Each year, once I’ve completed and filed our income taxes, I like to spend a little time calculating my household’s effective tax rate. What’s an “effective tax rate,” you ask?
Well, it’s a way for me to get outside of the usual “What tax bracket are you in?” thinking that so many folks seem mired in. Yes, income-tax brackets get all the media focus and hubbub, especially when tax rates change, but last time I checked, I pay more taxes than just the “income” variety.
Since income taxes are really only part of our overall, real-world tax picture — think Medicare taxes, Social Security taxes, property taxes, and so on — it strikes me that figuring a more comprehensive “effective tax rate” gives a much better feel for how much of our money is really going out the door to the Tax Man.
What’s Included in ETR?
When I calculate my effective tax rate (“ETR,” for short), I start by figuring out my household’s gross annual income. That includes total wages and salaries (Form W-2, Box 3), interest earnings, non-retirement-account investment income, and any other sideline income that existed for that tax year. Added together, all those items get me the “Gross Income” figure for my formula below.
On the taxes-paid side of things, I tally up our federal income taxes paid (Form 1040, Line 60), minus any credits below that line — the last two years’ “Making Work Pay” credits would qualify here. Added to that are state income taxes paid (if any), Social Security taxes, Medicare taxes, and any property or local taxes that I forked over during the year. If I have any excise or other taxes that I paid during the year, I lob those in here, too.
Since I do separate some of my utility-bill taxes in Quicken, those figures go here, as well.
What About Sales Taxes?
Yes, to get a true tax picture, the year’s cumulative sales taxes also should get figured in.
However, tracking sales taxes in Quicken with any sort of precision would mean that most every transaction becomes a split. Whilst I love me some in-depth financial data, I’m just not gung-ho enough to go that far. You gotta draw the line somewhere, right?
(My annual use taxes do get figured in, though, because they’re included in the amount shown on the tax-form line I use for my Oklahoma “state taxes paid” above.)
Initially, I planned to omit sales taxes altogether. But as I wrote this, it occurred to me that I could simply fire up an annual cash-flow report in Quicken, export it to Excel, and remove all categories that either (1) aren’t sales-taxable, or (2) already had use tax paid applied. I could take the remaining categories and do a little math on them.
So I did. Figuring a rough estimate of total sales-taxes paid wasn’t too hard, with exception of auto fuel and its “cents-per-gallon, plus X percent sales tax” setup. Everything else? Pretty simple.
For instance, our sales-tax rate on groceries was 8.25 percent, and we spent $5,332 on groceries last year, taxes and all. We can estimate that $406 of this was due to sales tax. [5332 − (5332 / 1.0825) = 406]
Once I dumped that Quicken report into Excel, and autofilled the correct formulas, the sales-tax math was a breeze.
(Yeah, over time, changes in sales-tax rates will complicate this. But again, all I’m looking for is a rough estimate!)
A Tax Rate That’s “Effective”
Once all those items are tallied up, the rest is easy:
And that’s all. Take your [Total Taxes Paid] amount, and divide it by your [Total Gross Income] amount. The rate that results is your Effective Tax Rate.
Now, I’ve been calculating my effective tax rate for years, though prior to 2010 I focused only on income taxes. Because I’m a dork who finds such comparisons fun, I tried to standardize things a bit this year so that I could go backwards through our tax returns and see how our ETR — now expanded to include all the other taxes we pay — has changed over time.
So, for tax year 2010, roughly 21.9 percent of our income went toward taxes of one kind or another. For 2009, our effective tax rate was 21.5 percent. And back in 2008? A bit higher, at 23.9 percent.
Summary
For a while now, I’ve really preferred to think of my tax burden in terms of this overall “effective tax rate,” rather than in terms of federal and state tax-bracket rates … which is what so many people do. Income taxes are only part of the picture, after all. Until you look at your tax burden in total, taking into account all the directions from which the Tax Man gets into your wallet, then it’s pretty easy to miss the immense impact that taxes have on your total financial picture.
As the figures above show, I might be in the 15 percent federal tax bracket … but that sure doesn’t mean I’m handing a mere 15 percent of my income to the tax authorities!
Mike wrote:
Not as bad as I would have expected. I’m guessing compared to most American’s you are on the low end. Still it’s not easy to know you are keeping only 80 cents of every dollar earned. Another way I’ve heard it laid out is that you worked from Jan 1st until about March 19th for the government, so you are only about now starting to work for yourself.
The real cost of taxes is of course way beyond that. Every product we buy is taxed on the other end too right?
Jason wrote:
Great post. I will share this with all my clients.
Edwin @ Cash The Checks wrote:
I’m surprised, I would have guessed it’d be at about 33%.
Steve Adler wrote:
Really interesting post which shows how many different taxes people can end up paying without really noticing (I think that you can take a deduction for local taxes on your 1040 which helps those people in high sales tax States). I have a friend who works in Portland, OR which has no sales taxes and lives across the river in Vancouver, WA, which has no State Income tax. He claims to buy most of what he needs in Oregon to avoid the 8 – 9% WA State sales tax while paying no income taxes in his home State. Interesting to see how these border cities in States with radically different tax policies can be so much cheaper for overall costs just due to the proximity.
Doubler wrote:
Very interesting, and of course you’re right. To boil it down: Money is fungible.
Michael wrote:
What is amazing is everything that less than 25% of your income pays for, including medical coverage and social security payments if you are disabled or when you retire; a military as large as the combined militaries of the rest of the world (including those neat air shows and bands…I even heard the military has more personnel serving in bands than the entire State Department has foreign civil servants!); schools; local, state and national parks as well as public lands which provide clean water and recreation; the local, state and federal judicial systems; streets, sidewalks, sewer systems, flood control, water supply systems, highways, freeways, airports, and transit systems; clear water, air, and toxic waste cleanup; patents and property right protections; regulations governing everything from medical devices to lead in toys and use of public airwaves; libraries, fire and police departments, weight and measurement standards and consumer protections; medical research; foreign aid for some of the billions of destitute and diseased; monitoring of radiation, insect pests, foreign diseases….The list is amazingly long and every time I complain about taxes I try to remember the books my son is reading from the library, the police who responded to the party across the street at 2 AM, the water I can drink from my tap and the rode I drove home on, and all the rest. And I remember I am glad to live in a fairly civilized society that exists largely because we are all jointly willing to fund the multiplicity of functions necessary to maintain our society.
Michael wrote:
Michael,
Unfortunately, that “less than 25%” of my income doesn’t BEGIN to pay for any of that, as our national debt — and the condition of our states’ finances — will attest.
But it’s okay. I’m sure your son, and my daughter, will be only too happy to pick up the tab later on. I mean, they owe us. Right?
I am glad to live in a fairly civilized society that exists largely because we are all jointly willing to fund the multiplicity of functions necessary to maintain our society.
We’re not “jointly willing” to fund anything. We’re only willing to borrow and spend and play accounting games like there’s no tomorrow, and then hope the Magic Debt Fairy shows up at some point and tidies things up, all nice and pretty-like.
Failing that … ah, who cares. By then it’ll be someone else’s problem.