September 22, 2024
Top W-2 earners in the U.S. not only work some of the hardest jobs but also bear the brunt of the tax system.
In the U.S., high-income W-2 earners often face a stark reality: they not only work long hours in demanding careers but also pay some of the highest tax rates in the country. Despite their considerable income, much of it is claimed by the government through taxes. Let’s break down why these top earners are taxed so heavily, how their work is taxed more aggressively than investment income, and the impact this has on their overall financial standing.
High Taxes for the Hardest Workers
For many top W-2 earners, including executives, doctors, and lawyers, federal income taxes alone can reach up to 37%, the highest marginal tax bracket. But the story doesn’t stop there. In states like California, New York, and New Jersey, state income taxes can add another 10-13%, creating a combined federal and state tax burden of nearly 50%. And if you live in a major metropolitan area with local income taxes, such as New York City, that burden grows even higher.
On top of federal and state taxes, these high earners also pay payroll taxes like Social Security and Medicare. While Social Security taxes are capped after earning $160,200 in 2023, Medicare taxes have no cap, and an additional 0.9% Medicare surtax kicks in on wages above $200,000 for individuals and $250,000 for couples .
Comparing W-2 Earners with Capital Gains
One of the major frustrations for high W-2 earners is that capital gains—profits from investments like stocks or real estate—are taxed at a much lower rate. The top capital gains tax rate is just 20%, and in some cases, can be as low as 0-15% for certain investments held long-term. This stark contrast between earned income and investment income highlights a fundamental tax imbalance in the U.S. system: those who work for their income often pay far more in taxes than those whose income comes primarily from investments .
The Effective Tax Rate Can Be Overwhelming
When combining federal, state, and local taxes, as well as payroll taxes, the effective tax rate for top W-2 earners can easily surpass 45%, and in many cases, approach 50%. This means half of their hard-earned money goes directly to taxes, a higher proportion than for many lower-income Americans. According to data from the Congressional Budget Office (CBO), the top 1% of income earners paid an average effective tax rate of 29.8% in 2021, which includes federal, state, and local taxes .
While this number seems lower than expected, it’s important to remember that this is an average across various forms of income, including capital gains. W-2 earners in high-tax states often pay more than 40% of their income in taxes. For example, an executive earning $600,000 per year in California could easily see a tax bill of $250,000-$300,000, depending on their deductions and local tax rates.
Why Do W-2 Earners Pay So Much?
W-2 earners pay more for several reasons:
1. Progressive Tax System: The U.S. tax system is progressive, meaning the more you earn, the higher your tax rate. For high-income W-2 earners, they are often taxed at the highest marginal rates on most of their income.
2. Limited Deductions: High-income earners have fewer deductions available to them compared to those with lower incomes. Popular deductions and credits like the Earned Income Tax Credit (EITC) phase out for higher earners, and even charitable deductions and mortgage interest deductions offer only limited relief .
3. Payroll Taxes: W-2 income is subject to payroll taxes that don’t apply to income from capital gains, dividends, or other investment earnings. This adds an additional 7.65% for employees and even more for those subject to the Medicare surtax.
Real-Life Example: The Bay Area Tech Executive
Consider a tech executive in Silicon Valley earning $500,000 per year. At the federal level, their taxable income puts them in the 37% bracket, which translates to about $185,000 in federal taxes. Add California’s 13.3% state tax, and that’s another $66,500. Include payroll taxes for Social Security and Medicare, and the total tax burden can easily surpass $270,000—over 50% of their income.
What Can Be Done?
The discrepancy between W-2 income and investment income taxation is a key topic of debate in tax policy. Proposals to raise capital gains taxes or provide more deductions for W-2 earners have been discussed, but the fundamental structure of the U.S. tax system remains largely unchanged. High earners can take advantage of strategies like retirement contributions, charitable donations, and real estate investments to reduce taxable income, but these options are limited compared to the tax benefits available to investors .
Conclusion
Top W-2 earners in the U.S. not only work some of the hardest jobs but also bear the brunt of the tax system. With federal, state, local, and payroll taxes combined, many of these earners pay close to half their income in taxes. While capital gains and other investment income enjoy favorable tax treatment, high W-2 earners are often left wondering why their hard work results in such a steep tax bill. The current tax system creates a stark contrast between different income types, leaving many to question whether it’s truly fair .