The 4 things you need to understand about taxes

Couldn’t find any cute tax pictures. So here’s a cute dog! Photo by Irene Davila via Unsplash.

Originally I was going to write about international women’s day, but I decided that by the time the post is published it will be too far in the past! To prepare, I looked up international women’s day (celebrated on March 8).

And what I discovered was that it was actually started by socialists in New York, and taken up by communists in Soviet Russia and elsewhere.

Socialism is in the news right now. Socialism, as a political movement, is different from democratic socialism, which is what progressives are championing. And neither is communism. Or capitalism, for that matter.

These are all different ways of asking the question, how much should the government pay for? And the way that governments raise some money for public programs — though certainly not all of them — is through taxes.

“The wages of sin are death, but by the time taxes are taken out, it’s just sort of a tired feeling.” — Paula Poundstone

So, to the barricades, tovarisch! Let’s talk some taxes, American-style.

The 4 things you need to know about taxes (income and capital)

I won’t go into detail about other taxes like personal property, sales tax, etc. This article is just focused on federal taxes.

  1. You have to pay them and if you don’t there’s a penalty
  2. What is “ordinary income” for tax purposes?
  3. What does “marginal tax rate” or “marginal tax bracket” mean?
  4. What is capital gains tax and how is it calculated?

You have to pay your taxes

It’s required. The US didn’t always have an income tax. In 1913 the 16th amendment to the Constitution was ratified, allowing the federal government to collect tax.

“Our new Constitution is now established, and has an appearance that promises permanency, but in this world nothing can be said to be certain, except death and taxes.” — Benjamin Franklin

What is “ordinary income” for tax purposes?

In other words, what is income? This is also known as “ordinary income”.

There’s the obvious income if you work for a company. In January employers issue a form W-2 to each employee. It shows how much was made, how much deducted for taxes, how much contributed to various types of accounts, etc. If you’re a contractor, the record often appears as a form 1099.

Before the 2018 tax year, alimony or spousal support was included in taxable income for the spouse receiving it. Alimony was a tax deduction for the one paying it. Now that has been changed due to the Tax Cuts and Jobs Act, so it’s no longer considered income.

Business revenue, less expenses,is income, depending on the legal structure of the business. So are the monies, less expenses, received from rental properties. Royalties from your creative enterprise are taxed as income in the year you receive them.

Withdrawals from pre-tax retirement accounts are considered income. Distributions taken from a Traditional IRA/401(k)/403(b) etc., are taxed as ordinary income, because no tax has been paid on the money yet. If you convert some amount of a Traditional IRA to convert it to a Roth IRA, that is also considered income.

Dividends paid out from stocks may be ordinary, in which case they’re taxed as ordinary income. If they’re qualified dividends, where you’ve held the stock long enough, then they’re taxed at the lower capital gains rates.

There are other categories as well, but these are the main ones that readers tend to report.

Why do people refer to marginal tax rates or brackets?

Many Americans don’t understand how the income tax actually works. First, the tax brackets depend on how you file: as a single, married filing jointly, etc.

Federal income tax is progressive. Taxable income (I will use the numbers for singles) up to $9,525 is taxed at 10%. The next tax bracket is 12%, so income from $9,526 to $38,700 is taxed at 12%. The next is 22%, for income from $38,701 to $82,500. (The remainder of tax brackets and more information can be found here.)

That means that if you’re in the 22% tax bracket, not all of your income is taxed at 22%. Your marginal rate, only the amount of your income that’s $38,701 and over, is 22%.

Essentially, your income tax bill is $4,453.50 plus 22% of whatever’s over $38,701.

Where does the $4,453.50 come from? Well, 10%* $9,525 (the first, 10% bracket) is $952.50. Then 12%*$29,174 (the amount of the second, 12% bracket) is $3501 with rounding.

So your total tax for the first two brackets is $4,453.50.

Suppose you make $50,000. That means $11,299 of your income is taxed at 22% (the amount over $38,701).

How do capital gains work?

As you probably guessed from the name, capital gains are taxed on your capital. Otherwise known as investments, such as taxable brokerage accounts and real estate. Retirement accounts are not subject to capital gains taxes on qualified distributions.

