A lot of the advice you'll get from your financial advisor or accountant depends on the taxes you pay. The tax code can affect these (and many more) financial decisions:
Your decision to contribute either to a traditional or Roth-type retirement savings account
Which types of investments (e.g. stocks, bonds, real estate, commodities) you should put in each type of account
Which funds you invest in
How you donate to charity
In order to get the most out of discussions with your advisor or accountant, it's helpful to have a basic understanding of how the US tax code works.
Please note that where actual tax rates or tax brackets appear, they are subject to change. Please consult a tax professional, the IRS, or your state taxing authority for the official numbers.
Different Types of Income
In general, the US tax code recognizes two* basic types of income:
Earned income. Examples include wages, tips, pensions, and distributions from traditional retirement accounts.
Investment income. Common examples include dividends paid from stocks and bonds or capital gains (the difference between the price you paid and the price at which you sold) of stocks and bonds, but this also includes lots of other things like a gain on the sale of your home too.
* For simplicity, we're going to ignore passive income here.
Investment income usually gets taxed in two different ways:
For dividend payments from most investment products (like bonds) as well as gains on everything else if you haven't owned it for long enough (in most cases, less than a year), the tax rate is usually the same as normal earned income, but with a twist: an extra 3.8% tax applies above $200,000 for single filers, or $250,000 for married filers.
For everything else (if you do hold it for long enough), the gains are taxed at lower capital gains rates. This frequently applies to capital gains and qualified dividends from stocks, among other things. You'll frequently see 0%, 15%, and 20% cited as tax rates for capital gains, but the 3.8% tax we mentioned before applies here too, so the rates are actually 0%, 15%, 18.8%, and 23.8%.
All of that ends up in brackets that look like this, although note that these brackets only apply for married filing jointly returns and are based on the 2019 tax year:
Let's work through how these brackets actually get applied. In the following example we're more concerned with the methods than the actual numbers, so we've left out much of the math.
The Income Stack
Start by arranging all your income in a column. If it helps, picture a stack of dollar bills that includes every dollar you earned in a paycheck or got through investments. Start with earned income first at the bottom of the stack, then investment income, with anything taxed at the lower capital gains rate at the top. For simplification, we're going to use an example that only has income (green dollars) and capital gains (blue dollars) but no other investment income:
Deductions
Next, we'll take your deductions; for most people this is $12,000 if you're single or $24,000 if you're married and file a joint return, if you're taking the standard deduction. Deductions always come off the bottom of the stack, so pull that many dollars out from the bottom. If you run out of income before you've pulled enough dollars out from the bottom of the stack, keep going with investment dollars and then capital gains dollars. These dollars are entirely yours* – you don't have to pay any tax on them.
* You still have to pay Social Security and Medicare tax on the income dollars. See "Much Ado About FICA" below. Nothing is free!
Tax
Now let's show the income tax brackets and capital gains tax brackets alongside your stack of dollar bills.
As you can see, tax rates get applied, dollar by dollar, across the stack. Starting at the bottom dollar, you'll put ten cents of each dollar into your "taxes to pay" pile. After a while, you'll start putting twelve cents out of each dollar into the "taxes" pile, then 22 cents, then 24 cents, and so on up through the brackets. You keep the rest.
After you're done paying taxes on all your earned income, start paying taxes on your capital gains. (Remember that in this example, you don't have any investment income.) Put fifteen cents out of every dollar onto the "taxes" pile, then 18.8 cents. Again, you keep the rest.
A Tangent About Withholding
Note that not all of this "taxes to pay" pile is really "to pay" – by the time April 15th comes, you've probably paid at least most of it (and maybe paid too much!) Some tax payments come out of your paychecks as you earn it. This is called "withholding" and is based on an estimate of what you'll end up owing at the end of the year, but it's not exact. When you file your yearly tax return you are actually "settling up" with the government: if the withholding was more than you actually owed, you'll get the difference back (your refund). If the withholding wasn't enough to cover your tax, you'll end up paying the difference.
