With the combination of all the craziness of Bitcoin, Gamestop, AMC, etc., and tax season being around the corner, I thought it could be helpful to take a deep dive into something that confuses a lot of people, taxes. As I scroll through Twitter, I think I see a minimum of 10 tweets a week talking about how people wish they were taught about taxes in high school. I figured with so many people interested in understanding taxes, it would be worthwhile to write a blog post on the basics of taxes. In this post, we are going to look into both income taxes as well as capital gains taxes.
In the US, federal income tax is progressive, meaning that taxes go up as your income goes up. What confuses a lot of people is that taxes are also marginal which means that you don’t just fit your entire income into 1 tax bracket. The marginal tax is the amount of tax you incur on each additional dollar of income. Let’s look at the chart below and go through a simple example for an individual tax filer to explain this further (there are separate income tax brackets based on tax filing status. I can share this with you if it interests you).
For this example let’s assume we have an individual who has an adjusted gross income (AGI) of $100,000 (AGI is the amount you earned less deductions taken). How much would he owe in tax?
If you look at the chart you’ll see that he is in the 24% tax bracket. So, he would owe $14,605.50 plus 24% multiplied by $14,475 (this number came from subtracting $85,525 from $100,000). This means he would owe $14,605 + $3,474 = $18,079 of tax for 2020.
As you can see he does not pay 24% tax on all the income he makes. He would be taxed 10% on the first $9,875 he makes. Then he would be taxed 12% on the dollars he makes between $9,876 and $40,125 and so on. This is what I mean by marginal taxes — is the amount of additional tax paid for every additional dollar earned as income.
The other number to be mindful of is a person’s effective tax rate. The effective tax rate represents the percentage of a person’s taxable income that individuals pay in taxes. To find this number you divide your income by your total tax. For this example it would be $100,000 / $18,079 = 18.08%. This is important to understand because most people say and think they are taxed based on where their income lies within the tax brackets. So if someone makes $100,000 most times they say they are in the 24% tax bracket, but only the dollars they made above $85,525 are taxed at that 24% rate.
The key takeaways here are that taxes are progressive, meaning that as your income goes up so do your taxes. However, not every dollar you make is taxed in your top marginal tax bracket. This creates a lot of opportunities for tax planning. You can fill up tax brackets for ROTH conversions to maximize that tax bracket. Or you can utilize accounts that reduce your taxable income so no dollars are in a certain tax bracket.
Capital Gains Taxes
Capital gains are the profits you receive from the sale of some asset. This could be from selling a stock, mutual fund, house, etc. The gain you receive from the sale is considered a taxable event. To understand how much you will be taxed depends on the time frame you hold the investment for as well as your tax bracket. We are going to break this up into short term (investments held for less than 1 year) and long term (investments held for more than 1 year).
Note: This is for taxable accounts, not tax-sheltered accounts
Short Terms Capital Gains
Investments that are held and sold within 1 year are taxed based on your ordinary income tax rate which we talked about above (10%, 12%, 22%, 24%. 32%, 35%, or 37%). Let’s keep using the example above and assume he still has an income of $100,000. If he had a short term investment he sold with a gain of $30,000 all you would have to do to figure out his tax liability is add that number to $100,000. He now has a total income of $130,000 resulting in more money being taxed in the 24% tax bracket.
If you are someone in a higher tax bracket, holding investments for a longer period of time can be beneficial since you will be taxed at a lower rate (this will be explained more below). If you are in the 24% tax bracket and sell a short term investment, it could potentially propel you into the 32% tax bracket. This is why financial planning is so important! Many people get themselves in tough situations by not knowing this information and then they are stuck trying to figure out how to afford this hefty tax bill.
Long Terms Capital Gains
Long term capital gains come from investments that are held for over a year. They generally come at a lower tax rate than short term capital gains do. In 2020, the long-term capital gains tax rates are either 0%, 15%, or 20% depending on your income. The chart below shows what tax rate you correspond to based on income and how you choose to file your taxes.
To help explain this further let’s look at an example. Let’s say we have the same person as above who makes $100,000 and is a single filer. Let’s also say he bought an investment for $10,000 5 years ago and just sold it for $30,000 resulting in a gain of $20,000. To figure out what he owes in tax you first have to find his tax rate. Since he makes $100,000 he has a capital gains tax rate of 15%. Then you multiply this number by the gain he received from the sale ($20,000) resulting in $3,000 of tax. It’s pretty simple to figure out once you know what to do.
Tax Treatment For Each Type Of Investment Account
Hopefully from this post, you have a little better understanding of how you are taxed and how important planning is for minimizing taxes over your lifetime.
Disclaimer: Nothing on this blog should be considered advice, or recommendations. If you have questions pertaining to your individual situation you should consult your financial advisor. For all of the disclaimers, please see my disclaimers page.