While looking into my taxes this year, I was a little surprised that while taxation within a form is pretty progressive (more income = higher tax rates), the forms of taxation seem to be regressive.

Here’s a few examples of someone earning $1MM dollars over 10 years and how they’d be taxed (federally). All calculations are for a single filer with some other simplifying assumptions¹

How much you’d take home after taxes in an average if you “made” $1MM over 10 years by how you made it:

1. Inheriting enough to live on is the best, keeping all of $100,000 every year
2. Living off savings is close behind with ~$99,000
3. A steady salary clocks in at $85,232
4. A variable salary a little worse at $84,516
5. Going to school to earn big bucks $79,956
6. And winning it in the lottery leaves you scrounging off $66,500

Of course it’s a silly exercise in a lot of ways: you never get to choose one of those options and both the 10 year and $100k numbers are completely arbitrary.

… but I can’t help but notice the skew away from working and towards owning which really feels like it encourages the wrong things at the margins.

Here’s the math:

Base case: earning $100k/year for 10 years Earn $100k, pay $14,768 in taxes every year. Total: $147,680 in taxes.

Getting a fancy degree in 5 years and earning $200k/year for 5 years Pay $0 for the first 5 years, then $40,088/year for the last 5 years for a total of $200,440 in taxes²

Earning $150k some years and $50k other years Let’s say you’re in a boom-bust industry, some years are better than others. This could be because of sales commissions or just project based work where some years you get more work.

Pay $4,241 in the bust years and $26,728 the boom years, assuming a 50/50 split that’s $154,845 in taxes paid.

Inheriting $2.5MM and withdrawing 4% a year I’m going off the principal that you can usually withdraw 4% safely per year.

This one is a little more complicated to calculate. Because of the step-up basis rule, neither side will pay anything on the inheritance. You’ll only be paying long term capital gains on the growth since inheritance of whatever you cash out.

So let’s the asset grows 5% every year and you cash out $100k. There’s a 0% rate on the first $44,625 of capital gains, so there’s nothing to tax until the asset has appreciated at least 44.6%. At 5% this doesn’t happen until year 14, but even then the standard deduction still applies so there won’t be any tax paid at all until year 20³.

Earning $2.5MM yourself and withdrawing 4% a year If you didn’t inherit the stocks, you pay capital gains on any growth since you bought them. So how much they’ve grown before you start withdrawing the $100k matters but it’s still pretty low. If they’ve doubled on average, you’ll be paying ~$6000 total over the 10 years and it won’t start until the fourth year⁴.

It doesn’t feel intuitive but if you’re selling $100k worth of stock that has doubled in value then half of it is gains so you’re only being taxed on $50k which is still under the threshold once the standard deduction kicks in. By year 4, you’re assets have grown 243% so 59% of the value of is gains and selling $100k worth finally realizes enough gains to sneak some of it into the 15% bracket.

Winning $1MM in the lottery Easy again, if you win $1MM in the lottery and somehow get it as a lump sum of $1MM, you’ll pay federal taxes of $328,164 + the additional medicare tax of ~$7k for about $335,000

Footnotes

1. … in a state without an income tax at an employer that doesn’t offer a 401k. I haven’t included FICA/Social Security (because the amount you pay goes into your benefit calculations). All rates calculated for tax year 2023, rather than a span of 10 years; tax brackets tend to rise pretty cleanly with the CPI so you could consider this $100k in real (not nominal income). You’re always invited to check or re-do my math. I’m using https://smartasset.com/taxes/income-taxes unless otherwise indicated. ↩

2. Up to $2500 of student loan interest is tax deductible, which helps a little — but of course that means you still have to pay it and the principle on any loans. Let’s oversimplify and imagine you got a full ride scholarship. ↩

3. Math here. If anything this understates the advantages: if there are multiple different assets (stocks etc) you can optimize the sales, selling some faster gainers earlier on to max out the 0% rate. ↩

4. Again math is here but the biggest input by far is just how much capital gains have already happened since htey don’t get wiped like they would in an inheritance. ↩