The Average Effective Tax Rate And How To Lower It

The average effective tax rate in America and how to lower it

Let's take a look at the average effective tax rate and how to lower it. With President Biden now in office, the capital gains tax rate and marginal income tax rate are likely going up!

Every year, the Bureau of Labor Statistics (BLS) comes out with its Consumer Finance Survey that compiles data from two years ago. The data gives us some detailed insights into how the U.S. consumer is doing.

For example, let's look the most recent average expenditure per consumer unit available from the U.S. Bureau of Labor Statistics in 2021. For 2018, average expenditures per consumer unit were $61,224. This is a 1.9% increase from 2017 levels.

Given the median age in America is roughly 38, spending over $61k in after-tax income is quite a healthy amount.

Nobody should be crying for the average American. We are truly living in one of the richest, most comfortable countries in the world.

The Average Effective Tax Rate In America

Below is the latest data from the BLS which shows the average income before taxes of $78,635.

To calculate the average effective tax rate, we simply input the average income of $78,635 into an income tax calculator.

Based on the calculations, the marginal federal tax rate is 22% and the effective tax rate is 13.32%.

Given the maximum taxable amount for FICA is $137,700 for 2020, the average income earning household pays the full 7.65% FICA amount.

  • If the average household lives in one of the seven no state income tax states, then their total effective tax rate is 20.97% (Federal + FICA).
  • For those living in high income states such as California, the average American households there would pay an estimated 26.13% effective tax rate, or $20,547 in taxes on their average $78,635 income.
  • If you want to exclude FICA from the effective tax rate calculation given it is included in Spending, then the average effective tax rate ranges from 13.32% – 20.97%.

How To Reduce Your Tax Liability

Tax will undoubtedly be your largest ongoing liability, especially if most of your income comes from W2 wages. Your mission should be to figure out ways to reduce your tax liability as much as possible.

Here are three of the best ways to reduce your tax liability.

1) Reduce W2 Income, Increase Dividend Income

Instead of earning most of your money from W2 wages (traditional full-time work), think about earning more investment income that is often taxed at a lower rate.

As soon as an individual starts making over $38,701, their long-term capital gains tax rate falls below their marginal Federal income tax rate.

Long-term capital gains tax rates by income for single filers

Your goal is to build a large after-tax investment portfolio so you have more financial freedom. Your 401(k) and IRA retirement accounts can't be touched without a 10% penalty before the age of 59.5.

The larger your after-tax investment portfolio, the more passive income you can generate to live more free. Here is a list of the best passive income investments you can make based on variables such as feasibility, risk, return, and more.

2) Increase Rental Property Income

In addition to earning more efficient investment income, you can look into generating rental property income. Real estate is one of my favorite asset classes to build long term wealth because it is a real asset that generates real income.

Unlike stocks, real estate just doesn't go *poof* overnight in a downturn. Real estate is usually less volatile and provides a much steadier stream of cash flow due to rental lease agreements and the friction it takes for a tenant to move.

Recessions usually last only 8-18 months. Rental lease agreements are usually 1-3 years long. Therefore, rental lease agreements really help with the stability of cash flow.

Further, rental income is shielded due to non-cash amortization expense as well as all other expenses that result from running a rental property.

How to pay no taxes on rental property income

The only thing about owning rental property is that it scores low on the passive investing scale. The older and richer you get, the less you want to deal with maintenance and tenants. This is where investing in real estate crowdfunding platforms like Fundrise and CrowdStreet come in.

Real estate crowdfunding allows you to invest in commercial real estate around the country with potentially higher returns without any grunt work. I personally have $810,000 invested in real estate crowdfunding to invest in heartland real estate.

For example, there is huge valuation and cap rate differences today between expensive coastal city real estate and heartland real estate. With real estate crowdfunding, an investor can arbitrage the valuation and cap rate differential for potential profits.

There's no reason employees need to be stuck paying $4,500 a month for a crappy two-bedroom apartment in San Francisco or Manhattan when they can rent a massive house for half the price in Austin, Texas.

Companies like Google have committed an additional $13 billion to buying heartland real estate in 2019-2020, and the trend is definitely going towards cheaper areas of the country thanks to technology and sky high coastal city real estate prices.

Getting wealth is all about investing in long-term trends. Investing in heartland real estate is a multi-decade trend I foresee.

3) Earn Business Income

Business income can be shielded by various business deductions. For example, you can write-off your cell phone, laptop, and office to your revenue. If you go on a business trip to Hawaii, all transportation and hotel fees are also deductible.

The most common business set ups are an LLC or an S-Corp. The S-Corp has an advantage of paying yourself a smaller salary to pay less FICA tax, and paying the rest of your profits in distribution.

Below is an income statement for a business that has loads of deductions. Instead of paying taxes on $100,000 of revenue, the business will only have to pay tax on $24,000 or less of operating profits.

How to pay no taxes on a business

The best way to start a business is to simply start your own website like this one. Here's my step-by-step guide on how to start your own website in under 35 minutes.

It's so cheap and easy to do nowadays thanks to technology. When I established Financial Samurai in 2009, I had to pay 20X more and hire someone to do it for me.

Not only is running my own lifestyle business more lucrative than when I was working as an investment banker, it's much more fun! I can run it from anywhere there's internet access, which means I can travel endlessly. To be your own boss is a dream come true.

Related: How To Pay Less Taxes Like Billionaires

The Average Tax Rate Is Going Down

Federal income tax levels are at its lowest levels in decades. Take advantage by earning more money and boosting your wealth as much as you can today. There's no telling what will happen to tax rates once the Tax Cut And Jobs Act expires on December 31, 2025.

You've only got to get rich once. Once you're rich, it's all about holding onto your capital for as long as possible.

Grow Your Wealth

The best way to grow your wealth is to diligently keep track of your wealth. Check out Personal Capital, the best free financial tool to make sure your finances are on track. I've used their free tools since 2012 and have seen my net worth 5X since.

You can track your cash flow, analyze your investments for excessive fees, and meticulously plan for your retirement with their award-winning Retirement Planner tool. All you've got to do is link up all your accounts so the software can use real data to analyze your most likely financial outcomes.

Personal Capital Retirement Planning Calculation For Estate Tax Planning

Remember, there's no rewind button in life. Find ways to minimize your tax liability and grow your capital. Your old self and your children will thank you!

About the Author: Sam worked in finance for 13 years. He received his undergraduate degree in Economics from The College of William & Mary and got his MBA from UC Berkeley. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $250,000 a year in passive income. He spends time playing tennis, taking care of his family, and writing online to help others achieve financial freedom too.

Sam started Financial Samurai in 2009 and has grown it to be one of the largest independently owned personal finance sites in the world.