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33% Marginal Tax rate on 'side job' money?
Old 03-25-2014, 02:56 PM   #1
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33% Marginal Tax rate on 'side job' money?

OK, I'm not a 'young dreamer', but this conversation came up with DD today. She is a teacher, and is considering taking on some private tutoring jobs. The parents would pay by cash/check. She asked me about taxes.

A little probing and it looks like you should file a Schedule C (or C-EZ). I'm assuming this income would be taxed at your marginal rate (looks like she is at 15% marginal rate), plus SS withholding (employee/employer)? But then the SS would not be subject to Fed Taxes, so some iterative calcs here, I guess?

I plugged it into an on-line calculator, and it looks like $1,000 in 'side income' would be taxed at a 28% rate, plus we have 5% flat tax in IL for ~ 33% (a bit less I guess the full amount is not taxable). An added $1,000 in regular income would be taxed at her 15% marginal rate.

I'll just say that a young person in a low tax bracket was surprised that a little extra work would be taxed so heavily. She's definitely not a 1%-er!

No surprise that many do not report this income. Giving up over $300 for every $1,000 earned removes a significant incentive to do side work.

I'd always heard about the self-employed having to pay both sides of SS, but seeing the effects up close and personal was an eye-opener.

-ERD50
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Old 03-25-2014, 03:25 PM   #2
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Welcome to the world of those of us with our own businesses (or self-employed)! Add in that regular employees get "subsidized" health insurance through pre-tax contributions and it gets worse.

Your number seems a little high, though. Paying the second half of FICA/Medi taxes should be an additional ~6%. I can't comment on the IL 5% but I'd expect that to apply equally to income from regular or self employment.

She should track and may be able to write off expenses to offset some of that extra income and reduce the effective rate. Mileage, supplies and the like are all potential deductions. If she's not maxing tax deferred, she could bump contributions to that up.

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Originally Posted by ERD50 View Post

I'll just say that a young person in a low tax bracket was surprised that a little extra work would be taxed so heavily. She's definitely not a 1%-er!

I'd always heard about the self-employed having to pay both sides of SS, but seeing the effects up close and personal was an eye-opener.

-ERD50
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Old 03-25-2014, 03:40 PM   #3
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Originally Posted by ERD50 View Post
I plugged it into an on-line calculator, and it looks like $1,000 in 'side income' would be taxed at a 28% rate...
I assume this 28% is this?

* 15% federal income tax
* 7.65% SS and Medicare tax
* 7.65% self-employment tax
* Offset by a tax deduction of about 1.15% (15% of 7.65%)

Adding that up, I actually get 29.15%.

Social Security and Medicare taxes are not deducted from federal income tax liability, unlike 401K contributions, HSA contributions or employee portions of employer-provided health insurance.
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Old 03-25-2014, 04:18 PM   #4
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She could start a Solo 401K and avoid all the income tax for now (though the payroll taxes would be due).

I'm sure you reminded her that the same taxes are being taken out of her "regular" paycheck, too (incl the "employer's part" of SS and Medicare).

It's illuminating calculations like these that can introduce a young person to the way the world actually works, taking things quickly from the abstract to the very personal and real. That's a great thing.

I'm glad to see she's even thinking about taxes, I'm sure much of the money paid in these situations goes unreported.
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Old 03-25-2014, 04:44 PM   #5
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Ziggy a lot of young people only take the standard deduction, plus there is a 5% IL state tax.

But I would think she would owe SS/medicare tax on her regular income, unless IL still doesn't have its public employee enroll in SS. . In which case I am sure ERD calculations are correct.

For a person who is self-employed and makes a modest income of $30k the marginal tax rate can easily be in the 50% range with the 15% Fed, 5-10% state/local, 15.3% payroll taxes,and then they lose an ACA subsidy of another 15% or so
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Old 03-25-2014, 05:10 PM   #6
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I assume this 28% is this?

* 15% federal income tax
* 7.65% SS and Medicare tax
* 7.65% self-employment tax
* Offset by a tax deduction of about 1.15% (15% of 7.65%)

Adding that up, I actually get 29.15%.

Social Security and Medicare taxes are not deducted from federal income tax liability, unlike 401K contributions, HSA contributions or employee portions of employer-provided health insurance.
I'm not up on what is and is not exempt from FIT, but I used this calculator:

1040 Tax Calculator

I entered $40K income, single, and got a tax of $4054, then
I entered $41K income, single, and got a tax of $4204

so delta $150 on $1,000 added income is 15%, then

I entered $40K income, plus $1K on schedule C and got a tax of $4334, so that is $280 on $1,000 added 'business income', for 28%.

Were some of those rates changed recently? Taxable income is well within the 15% range, so we are not seeing offsets there.

I clicked on view report, and saw this:

Self-employment tax deduction (Schedule SE) $71
Self-employment tax (Schedule SE) $141

But I didn't try to backwards engineer that. I was really looking for round numbers anyhow.

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Originally Posted by samclem View Post
She could start a Solo 401K and avoid all the income tax for now (though the payroll taxes would be due).

I'm sure you reminded her that the same taxes are being taken out of her "regular" paycheck, too (incl the "employer's part" of SS and Medicare).

It's illuminating calculations like these that can introduce a young person to the way the world actually works, taking things quickly from the abstract to the very personal and real. That's a great thing.

I'm glad to see she's even thinking about taxes, I'm sure much of the money paid in these situations goes unreported.
Yes, my little teacher is getting a 'teaching moment' from this.

