Financial Planning, Taxes

How Am I Taxed?

Taxes confuse almost everyone.

And people wrongly assume because they have an accountant or CPA that they are getting tax advice. To be fair, the tax code is long and confusing. To make matters even worse, for some reason, taxes are not actively taught to people. And for most people, their tax adviser is handing them their tax return with little explanation.

This is exactly why most people do not understand:

  • How income is actually taxed
  • What marginal tax rates are
  • That not all capital gains are taxed the same.
  • That all investment accounts are not created equal.

There’s a reason the tax code seems so mysterious to the majority of its would-be readers – it’s over 6,500 pages long, and when you add in the official cases and notations, it jumps to a nearly impossible 70,000. The good news is most taxpayers only need to concern themselves with a handful of topics.

So this week’s blog post is going to take a deep dive into everything you need to know about the stuff that is likely to affect you. We will talk:

  • Income Taxes
  • Capital Gains Taxes (short term and long term)
  • Tax Treatment of Various Investment Accounts

Let’s get started.

Income Taxes

We have a progressive tax system in the US, which taxes its taxpayers marginally. This means that as your income meets certain thresholds, your tax rate increases. This confuses a lot of people and leads them to believe that all their income gets taxed at a higher rate as they make more, but this is not true since taxes are calculated on a marginal basis. So what does marginal really mean? This means that large chunks of your income are subject to different rates. Think of it like you’re filling buckets. These buckets are different sizes and as they’re filled with income, the IRS assesses an updated tax to each bucket incrementally. These rates range form to 10% to 37% and as your income increases it fills each of these buckets individually until they reach the last bucket. That is your marginal rate and your last dollars taxed are taxed at this rate. Managing this highest rate is a laudable goal because the more you make, the higher marginal tax bracket.

Capital Gains Taxes

Everything we talked about above is around taxes on income you earn. Capital gains taxes are taxes on the profits you make from the sale on an asset like a home, investment, etc.

The first consideration for calculating capital gains is how much you acquired an asset for – this is called cost basis. Now, this can get more complicated as you add various complexities to your transactions, but for this post, we’re going to keep it simple and stick to cost basis = what you originally paid for the investment. Anytime you have a sale that comes out positive, in excess of basis – a fancy way of saying profit, it is considered a taxable event.

To figure out how much you will be taxed depends on the time frame you held the investment for. If you held the investment for less than 1 year, you would be taxed at the short term capital gains rate which is the same as your marginal tax rate (discussed in the last section). If you hold for greater than a year, then you are taxed at long term capital gains rates which are more favorable.

Short Term Capitals Gains

Investments that are sold within 1 year are taxed at ordinary income rates like the first chart above. This means you will be taxed at 10% up to 37% depending on your income.

Long Term Capital Gains

Long term capital gains are from investments you hold for over a year. They typically come at a lower rate than short term capital gains rates. The tax rates are 0%, 15%, or 20%. But you also can get hit with Net Investment Tax (3.8%) once your income is over a certain threshold. The chart below shows the tax rates based on income for long term capital gains.

Key takeaways on capital gains tax:

  • Short term capital gains are taxed at income rates
  • Long term capital gains have favorable tax treatments: 0, 15, or 20%
  • Net investment tax is taxed at 3.8% and added on as you break through the income threshold.

Investment Accounts

  • Non Qualified Accounts are savings accounts that are after tax dollars, your bank accounts, brokerage accounts, your 529’s. These accounts are taxed at your ordinary income rates unless there are dividends on stocks or funds you have held for more than a year and then they are taxed at your capital gains rates as are the sale of any of these assets if held for more than a year.
  • Qualified Accounts are pretax accounts and the dollars going in are not included in your taxable income. They are your IRA’s 401k’s 403B’s. Your money here is taxed upon withdrawal.
  • Tax Free Accounts are accounts that are funded with after tax dollars and when the money is withdrawn there are not axes paid on the earnings. These are Roth IRAs, Roth 401K’s, the earnings on muni bonds.
  • Totally Tax Free is the Health Savings Account if the money withdrawn is used for medical expenses. Deposits are tax deductible, earnings tax free and so are the withdrawals if used to reimburse you for medical expenses.

Now Here Is The Complexity

  • All of your money is piled up into one big pile.
  • You have tax advantages offered to you, deductions, credits, but they all are a function of how big that pile is.
  • The more money you make the more difficult to take advantage of credits and deductions.

This is why every year it is well worth taking a look at your tax return to determine what to do the next year to reduce taxes.