Attempting to read the entire tax code is one of the most boring things you can do. Trust me, I’ve tried. However, in this article, I’m going to explain nine items you need to know about taxes.
These items will help you understand how the tax system works and how to minimize your tax bill. This is extremely important because taxes are the largest expense most of us will have to cover during our lifetimes.
Before we get started, here is a general disclaimer: This article is not tax advice. The author nor FitBUX is a licensed tax advisor. We highly recommend consulting a licensed tax advisor with any personal tax questions you may have.
Overview: How Do Taxes Work?
One thing you need to quickly realize is that not all money is treated equally when it comes to taxes!
There are three basic types of taxes in America: Income tax, capital gains tax, and dividend tax. Each of these is taxed differently. More on this later.
Most Americans are concerned about income taxes because the amount we make from capital gains and dividends each year is relatively small. Most of our income comes from wages and salaries. This is especially true if you are just starting out on your financial journey.
Wealthy people, i.e. those millionaires and billionaires you hear of all the time, are primarily concerned about capital gains and dividend taxes. Thus, when you hear a politician saying something like, “I’m only going to raise income taxes on people making $400,000 or more per year,” it’s really just a way to try and get votes from the people making up to $399,999/year.
In addition, extremely wealthy people such as Warren Buffett don’t have high incomes as most of their money comes from capital gains and dividends. Don’t worry, this will all make since soon so keep reading.
History & How We Got Our Current Tax Code
Warning: This is not a political discussion. However, understanding how we got to the current tax code will give you more insight on how to use it to minimize your taxes.
It could also start to influence how you vote in the future because you’ll be able to understand what politicians are aiming for as well as plus understand how their actions affect you!
Our current tax system was put into place in 1913 and is called a “progressive tax system”. Simply put, one a low income earner should pay less taxes, percentage-wise, than a high-income earner. The individual that often times is accredited with this system is Karl Marx and he wrote about it as one of his 10 planks in the Communist Manifesto.
The goal of the progressive tax system Marx advocated for was to reduce the ability of the individual to generate wealth. In short, it transfers wealth from the individual to the government for redistribution among society based on how government officials determine it should be distributed.
To easily understand why, I turn to our 2 FitBUX Formulas:
- Income – expenses = Remaining Cash
- Assets – Debt = Net Worth
The long-term goal for someone starting out with a salary or wages is to increase their net worth. In order to do so, you need to increase your income, decrease your expenses, then take your remaining cash and use it to build assets (investments) or pay off debt.
The two formulas make it easy to see that the more remaining cash you have, the easier it is for you to increase your net worth.
In other words, a progressive tax system will increase your expenses via taxes thus reducing your remaining cash and fills the coffers of the government to redistribute as they see fit.
Let’s see how this progressive tax system works in the next section.
The Progressive Tax System For Income Taxes
Not every dollar you earn in wages and salary is taxed at the same rate. This is one of the biggest misconceptions about taxes.
You’ll hear people say something like, “I’m in the 22% tax bracket.” When you hear that, often times people think all their money is taxed at 22%. That is not the case.
Instead, each dollar is taxed according to a “bracket” that it falls into. Let’s just say you earn $75,000 per year.
The first $10,000 you earn is taxed at 10% which means you pay $1,000 in taxes.
Next, the money you earn between $10,001 and $37,000, or $26,999 of your income, is taxed at 15%. So you will pay $4,050 on that money.
Anything you make between $37,001 and $91,000 is taxed at 25%. Therefore, since you made $75,000 the remaining $38,000 of your earnings will be taxed at 25%. That is $9,500.
Add these numbers up and that means you owe $14,550 in taxes.
There are two big things to know about if you want to reduce your taxes: Marginal tax rate and the effective tax rate. I discuss both below.
Marginal Tax Rate AKA Your Tax Bracket
The marginal tax rate is also known as your tax bracket. It is the tax bracket that your last dollar earned was taxed at.
Using the example in the previous section, my marginal tax rate would 25%. This is the number you often times hear when people refer to their tax bracket.