She was going to text a friend of hers to ask her what she does about reporting her tutoring income, and I kidded her - if your friend is smart, she is not going to reply by text or email - the NSA/IRS are listening!

The motivation for many to hide this income is one reason I like the National Sales Tax idea. Since I was a W2 person my whole career, with little opportunity to hide anything (not that I would anyhow), it does ruffle my feathers to think how much of this income hiding goes on.

Sure, the same taxes are effectively taken from her regular paycheck, and this really points out the psychological value of getting $40 in your hand and realizing it is really only ~ $28, versus having that taken out before you get it, and getting a 'refund' at tax time.

-ERD50
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Old 03-25-2014, 05:20 PM   #7
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The effective tax rate is why I haven't "gone contractor" after retirement. Sure, the gross income would look great; but I'd be working for, at most, 45 cents on the dollar, with some of that going toward a SS for which I will never earn enough quarters to be eligible (having paid into my CSRS pension, rather than SS, during my career).

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Old 03-25-2014, 05:31 PM   #8
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I think your analysis sounds right and her best option is to do the tutoring, set up a solo 401k that would negate the income taxes. If she really wants to benefit if she is making tax-deferred 403 or 457 contributions at work she could reduce those but the amount she is putting into the solo 401k and pocket the cash. She would still be short by the self-employment tax but she will ultimately see a benefit from that in higher SS benefits.
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Old 03-25-2014, 05:53 PM   #9
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Old 03-25-2014, 06:25 PM   #10
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Originally Posted by ERD50 View Post
Sure, the same taxes are effectively taken from her regular paycheck, and this really points out the psychological value of getting $40 in your hand and realizing it is really only ~ $28, versus having that taken out before you get it, and getting a 'refund' at tax time.
It is one of history's great ironies that Milton Friedman, perhaps the most eloquent voice against big government for the last half of the 20th century, had a large role in devising and implementing the US system for income tax withholding. This was during WW-II, and he regretted his role in it for the rest of his life.

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"Far more important, without a system of current collection, it would have been impossible to collect the amount of income taxes that we collected during the war. At the time, we concentrated single-mindedly on promoting the war effort. We gave next to no consideration to any longer-run consequences. It never occurred to me at the time that I was helping to develop machinery that would make possible a government that I would come to criticize severely as too large, too intrusive, too destructive of freedom. Yet, that is precisely what I was doing."
-- Milton Friedman

The Solo 401K idea seems good now, and it always feels good to avoid taxes. From a big picture perspective (and if nothing changes in the law), she'll probably never be at a lower marginal rate and it might be better for her to put money into a Roth account now (at work). If she couldn't otherwise afford to max out the Roth, use the tutoring money to max out the Roth.
But: who know what will happen down the road.
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Old 03-25-2014, 08:08 PM   #11
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Thanks all for the perspective and options. Yes, I think I'll talk to her about a ROTH, we'll see how that goes.

-ERD50
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Old 03-25-2014, 09:41 PM   #12
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I did some consulting and the Schedule C thing. The trick is that you charge an hourly rate that covers the extra taxes and health insurance. That made it worth it.

If the take home doesn't seem worth it, have her look for a gig that pays a little more.
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Old 03-25-2014, 09:43 PM   #13
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Check to see what taxes are avoided by putting money into a 401(k)...

I think you still pay medicare taxes... not sure of SS... income is exempt...
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Old 03-26-2014, 07:21 AM   #14
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I think people sometimes get too hung up on what the govt cut is. Look at how much you take home + how much you save via IRA/401K. Does that make the extra work worthwhile?

I don't like paying high taxes either, but ultimately what matters is how much YOU get.
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Old 03-26-2014, 11:59 AM   #15
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I don't like paying high taxes either, but ultimately what matters is how much YOU get.
I wouldn't say quite that, not really. What REALLY matters is if you can bring value to a customer. If a large tax burden causes you to raise the price to a point where you no longer can provide a reasonable value to a customer, the improvement to society does not take place.


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The motivation for many to hide this income is one reason I like the National Sales Tax idea. Since I was a W2 person my whole career, with little opportunity to hide anything (not that I would anyhow), it does ruffle my feathers to think how much of this income hiding goes on.
On the 'fairness' side, I kind of agree, but are you ready to pay twice? You have already paid tax on everything on the taxable side of your net worth (including non-liquid assets you might sell, like your house). And then can you really trust 'em to remove income tax if they add sales tax? Oops, this is probably a thread hijack! Even though I, like you, never had the opportunity to hide income, I can understand the motivation, and often give a small tip on the CC and a matching tip in cash, hehe.
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Old 03-29-2014, 12:24 PM   #16
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ERD50, if you all (both of you) are not contributing the maximum allowed to retirement plan, then the extra income can allow that. Let me give a "fer-instance".

Suppose you contribute only $15,000 and need the other $8,000 for expenses. Even if your spouse earns $3,000 a year, you can up your contribution by $3,000 and that would shelter her $3,000 from income taxes. Yes, she would have to pay FICA/medicare, but so what?

Of course, it is psychologically tough to get a $0 paycheck even if all of it is going into retirement savings and not being taxed away.

We do something similar in our household. In the early months of each year, I contribute all my paycheck to my 401(k) plan and bring home essentially nothing. Then when I have maxed out my annual contributions, my spouse changes her contribution to max it out and brings home nothing. We get our $46,000 contributed then as soon as possible just in case we decide to quit our jobs before the end of the year. So we are both used to working and having almost 100% of our paychecks going someplace besides our checking account.
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