FREE NEWSLETTER

Taxes

Payroll tax. The Social Security and Medicare payroll tax is 15.3% of earned income. Half is typically paid by employers and half by employees, though the self-employed have to pay the entire amount. The portion that pays for Social Security—which is 12.4% in total, with 6.2% coming from employees—is levied on the first $137,700 in 2020 and $142,800 in 2021. The Medicare portion—2.9% in total, with 1.45% coming from employees—is levied on every dollar earned.

Average vs. marginal tax rate. Your marginal income tax rate is the rate you paid on the last dollar of income that you earned. The average rate is the total income tax you paid divided by either your total income or your total taxable income.

Standard vs. itemized deductions. The standard deduction, which varies depending on your filing status, can be claimed by any taxpayer. It reduces the amount of income that’s subject to income taxes. Instead of taking the standard deduction, some taxpayers itemize their deductions, which can result in a larger tax savings. These itemized deductions can include unreimbursed medical expenses, property taxes, mortgage interest, state and local income taxes, and charitable contributions.

Income vs. capital gains taxes. Income taxes are levied on wages, interest from bonds and bank accounts, short-term capital gains and retirement-account withdrawals, among other items. Capital gains taxes are paid on investments sold at a profit after holding them for more than a year. The capital gains tax rate can be as high as 20%—but it’s still well below the tax rate on income, which can be as high as 37%.

Short-term vs. long-term capital gains. If you hold an investment for a year or less before selling, any profit would be considered a short-term capital gain and taxed at the higher income tax rate. If you hold the investment for more than a year, any gain would be taxed at the lower long-term capital gains rate.

Qualified dividends. If a stock pays a qualified dividend, it’s taxed at the long-term capital gains rate, rather than at the higher income tax rate. Real estate investment trusts and some foreign companies don’t pay dividends that are qualified. Even if a company pays a qualified dividend, you need to hold the stock for more than 60 days to receive the favorable tax treatment.

Traditional vs. Roth individual retirement accounts. A traditional IRA may give you an initial tax deduction, but withdrawals are taxed as ordinary income. A Roth IRA won’t give you an initial tax deduction, but all withdrawals are potentially tax-free.

Tax-deductible contributions. When you fund a traditional IRA, you may be able to deduct your contributions, assuming you meet the income criteria or you aren’t covered by a retirement plan at work. Contributions to traditional 401(k) or 403(b) plans are also effectively tax-deductible. Instead of receiving a tax deduction on your tax return, however, your employer takes your retirement-plan contributions out of pretax income, which results in comparable tax savings.

Earned vs. unearned income. Earned income is income earned from running your own business or working for others. This income is subject to payroll taxes, but also qualifies you to fund retirement accounts. Unearned income includes dividends, interest and capital gains. This income isn’t subject to payroll taxes, and it may also be taxed at the preferential long-term capital gains rate.

Tax efficiency. When investors strive for tax efficiency, they aim to minimize the annual tax bill generated by their portfolio. This can involve placing investments that generate big annual tax bills inside a retirement account, buying tax-free municipal bonds in a taxable account, and using a taxable account to buy and hold stocks and stock index funds.

Asset location. To reduce a portfolio’s annual tax bill, investors should pay careful attention to which investments they hold in tax-sheltered retirement accounts and which in taxable accounts. Investors might hold municipal bonds and long-term stock holdings in a taxable account. Meanwhile, they might use their retirement account to trade individual stocks and to hold actively managed stock funds, taxable bonds, real estate investment trusts and other investments that generate a lot of immediately taxable income.

Next: Borrowing

Previous: Risk and Return

Subscribe
Notify of
0 Comments
Inline Feedbacks
View all comments

Free Newsletter

SHARE