The holidays are officially in full swing, which means we're all likely packing on the pounds from fantastic home-cooked food and basking in the idea of much-deserved time off with family and friends.
But, the end of the year, which is now less than four weeks away, brings a potentially unwelcome reminder for the approximately 150 million Americans expected to file an individual tax return for the current year. With few exceptions, any tax-based moves that consumers want to make to better their tax situation in 2015 need to be completed by 11:59pm on Dec 31, 2015, otherwise they'll take effect for the following calendar year.
Everyone's tax situation is different from the person sitting next to them, but a recently released research report from the Tax Foundation, using data from the Organisation for Economic Co-operation and Development (OECD), has created a model that allows us to see what the average American pays in taxes each year.
Before we dive headfirst into what the average American's tax burden is, we should first get a better understanding of what taxes taxpayers, and possibly employers, are responsible for paying.
Calculating your income tax
The average American, according to the OECD, earns $54,977 in pre-tax income per year. Now let's start whittling that total down through taxation.
The tax that consumers are probably most familiar with is the federal income tax. Federal income taxes are what the government uses to fund its enormous defense budget, to pay for education and job-training programs expenses, and even to fund its interest payments on debt borrowed from other countries.
Federal tax rates are progressively separated into seven tax brackets, ranging from as low as 10% to as high as 39.6%, which vary based on your filing status (single, married filing separately, married filing jointly/qualifying widow(er), or head of household) and income. In general, the more money you make, the more you'll owe in federal income taxes.
Below you can see how the federal tax brackets affect a single filer in 2015:
You'll note that your highest marginal tax bracket isn't your effective tax rate. In other words, the average American earning $54,977 annually doesn't owe 25% on their entire pre-tax income of $54,977. For one thing, taxpayers get standard deductions and personal exemptions that help lower their taxable income. For instance, single and married persons filing separately are looking at a $6,300 standard deduction in 2015, and taxpayers may have additional personal exemptions on top of this which can lower their taxable income to the federal government.
Even once you take out those deductions and exemptions, you won't owe your marginal rate on the entire amount. Instead, singles will owe 10% on their first $9,225 in taxable income, 15% on every dollar earned between $9,226 and up to $37,450, and so on according to the brackets listed above.
Using some assumptions and running the math, this works out to a total federal income tax burden of $8,631. That's an effective tax rate of 15.7% per the OECD for the average American taxpayer.
In addition, we should note that consumers also potentially pay state and local taxes, too. Even though Tax Foundation's findings don't go into great detail about state and local taxes, the OECD findings from the U.S. in 2014 suggest the average taxpayer paid roughly $2,600 in state and local taxes.
Understanding your payroll tax obligations
The other primary component of taxation for the American worker is the payroll tax. Payroll taxes are paid by you and your employer, or if you're self-employed you get the "luxury" of covering both halves.
There are three basic components of your payroll tax obligations: Social Security, Medicare, and unemployment insurance taxes.
Social Security is the program primarily designed to provide a financial backdrop for low-income Americans during retirement. In general, workers and employers each pay a 6.2% payroll tax which heads to the Social Security Administration on each dollar earned up to $118,500 as of 2015. Every dollar beyond $118,501 is untouched by the Social Security payroll tax. The payroll earnings cap is adjusted each year based on the rate of inflation. Self-employed persons are required to pay the employer and employee portion, and are thus shelling out 12.4% of their pre-tax income to the SSA's payroll tax.
Medicare is the second component of a workers' payroll tax. Medicare is the social program that primarily helps seniors pay for their hospital coverage and outpatient physician visits and services during their golden years. Workers also split this tax with their employers, with each party paying a 1.45% tax on your pre-tax income. Just as with Social Security, if you're self-employed you'll need to come up with the 2.9% tax on your own.
However, one major difference is that there is no earnings cap on Medicare. If you make $1 million, you'll be paying tax on every dollar that you earn unlike with the Social Security payroll tax. Furthermore, each dollar earned in excess of $199,999 leads to an additional 0.9% tax on the employee, not the employer.In other words, employees earnings more than $200,000 annually are on the line for a 2.35% Medicare tax.
Finally, there's the amount diverted to pay for unemployment insurance. As you might expect, unemployment insurance covers workers against an unexpected loss of income should they lose their job. This is a tax levied on the employer, and it varies from state to state based on how often employees collect unemployment insurance. As Tax Foundation notes, the federal and state tax rates aren't additive, and employers can credit 90% of their state tax against the federal tax, reducing the federal rate to as little as 0.6%.
Altogether, payroll taxes account for an effective tax burden of 15.9% to the average American taxpayer, or $8,741.
The average American's tax bill
Together, income taxes and payroll taxes (with some percentage rounding involved) led to an effective tax rate of 31.5% on the average American worker, or $17,372 out of the $54,977 in pre-tax income. The average American worker is left with $37,604 in after-tax income, or about $3,134 per month.
The amount we pay in taxes might seem egregiously high, but compared to the 34 nations that comprise the OECD we're nicely below the average tax burden of 36%. We're right on par with Canada (31.5%), and just 0.4% higher than the tax burden of U.K. residents (31.1%). On the flipside, residents in Belgium, Germany, and France face tax burdens of 55.6%, 49.3%, and 48.4%, respectively.
What you can do to reduce your tax burden
To be clear, there's not much you can do about escaping payroll taxes short of moving to another country, such as Chile, which has exceptionally low tax burdens on single workers. However, there are a few smart moves you can make now to ensure you pay as little in lifetime taxes as possible.
First, ensure that you're minimizing your federal tax refund by adjusting your withholding status throughout the year. Around 80% of individual tax filers will receive a refund in any given year – and for many this can be a form of forced savings. The problem is that you're allowing the government to keep your income for up to 15 months without offering you a cent in interest. It's in your best interests to get as close as possible to a $0 refund so you can put your money to work as quickly as possible.
Secondly, consider taking advantage of deductions that won't always be around. The Residential Energy Efficient Property Credit will only be around through 2016, but it allows homeowners to take an across-the-board 30% write-off on product and labor costs to install solar systems, wind turbines, solar heaters, and other eligible alternative energy systems. If you plan on staying in your home for many years to come this could be a smart move to consider.
Finally, don't forget about the importance of tax-advantaged retirement tools. Contributing to an employer-sponsored 401(k) or Traditional IRA can lower your taxable income in the current calendar year. But, if you want to really juice your nest egg over the long run, consider opening or contributing to a Roth IRA. With a Roth, your investments can grow completely free of taxation for life as long as you don't make an unqualified withdrawals. In other words, the government can't touch it!
Making smart tax moves now should ensure you get to keep as much of your hard-earned money as possible.
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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