Understanding Income - How to Take Advantage of the Tax Code by Investing
Rizek Housari, CPA, CFP®
AUTHORS NOTE
Creating a custom financial model of your future gives you the framework and lens to make important financial decisions.
How to best mitigate and manage your tax burden is just one of the important decisions to consider.
At Divergent Wealth we are state-of-the-art financial planners and investment professionals who specialize in simplifying complicated things.
To create a complimentary customized financial plan, call us at 385-CFP-4000. For information, visit us at www.divergentwealth.com.
----
News Flash! The IRS taxes the same dollar very differently depending on how that dollar was made. Your money is getting taxed; what's new? Now is the time to learn and create an efficient strategy to keep more. This article highlights the fundamentals of personal tax that you need to know which will empower you to build and keep wealth.
Earned Income
There are two major forms of income, earned and unearned. Earned income is typically the money you work for and take home from your day job. Often, you pay more taxes on your earned income than you would on your unearned income. This is primarily due to Medicare and Social Security taxes (FICA), which many Americans have withheld from their paychecks.
Self Employed
Some of the worst tax rates are those that combine ordinary income with self-employment tax. The self-employed business owners know exactly what I am talking about. That 15.3% self-employment tax is something that should be strategically discussed with an advisor. Not doing so can be costly.
Employee Income
Then there are the workers of the world. I am talking about the ordinary income folks who receive W-2s. They are a little better off than their self-employed counterparts because their employers pay half of the 15.3% employment tax. However, the employee is still on the hook for the other half. This is because you pay ordinary income tax on top of Social Security and Medicare tax. Typically, your employer will withhold both types of tax from your paycheck, so it can be hard to recognize if you are new to the world of tax.
Unearned Income
Unearned income comes from not working. This is income that you receive from your assets working for you. There are numerous benefits to creating unearned income. Examples of unearned income include capital gains, interest, and dividends.
Within unearned income, there are multiple tax rates. The big kicker is the length of time you held the investment. For example, if you bought a stock yesterday and sold it today, then you pay short-term capital gains tax on the gain. The tax rate you would pay on that short-term investment is the same tax rate as your marginal income tax rate, which is typically a higher rate.
Ideally, you want to be a long-term investor to pay lower tax rates. If instead you bought the stock and held on to it for more than a year, then you are taxed at much lower rates. The key takeaway, unearned income is generally taxed at significantly lower rates than earned income. This is how many people generate increased wealth while paying significantly lower effective tax rates.
Capital Gains of Investors
Capital gains tax is reserved for those who invest. It is not enough to just be a saver. Storing cash does not generate much increase, you need to invest it. Capital gains tax is applied to the income that your investments generate. If the capital gain is long-term, then you typically pay significantly lower taxes.
See there are two big buckets that most people pay taxes in. The first is earned income, which is the money that you work for. The second is unearned income, which is often the preferred bucket because this is money that your money worked for.
Dividend Income
A dividend is a type of unearned income given to investors by a company when the company earns a profit. Once you receive a dividend, that money gets taxed. The dividend can be non-qualified, or qualified. The qualified dividends are usually taxed at a lower rate whereas non-qualified dividends are taxed at a higher rate. There are many strategies and accounts that you can use to either offset or defer the tax you must pay.
The Salmon family buys a stock
Example time. If Mr. and Mrs. Salmon buy a stock for $5 and the company does well and the stock price increases to $15, they have a $10 gain. When they sell the stock, the $5 they paid for the stock is not taxed, just the $10 gain is taxed. For this example, the Salmons filed jointly in 2021 and earned an income of about $150,000. They held the investment for more than a year to get the preferential tax rate. In this scenario, they pay just 15% tax on the $10 gain. So, after paying $1.50 of taxes on that $10 gain, they keep the remaining $13.50. This is significantly less tax compared to going to work and earning that same $10, especially if they were self-employed. Had they earned that $10 via employment income, they would have paid a 22% federal tax rate (See Appendix for tax rates). That is just the federal tax, let alone state, local, or employment tax.
Get your financial life in order so you can start investing!
Take time to discuss your options with a wealth advisor and learn more about the best strategies to help you make and preserve wealth. There are some incredible investing and tax strategies available to you. Your biggest enemy is fear and procrastination.
Paying yourself first will help you to save more and your desire to invest will grow over time as you begin to see your money at work for you.
The goal of any excellent financial planner is to help you understand your situation and your options. Taking time to learn and understand your options will set you up to achieve financial independence.
APPENDIX
The tables below are the income brackets for 2021. The first chart contains information about long-term capital gains and the rate your income is taxed when you have those long-term investments or qualifying dividends. The second chart contains information about ordinary income rates and the rate your income/gain is taxed when you have short-term investments.
Married, filing jointly 2021
Long-Term Capital Gains Tax Rates
0% for Income $0 to $80,800
15% for Income $80,801 to $501,600
20% for Income $501,601 or more
Short-Term Capital Gains & Ordinary Income Tax Rates
10% for Income $0 to $19,900
12% for Income $19,901 to $81,050
22% for Income $81,051 to $172,750
24% for Income $172,751 to $329,850
32% for Income $329,851 to $418,850
35% for Income $418,851 to $628,300
37% for Income $628,301 or more
CONCLUSION
Creating a custom financial model of your future gives you the framework and lens to make important financial decisions. Tax Planning is just one of the important decisions. At DivergentWealth®we are state-of-the-art financial planners and investment professionals who specialize in simplifying complicated things. To create a customized complimentary financial plan, call us at 385-CFP-4000. For information, visit us at www.divergentwealth.com.
The SCT Library’s mission is to cut through the clutter and the spin to deliver financial straight talk -- to simplify complicated things. These short guides will reduce complex topics to their core issues to assist in making the best financial decisions for your family.
DIVERGENTWEALTH® is changing the way people engage with advisors. They are a competent, dedicated, and credentialed financial partner should you ever decide that’s what you need. Experience the difference at www.divergentwealth.com or call to interview us at 385.CFP.4000.
Divergent Wealth Advisors LLC is registered as an investment adviser with the SEC and only transacts business in state where it is property registered or is excluded or exempted from registration requirements. SEC registration in an of itself does not constitute an endorsement of the firm by the commission nor does it indicate that the adviser has attained an adequate level of skill or ability.
The information contained in this material is given for information purposes only, and no statements contained herein shall constitute tax, legal, or investment advice. The information is not intended to be used as the sole basis for financial decisions, nor should it be construed as advice designed to meet the needs of an individual’s situation. You should seek advice on legal and tax questions from an independent attorney or tax advisor.
Individual clients should review with their adviser the terms, conditions, and risks involved with specific product or services. Neither the information provided, nor any opinion expressed constitutes a solicitation for the purchase or sale of any security.