I was recently working on our taxes for 2022, and it looks like our effective federal tax rate was 1.4% (about 6% if you include Social Security and Medicare taxes). According to the Tax Policy Center, the average effective federal tax rate in 2021 was 8.1% (14.7% including payroll taxes), so our rate appears quite low. However, income levels have a big effect on tax rates (which is unsurprising since we have a tiered tax system where higher earners pay a higher income tax rate). In fact, the average effective federal tax rate for those in the bottom 20% of income (below $27,900) was -19.9% in 2021. That means they actually received money from the government in the form of refundable credits rather than paying taxes. On the other hand, those in the top 1% of income (over $882,500) had an effective tax rate of 24.2%. So, how was our tax rate so low?
Every tax filer gets to choose between either taking the standard deduction or itemizing deductions. About 90% take the standard deduction as of 2018. This deduction does not reduce your taxes directly, but it instead reduces the amount you owe taxes on. For example, the standard deduction for a single filer is $12,950 for 2022. This means that if you were in the 22% tax bracket (assuming the deduction does not move you down to a lower tax bracket), the standard deduction would reduce your taxes by $12,950 x 0.22, which is equal to $2,849.
Like most tax filers, we took the standard deduction, which was $25,900 for a married couple filing jointly.
Long-Term Capital Gains
Some income is taxed at more favorable rates. This includes long-term capital gains, such as from selling investments. Rather than ordinary income, which is taxed at rates from 10% to 37%, long-term capital gains are taxed at 0%, 15%, or 20% depending on your income. To qualify for these lower tax rates, make sure to wait at least a year before selling. You can read more about capital gains tax here.
For us, we made about $19,000 in long-term capital gains in 2022, which were taxed at 0%. This was the result of selling investments as part of the down payment for the house we bought at the beginning of the year. Since I was aware of the favorability of long-term capital gain tax rates, I made sure to only sell investments that I had held for at least a year.
Another source of income taxed at more favorable rates is qualified dividends. These are also taxed at the capital gains tax rate, while ordinary dividends are taxed as ordinary income. A dividend is considered a qualified dividend if you buy the security more than 60 days before the record date and hold it for at least 61 days during the 121-day period before the next dividend. However, keep in mind that some dividends are exempt from being treated as qualified dividends. These include dividends paid by REITs, MLPs, and employee stock options. You can read more about qualified dividends here.
About 84% of our dividends in 2022 were qualified dividends, so they were taxed at a lower rate than our ordinary income.
Child Tax Credit
Tax credits are better than deductions and favorable tax rates because they directly reduce the tax you owe. Some are refundable, meaning that you can get the credit even if you owe less tax than the value of the credit (hence the negative tax rate numbers mentioned above for people with very low incomes since rather than paying the government, they receive money instead), while others are nonrefundable, which can only reduce the tax you owe.
One nonrefundable credit is the child tax credit, which is a credit for $2,000 for each qualifying child. This amount is reduced above a modified adjusted gross income of $400,000 for those who are married filing jointly and $200,000 for other filing statuses.
Since we have two children, we received a $4,000 credit, saving us $4,000 off our taxes.
Child Care Expense Credit
Another nonrefundable tax credit is the child and dependent care expenses credit. This is a credit based on the amount you spent on child or dependent care worth up to $1,050 for one child ($3,000 of expenses x 0.35 for the lowest income level) or $2,100 for two or more children ($6,000 x 0.35). The multiplier is decreased at higher incomes. For those with adjusted gross income above $43,000, the amount of expenses is multiplied by 0.20 for a maximum credit of $600 for one child or $1,200 for two or more. You must file a joint return to claim this credit unless you are separated or living apart, and both partners must have earned income or be students.
We paid $3,288 for daycare and preschool expenses in 2022, so our child care expense credit was $3,288 x 0.20, which equals $658.
There are a lot of ways to reduce your tax burden. Some of the most common ways, which we personally took advantage of for 2022, include the standard deduction, long-term capital gains, qualified dividends, the child tax credit, and the credit for child and dependent care expenses. Make sure to consult with a tax professional to find out how you can reduce your taxes.