Eight Essential Tax Facts
Look, it’s December. Tis the season. We can talk about taxes now or we can talk about it in January. But you know that this discussion is coming so let’s get it out of the way right now. Here are eight things that everyone ought to know about taxes, and yet…
Quarterly Estimated Tax Payments. Just because taxes were not withheld from your income, that doesn't mean the income is tax-free. I am looking at you, 1099 earners and traditional retirement account retirees. For retirees, federal taxes were withheld before you received your distribution, but if your state taxes retirement income, you need to make a quarterly estimated payment to your state. Waiting until you file your taxes in April is not good enough! Whether it is state taxes or federal, the government expects you to pay as you go. Waiting until tax filing time could result in penalties.
Marginal versus Effective Tax Rates. Maybe you know your marginal income tax rate off hand — that’s the headline number that everyone talks about. But when you are planning on how much you need to save for retirement, it’s useful to know your effective tax rate which is calculated from the amount of income taxes you actually pay, after accounting for all deductions and credits. Just divide your total tax owed (1040 Line 24) by your adjusted gross income (Line 11).
Short Term versus Long Term Capital Gains Tax. We know what capital gains are, right? The amount of profit you make when you sell an investment. That gain is taxable and usually the tax rate for a capital gain is less than your ordinary marginal income tax rate. Except when it’s not. If you only hold the investment for less than a year, any capital gain will be taxed at your regular marginal income tax rate.
You don’t take a pay cut if you get a raise because of taxes. Oh, the number of times I have heard this one. People, please just do the math! While the total dollar amount of taxes that you pay will rise with your income, you cannot be worse off in total. Also know that income tax rates are marginal. That means that the tax rate for your income bracket, let’s say 22%, only applies to your income above a certain threshold (or margin). If you get a big pay bump and you cross into the next tax rate (let us say from 22% to 24%), only the fraction of your pay that exceeds the old income bracket will be taxed at the higher rate. Not all of your pay.
Payroll taxes are a different animal. Do you know what FICA stands for? Yeah, neither did I. It stands for the Federal Insurance Contributions Act. This is the part of your pay that goes for Social Security and Medicare. What you should know about FICA is that it only applies to earned income (which is why it is called a payroll tax) which is good news for retirees. You should also know that not declaring your earned income, aside from being illegal, hurts you because when you are not paying FICA, you are not earning Social Security credits. And finally, while income tax cuts are all fine and dandy, for low and middle income workers, most of the taxes they actually pay are FICA taxes; headline income tax cuts really don’t move the needle too much for them.
Dividend and interest income is taxed just like earned income. When your investment earns a dividend or pays interest, you declare that income every year and pay taxes accordingly, even if you have automatically reinvested said dividends and interest. If you have investments that throw off a lot of dividend and interest income, these types of investments may be best located in a retirement account where taxation is deferred (or even not at all, if a Roth retirement account).
Tax credits are better for you than tax deductions. A tax deduction reduces the amount of your income subject to tax. A tax credit, on the other hand, looks at the dollar amount of tax that you owe, and then reduces it by a set amount. Quick highly fictional example: Your income is $100,000 and your tax rate is 20%. You get a tax deduction of $10,000 for whatever reason and now your taxable income is just $90,000. You owe $18,000 (20% * $90,000). On the other hand, if you had a tax credit of $10,000, your total tax bill would be only $10,000 ($100,000 * 20% = $20,000; $20,000 - $10,000 = $10,000). With a new Congressional tax battle coming in 2025, expect to hear a lot about changing credits and deductions.
The Roth versus traditional retirement account battle has no winners. Which is best? It really depends on your personal situation AND the right answer may change for you from year to year. Understand what goes into the decision (start here) but also understand that “getting it wrong” is not the death knell of your retirement security.
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