Tax Credits
Let's go back to the "taxes to pay" pile for one final step: any credits you can take come directly out of the pile. There are a lot of credits out there, but here are some of the most frequently used:
Earned income tax credit
Child tax credit
Child and dependent care tax credit
Savers tax credit
Some tax credits are refundable, or partially refundable. This means that your "taxes to pay pile" can go negative – that is, you can get back more than you paid in (from withholding). Non-refundable credits can reduce the size of your "taxes to pay" pile, but you won't get a check for the excess.
State Income Tax
If you are a lucky resident of Alaska, Florida, Nevada, South Dakota, Texas, Washington, or Wyoming, you're in luck! Your state doesn't have a separate income tax and you can safely ignore this section. Tennesseans and New Hampshirites, your states don't tax earned income but do tax investments, although Tennessee is scheduled to phase even that out by 2021.
Of the rest, some states (Colorado, Illinois, Indiana, Kentucky, Massachusetts, Michigan, North Carolina, and Pennsylvania, and Utah) don't use brackets at all; rather, they usually have a single rate that applies equally to all income and investments, not including income that's not taxed due to deductions. Everyone else has multiple brackets, just like the federal tax.
Most states don't treat different types of income differently, so in most cases you'll pay the same state tax rate on the dollars you get from your paycheck as you do on the dollars you get from investing.
All state tax codes are different, so please consult your state's department of revenue and/or a tax professional for advice about your personal situation.
How State Taxes Work
If your state collects income tax, it generally (but not always) works similarly to federal tax.
You'll start with either the pre-deductions stack or the post-deductions stack (your adjusted gross income or taxable income).
Next, you'll start at the bottom of the stack and set aside pennies from each dollar into a "taxes to pay to your state" pile, based on the brackets your state has set.
Finally, you'll take any applicable tax credits out of your "taxes to pay to your state" pile; what's left in the pile is your tax.
A lot of states have adjustments to this procedure depending on certain factors. For example:
Arkansas, Connecticut, and New York eliminate the lower tax brackets for the very highest-earning taxpayers. These unlucky (or lucky?) individuals have to pay the top tax rate on their entire taxable income.
Maryland adjusts the amount of your deduction based on your overall income level. If you earn too much, you may not be able to take the full – or any – deduction (the dollars you take off the bottom of the stack that don't get taxed at all).
States do withholding too, just like the federal government, so you may get a refund or have to pay the difference just as you did with your federal tax return.
In some areas, you may also have to pay local income taxes to your county or city.
Much Ado About FICA
FICA is a separate tax that applies on top of your income tax. FICA is short for the Federal Insurance Contributions Act and has two parts: a 6.2% tax for old age, survivors, and disability insurance (Social Security) and a 1.45% hospital insurance tax (Medicare). Every dollar you earn from your first dollar to your 137,700th (in 2020) pays an additional 7.65% tax as a result. Above this limit, the Social Security portion of the tax phases out so additional dollars are only taxed at the lower Medicare-only rate.
Sources and Further Reading
Thank you to our friend Chad Elkins, a Certified Public Accountant, for providing information and comments on a draft of this article.
Much of the information on state tax systems, brackets, and rates came from The Tax Foundation. For the 2020 tax year, information on state income tax can be found here.
Disclosures
All information provided in this article is for informational purposes only and is not intended to provide investment or tax advice. Opinions expressed are those of CJW Capital LLC (CJW Capital) as of the date of publication and are subject to change at any time due to changes in federal, state, and local tax codes. While efforts are made to ensure information contained herein is accurate, CJW Capital cannot guarantee the accuracy of all such information presented. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by CJW Capital to be reliable and are not necessarily all inclusive. Reliance upon information in this material is at the sole discretion of the reader. Material contained in this publication should not be construed as legal, accounting, or tax advice.