The Common Misconception about the Lower Rate on Capital Gains and Dividends

“In a strong rejection of the current tax code, 90 percent of respondents believe income from investments should be taxed at least as much as wages.”

That was a finding from a recent survey from Wallet Hub.

Fortunately for that 90 percent of respondents, their wish is a reality.

Warren Buffett and His Secretary

Wallet Hub explains the tax code’s treatment of investment income in this way: “Current policy taxes income from investments at a lower rate than income from wages; which results in someone like Warren Buffett paying a lower effective tax rate than his secretary.”

On the face of it, it makes sense. With federal tax policy, that should be your first hint that something is amiss.

Income from capital gains and dividends is subject to a top federal rate of 23.8 percent. This is less than the top marginal income tax rate of 39.6 percent for ordinary income. Let’s say both Warren Buffett and his secretary earn $100 (and for simplicities sake, let’s assume that Warren Buffett’s secretary is well paid and pays the top marginal tax rate on every additional dollar), but Mr. Buffett’s $100 is from dividends and his secretary’s income is from salary.

The billionaire Mr. Buffett would pay $23.80 in taxes and takes home $76.20, while his secretary, who is probably not a billionaire, pays $39.60 in taxes and only gets to take home $60.40.

How is that fair? It’s almost twice the amount in taxes.

There is More than Meets the Eye

What is not easily seen is that the $100 that Mr. Buffett earns in dividends has already been taxed at the corporate level. In fact, Mr. Buffett’s $100 didn’t start at $100, it started as $153.85.

To receive his $100 dividend payment, Mr. Buffett must own shares in a corporation, which we will call Company A. Company A earned $153.85 in profits on Mr. Buffett’s behalf. This $153.85 is then subject to the federal corporate tax of 35 percent, or $53.85.

The corporation pays the $53.85 to the federal government on behalf of Mr. Buffett and then passes the remaining $100 to him in the form of a dividend. This is the $100 we discussed earlier, on which, Mr. Buffett pays $23.80 in dividend taxes.

Mr. Buffett’s Actual Tax Rate

Now that we know this, what would Warren Buffett actually pay in taxes and what would his tax rate be?

In the situation described above, Mr. Buffett pays $77.65 ($53.85 in corporate taxes and $23.80 in dividend taxes) on $153.85 in income.

This is a tax rate of 50.47 percent. Or, as 90 percent of respondents had hoped, 10 percentage points higher than the top marginal tax rate on wages.