NEWSFLASH: That number doesn’t mean anything important. What is important is your effective tax rate which I discuss next.
Your Effective Tax Rate
Most people look at their marginal tax rate or their tax refund at the end of the year to determine to decide wether they were “better off” from a tax perspective than, say, the prior year. That is absolutely the incorrect thing to look at.
This is also why people often times say the “Trump tax cuts didn’t save them anything.” Most of those stories you heard about are people referring to their refund being lower. However, they should be looking at their effective tax bracket!
Going back to our previous example, I earned $75,000 and paid $14,550 in taxes. If I take $14,550 and divide it by $75,000 the percentage I get is 19.4%. That is my effective tax rate, i.e. for every dollar I earned, how much in taxes did I pay? In our example, this translates into 19.4 cents for each dollar earned.
The proper comparison vs. a previous year is to run through the same exercise as this is the only way to truly compare “apple to apple”.
Tax Deductions and Credits
After the progressive tax system was implemented in the US, the opposing political group who wanted to make it easier to accumulate individual wealth had to make a choice:
Either they were going to fight the progressive tax system or work within it. They figured it would be hard to fight the saying, “tax the wealthy their fair share” so they instead decided to work within the progressive tax system.
The result is that we now have a ton of deductions and credits. In fact, some scholars have said that 99.5% of the tax code actually focus on how to pay less in taxes, while .5% explains how much you have to pay.
I’m going to touch on two deductions and credits to show you how they work:
Deduction #1: Retirement
The two most prominent retirement accounts in the US are 401k and 403b accounts. The names of these are simply tax codes and aren’t that important. What is important is to understand how they work.
Going back to my pervious example of making $75,000 per year. Let’s say I contribute $15,000 to my 401k. That money goes in on a pre-tax basis, which means that it’s taken out of my paycheck before taxes are withheld on my paycheck. This is by design of course, in order to encourage people to contribute to their retirement accounts.
Therefore, I am not taxed on $75,000 of my income, but only on $60,000 in the current tax year. Therefore, my tax bill would drop from $14,550 down to $10,800.
Thus, my effective tax rate is reduced from 19.4% to 14.4% ($10,800/$75,000).
When you combine this with other deductions and credits, it’s not uncommon to see an effective tax rate for Young Professionals be around 10%.
Deduction #2: State Income Tax
This deduction is used to illustrate how the wealthy can actually have their taxes increased without increasing the tax rate.
Each year, in most states you will pay state income taxes in addition to Federal income taxes. Prior to President Trump, you could deduct the amount you paid in state taxes from your Federal tax bill.
President Trump put a cap of $10,000 on how much you could deduct. This is referred to as the SALT Tax. Most people weren’t affected by this because their state tax is far less than $10,000.
However, it did hit wealthy wage earners, i.e. those that make $200k plus a year, extremely hard as they state income taxes were well above $10,000 in most states. Therefore, people that live in locations such as San Francisco, New York, etc… were hit hard.
This is why Nancy Pelosi, her district is in San Francisco and is made up of very high wage earners, is trying to repeal the SALT Tax. You won’t hear her on CNN or MSNBC talking about these efforts though because it would go against the “wealthy needing to pay their fair share” message.
However, like I said earlier, now that you know this much about the tax code, you can start deciphering the message yourself instead of relying on a politician to tell you about it.
Capital Gains Tax
Capital gains are taxed differently than wage income. Capital gains are when you own something for a given period of time then sell it for a gain. These gains have their own tax bracket and its typically capped around 20%.
For example, if I buy stock in a company, hold it for ten years and sell it for a profit then I pay taxes on the gain.
The two most popular capital gains taxes are on stocks and real estate transactions.
When you own stock in a company, sometimes that company will pay out some of its earnings to you the shareholder. The distribution of the earnings is referred to as a dividend.
The tax rates for dividends are similar to capital gains taxes, i.e. they are capped around 20%.
By Joseph Reinke, CFA