YOUR INCOME COULD be subject to as many as five different federal tax systems. First, if you have a job, and hence you have what’s called earned income, you pay Social Security and Medicare payroll taxes. For many folks, this is the biggest tax they pay.
Second, there’s the federal income tax, which is why we spend the early months of each year sweating over Form 1040. Why is the form so complicated? One reason: In addition to payroll and income taxes, you may owe three other taxes, especially if you have a hefty income or you have so-called unearned income, which is income from investments.
That brings us to our third tax: If you have qualified dividends or you sell investments that you held for more than a year, you may pay taxes at the long-term capital gains rate, rather than at the higher income tax rate. The dividend and long-term capital gains rate is 0% or 15% for everyone except those in the top 37% tax bracket and some of those in the 35% bracket, who pay 20%. This potential tax advantage should heavily influence how you invest your taxable account.
Fourth, you may be subject to the Medicare surtax, which took effect in 2013 and was introduced to help pay for Obamacare. Unlike the standard Social Security and Medicare payroll tax, the Medicare surtax can ding not only your salary, but also your investment gains. In effect, it’s two taxes—an additional payroll tax and an extra investment tax on high-income earners.
Finally, there’s the alternative minimum tax, or AMT. Initially introduced to ensure those with high incomes paid at least a minimum amount of federal income taxes, the AMT ended up hitting many middle-class families. Things have been better in recent years because the AMT now kicks in at higher income levels, thanks to the 2017 tax law.
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