In order to calculate gains, first you have to know the basis, or what was paid for the investment. If you bought a mutual fund or stock recently, this is easy: your brokerage firm keeps track of the basis.

If you have shares lying around from 20 years ago, it may not be as easy to get the basis. You’ll need to know when the investment was purchased to estimate it.

If you own stocks, the basis will likely have changed as the stock’s gone through buybacks and splits. Many stocks have a calculator on their investor relations website to help with this.

And you can increase your basis in a number of ways, depending on the investment.

For example, let’s say you bought mutual fund Kittens and Rainbows for $1,000 in January 2017. Then you put into place an automatic contribution of $100/month, so at the end of the year your basis is $2,100: the $1,000 you initially invested and then 11 months of $100 or $1,100.

If you own a house, you can make improvements to the house. Improvements are not the same as repairs! If you replace your dishwasher, that’s a repair. But if you remodel your kitchen, that’s an improvement. If you bought your house for $100,000 cash (I know, I know, but let’s pretend) and then remodeled the kitchen for $10,000, your basis in the house is $110,000.

When you sell your investments, that’s when you pay tax on the gains. You get a break on selling your house. Depending on whether you’re single or married, you shield the first $250,000 or $500,000 from capital gains tax if you meet the requirements.

In the example above, if you’re filing single and sold your house for anything less than $360,000 you wouldn’t pay capital gains tax at all. But suppose you sold it for $400,000.

$400,000 less your basis of $110,000 is $290,000. Assuming you meet the requirements, only $40,000 of that is taxable at capital gains rates. These rates depend on your marginal tax rate.

Likewise, suppose you didn’t make any more investments in your mutual fund Kittens and Rainbows after 2017. You decide to sell in March of 2019, when it’s worth $3,000.

It’s a long-term capital gain, because you held it for more than 12 months. So your $900 gain ($3,000-$2,100 basis) is taxed at long-term capital gains rates. If you hold a position for less than 12 months, it’s short-term, and taxed at ordinary income.

If Kittens and Rainbows was only worth $1200 when you sold it, then you would have a capital loss of $900 instead.

But the trick with mutual funds is that the managers of the funds are buying and selling too.They pass their capital gains onto the fund shareholders, i.e. you.

So at the end of 2017, even if you hadn’t sold any Kittens and Rainbows, you still might have ended up with capital gains from the activity inside the fund. They’ll let you know on your 1099 form how much is long-term and how much is short-term.

This is less likely with index mutual funds, and more likely with actively managed funds.

Summary

There are two main types of taxes that you have to declare to the IRS by April 15 of the following year: income taxes and capital gains taxes. Your taxable accounts — savings, brokerage, etc. — will normally issue a form 1099 so you have that information for capital gains reporting. Your employer will issue a 1099 or W-2. Other types of income may be harder to calculate.

Just remember government services are paid partially from these taxes. Countries with stronger “safety nets”, who might have services like universal healthcare or paid parental leave, have higher taxes so they can pay for these programs. You get what you pay for.

P.S.

I’ve been streaming a series on Amazon,”This Giant Beast That is The Global Economy”, hosted by Kal Penn (of Harold & Kumar, and also Washington, DC fame). The episodes are interesting, ranging from money laundering, the key component of the global economy (rubber) and how it’s made, to artificial intelligence and more.

He interviews knowledgeable people and so if you’re looking for some watching material, in addition to reading material, you might want to check it out. Especially if you’re a Prime member.

P.S.S.

Want help getting started in your investing life? Go here for your free guide to the Eight Great Investing Concepts… which are also explained in-depth in my book.

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Unlocking The Secrets To Business Achievement With More Life Balance For Women ⎸Speaker ⎸Productivity Queen ⎸Ghostwriter ⎸Author ⎸Pun Lover

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Jennifer Jank

Jennifer Jank

Unlocking The Secrets To Business Achievement With More Life Balance For Women ⎸Speaker ⎸Productivity Queen ⎸Ghostwriter ⎸Author ⎸Pun Lover

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