First, a few disclaimers. If you’re confused about whether you should use this information as tax advice, you should go back and read our first post. In this particular post, I will focus on federal income tax, which is one of multiple types of taxes that you might have to pay. Finally, this may not be my most exciting post yet (despite my best efforts), but it will provide the basis for some VERY exciting things over the next couple weeks. Ok, let’s get started.
Income Tax Basics
Take a look at the beautiful photo above. Think of the money you make in a given year as a bunch of water in a pitcher. At the end of the year, you have to pour your water into a series of wine glasses. When a glass becomes full, you move on to the next glass. Then, food coloring gets added to the glasses, making each one a different color. Each glass represents a tax bracket, and each food coloring color represents a corresponding tax rate which is applied only to the money (water) in that particular glass (tax bracket). In reality, there’s also another glass where no food coloring is added, because as we’re about to find out, some of your money won’t get taxed at all. With that wonderful thought in our minds, let’s take a look at the chart below.
In the first column you see ranges of “taxable income,” and in the second column you see how much tax is owed. You can see from the second column that being in the 35% tax bracket, for example, doesn’t mean that you pay 35% of your income in taxes. Not even close. You just pay 35% on whatever money you made above $200,000 (i.e. only the money in that wine glass), plus $45,689.50 (which represents tax on the money in all the previous wine glasses). So the rows on the chart are just the numerical representation of our wine glass example.
The left column of the chart is taxable income. If you make more money, you have more water to pour, so you’ll need more wine glasses. The water in each successive wine glass gets taxed at a higher rate than the previous glass. So your taxable income determines your tax bracket. Your tax bracket is not the rate at which all of your money is taxed, just the rate that the small fraction of your money in the last wine glass gets taxed.
So looking at the chart, does this mean that if you make $40k you’ll be in the 22% tax bracket? No! Your taxable income is actually going to be less than your actual income, thanks to these wonderful things called deductions. Deductions work to reduce your taxable income (a good thing!) and are applied in two stages. Some deductions are subtracted from your gross income to come up with your adjusted gross income. These are called deduction for adjusted gross income, and include things like contributions to certain retirement accounts like Traditional IRAs (among other things), which will be covered in my next post. The second stage is deductions from adjusted gross income. These are subtracted from your adjusted gross income to come up with your taxable income, which is the left column in the chart.
You have two options with deductions from adjusted gross income. The first is to simply take the standard deduction. For a single person in 2018, the standard deduction is $12,000 ($24,000 for married couples filing jointly). That means that you can deduct $12,000 from your adjusted gross income to arrive at your taxable income. That’s 12k of Real Money that doesn’t get taxed at all! Thanks, The Government! This is actually an important point that will come up again later, so read this closely and slowly: the first $12,000 of your income ($24,000 if you’re married) DOES NOT GET TAXED. The second option with deductions from adjusted gross income is to itemize your deductions, which just means that the stuff you are allowed to deduct, like donations to charity and mortgage interest payments for example, exceeds the standard deduction, so you’ll want to deduct those instead so you have to pay even less taxes.
Once you come up with your taxable income, the rest is pretty much just paying the IRS the amount of money indicated in the chart above. In reality, this money was probably withheld from your employer throughout the year, so you’ll probably pay close to nothing (or even get a refund) when you do file your taxes.
How Stocks are Taxed
Income from capital gains, or profits from the sale of investments1Profits equal the price you sold at minus the price you bought at, are taxed a little differently. Investments sold within a year of purchase are taxed at what’s called the short term capital gains rate. Since it’s silly to be selling your investments within a year of buying, we’ll ignore this here. Investments that have been held for more than a year are taxed at the long term capital gains rate according to the table below.
A few quick notes:
- Tax is due at the time that you SELL the investment (aka in retirement since we aren’t picking stocks or trying to time the market).
- Even though capital gains count as income, they are taxed at a different (more favorable) rate than other income.
- Note that up to $38,600 ($77,200 if you’re married) of taxable income, the long term capital gains rate is 0%. This has HUGE implications for retirement, which we’ll discuss further in the next couple Joey posts.
Finally, learning about taxes may seem boring, but this knowledge provides the basis for understanding retirement accounts which, if used appropriately, can save you thousands of dollars in tax liability and jump start you on the road to financial independence.