.
Instead of allowing the IRS to send you a refund, you could have adjusted your W-4 tax withholdings to reduce or eliminate what you pay the federal government in taxes, allowing your paychecks to be immediately bumped higher. Getting your money now rather in a few months can allow you to more effectively invest for your future and/or reduce existing debt.
In reality, getting a tax refund from the IRS probably isn't an optimal or effective use of your money. The goal should be to get your refund/tax owed to as close to $0 as possible.
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Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.
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