How Do Taxes Work?
Sarah Cuddy
Financial Advisor, Robert W. Baird & Co., Private Wealth Management - Looking for speaking opportunities with attorneys
The U.S. tax code is a mystery to the typical individual. But federal taxes (are a big expense for most of us —?and most of us are interested in paying less in taxes.
In this installment of Wealth Management 101, I’m going to lay out the most common types of federal taxes we all pay, give you some insight into how each works, and outline ways to potentially lower your tax bill.
Types of Taxes
Ordinary Income Tax
Nearly every taxpayer is subject to ordinary income tax, and it is likely the biggest part of your tax bill each year.
Ordinary income is any income earned by an individual that is taxable at ordinary rates. For most individuals this includes wages, salary, tips, bonuses, rental income, royalties, interest income from bonds, and commissions
Capital Gains Tax
A capital gain is the increase in value of a capital asset. A capital asset for most individuals would be things like real property, stocks, bonds, mutual funds, and exchange-traded funds. Capital gains taxes can be long-term or short-term and are only incurred?when an asset is sold.
Short-term capital gains are taxed at your top marginal ordinary income tax rate.
?Long-term capital gains are taxed at a more favorable rate that can range from 0% to 20% depending on your top marginal ordinary income tax rate.
Tax on Dividends
Some stocks pay dividends. Those are taxed in a similar fashion to capital gains in that they are taxed at either your highest marginal ordinary income tax rate or at your long-term capital gains tax rate. In general, most dividends are taxed as ordinary income. There is a three-part test to determine if a dividend is qualified to be taxed at your long-term capital gains rate.
1.?????Have been paid by a U.S. company or a qualifying foreign company.
2.?????Not be listed with the IRS as a company that does not qualify.
3.?????Meet the required holding period.
Employment Taxes
Employment taxes are due on income earned through employment. If you are a W2 employee, you pay half of this tax burden while your employer pays the other half.
The Income Tax Formula
There is a formula you can keep in mind to help you understand income tax a bit better:
Income Broadly Defined
- Exclusions
= Gross Income
- Deductions for Adjusted Gross Income (AGI)
= Adjusted Gross Income (AGI)
- The greater of Itemized Deduction or Standard Deduction
= Taxable Income
(applied to) Tax Table for Your Filing Status
领英推荐
= Tax on Taxable Income
- Taxes Already Paid
+ Credits
= Taxes Due
Income Broadly Defined is any money or item of value that came into your hands during the year — be it income from your job, a gift from mom and dad, or a loan to buy a car. From that you back out things that are excludable.
Now you have Gross Income, and from that you take certain deductions to arrive at Adjusted Gross Income (AGI). Those deductions include:
Once you’ve arrived at your Adjusted Gross Income, you can either take the Standard Deduction?or?Itemized Deductions.
After backing out your Standard (or Itemized) Deduction from Adjusted Gross Income, you’re left with your Taxable Income (the portion of your income that you’ll?actually?pay taxes on).
To this number you apply the relevant tax table for your filing status. That gives you Tax on Taxable Income. From this you back out any income tax you’ve?already?paid through withholding or quarterly payments and add in any Tax Credits[1]?you qualify for. These credits might include:
The final computation will get you to the bottom line and tell you if you owe tax or if you’ll be getting a refund.
Deductions for and from AGI
There are two points in the tax formula where deductions happen: before you calculate Adjusted Gross Income (AGI) and after you calculate AGI.
Getting to the lowest possible AGI is key to lowering your tax bill.?
Once you’ve arrived at your AGI, you’ll need to determine if you’ll take a Standard Deduction from AGI or Itemized Deductions from AGI.
Popular itemized deductions include:
Tax Minimization 101
Having a tax bill is a good thing; it means you earned money during the year. However, no one wants to pay more than they must, and there are some common-sense things you can do to lower your tax bill.
1.?????Maximize your 401(k) contributions.
2.?????Maximize deductions for AGI, such as certain IRA and HSA contributions.[3]
3.?????Plan to hold most investments for a year or more where it is practical to do so.
4.?????Limit trading in your non-retirement accounts where it is practical to do so.
5.?????Make tax-loss harvesting an annual practice. A taxpayer is eligible to deduct up to $3,000 in capital losses against ordinary income each year. This is one of those deductions for AGI that is so valuable.
?
If you are ready to implement any tax tip I’ve shared, then you are good to go for the complete article!
This will help you pay just a little less in taxes and keep more of your hard-earned dollars in your pocket and working for you.