Image Credit: https://www.foxbusiness.com/features/how-to-pay-uncle-sam-at-the-deadline
“It’s not how much money you make, but how much money you keep, how hard it works for you, and how many generations you keep it for.” — Robert Kiyosaki
Tax season is upon the Henry household, so naturally a post concerning taxes would be in order. Taxes are typically a dry subject, especially when you get into the weeds. At the risk of boring the hell out of some of you, I still thought I would cover some basic tax concepts in today’s post. I suspect there are many of you out there that think about taxes the way I did prior to taking a deeper dive into personal finance and investing. I used to think taxes were the last thing in the world I should be thinking about, and that I need not concern myself with something reserved for my accountant or tax software. What I eventually came to realize is that understanding and leveraging the tax code to my advantage can have a significant impact on my ability to build wealth and achieve financial independence. Let’s talk about why.
2020 Tax Brackets & Standard Deductions
Let’s start first with a basic understanding of the tax brackets and standard deductions.
Most people fundamentally understand that the tax system is progressive (i.e. the higher your income the higher your tax bracket). Below are the tax brackets for married filing jointly and single filers in 2020. In included these two because they are two of most common tax returns filed and likely cover many readers.
When calculating taxes, deductions are an important part of reducing your taxable income. For 2020 taxes filed in 2021 the standard deductions are as follows:
- $12,400 for single taxpayers
- $12,400 for married taxpayers filing separately
- $18,650 for heads of households
- $24,800 for married taxpayers filing jointly
- $24,800 for qualifying widow(er)s
The standard deduction, as the name implies, is an automatically available reduction in your earned income provided by the government. This reduction income reduces your overall tax liability. The alternative to the standard deduction would be itemized deductions. Itemizing your deductions allows you to “itemize” all of your deductible expenses for the year (e.g. property taxes, medical expenses, charitable giving, etc.) instead of taking the standard deduction. You would typically select this option if your total itemized deductions exceed the standard deduction available to you. Many people elect to take the standard deduction because they do not have enough itemized deductions for any given tax year. For this reason, and for simplicity sake, I am going to stick to examples in my post today that involve only the standard deduction.
Marginal vs. Effective Tax Rate
The charts above are relatively straight forward. However, many people tend to focus on their taxable income bracket (column 2) instead of their taxes owed (column 3). The two are related, but not the same. I have heard of people that consciously choose not to increase their income or accept a promotion or salary increase because they think that it will “put them in a higher tax bracket” thus making all of their income taxable at the higher rate. This is simply not true.
As a HENRY, you will fall somewhere in the 22% – 37% tax bracket. However, the tax bracket you fall into does NOT represent you actual tax rate. It represents your marginal tax rate. The technical definition of your marginal tax rate is the tax rate imposed on your last dollar of income.
For example, let’s say that your household taxable income in 2020 is $200,000 and you are going to file married filing jointly. This would mean you have a marginal tax bracket of 24%. Put another way, every dollar you make beyond $200,000 will be taxed at 24% because you fall in the 24% bracket ($171,051 to $326,600).
Marginal tax rate is important to understand because it can impact some of your decisions from a financial perspective. This is especially true when you are trying to control your tax rate and have different sources of income. However, it is equally important to understand that your marginal tax rate is NOT your actual tax rate. Your actual tax rate is referred to as your effective tax rate. The technical definition of your effective tax rate is the percentage of your income that you pay in taxes. It is essentially the average tax rate you pay based upon your income.
Let’s use the same example above.
What would be your effective tax rate if your household taxable income in 2020 is $200,000 and you are going to file married filing jointly? To keep the example easy, let’s assume you live somewhere with no state tax, contribute $0 to retirement accounts, have no children, no credits, and only take the standard deduction. What do you think? 24%?
The answer is 15.10%. Total federal taxes owed would be $30,207 even though you fall into the 24% marginal tax bracket. The quick math is below for you math nerds out there like me.
Total Income: $200,000
Standard Deduction: $24,800
Taxable Income: $175,200 = ($200,000 – $24,800)
Fed. Taxes Due: $30,207 = ($29,211 + .24 * ($175,200 – $171,050)
Effective Tax Rate: 15.10% = ( $30,207 / $200,000)
Understanding the difference between your marginal tax rate and your effective tax rate is not complicated. However, it is an often overlooked aspect of our progressive tax system.
Understanding FICA
FICA is often referred to as “payroll tax” because FICA taxes are typically deducted by your employer. FICA stands for Federal Insurance Contributions Act. The chart below outlines FICA taxes owed by you as the employee in 2020. It is important to note that this does not include the employer side. Again, I am keeping it simple.
Social security tax is pretty straight forward. You will sometimes see this referred to as OASDI (Old-Age, Survivors and Disability Insurance). This tax is how you earn your social security benefits later in life. As you can see above, this is a 6.2% flat tax with a cap. As a result, the most you can pay in social security taxes in 2020 is $8,537.40. For those who earned more than $137,700 in 2020, this explains why you saw a 6.2% pay increase at some point during the year.
Medicare tax is withheld for a similar reason. Medicare coverage is available for those 65 years of age or older as well as people with disabilities and certain health conditions. As you can see above, this is a 1.45% tax with no cap. In addition, there is an additional .9% tax for earnings over a certain threshold. This additional .9% Medicare tax originated from the Patient Protection and Affordable Care Act (PPACA) signed into law in 2010.
The combination of these taxes represents the FICA tax rate of 7.65% (6.2% + 1.45%) or 8.55% (6.2% + 1.45% + .9%) for those with wages in excess of the threshold.
Let’s now look an example. Using our previous scenario above of someone with a household taxable income in 2020 of $200,000 married filing jointly, total taxes due to include FICA would be $41,644. The math is below.
Total Income: $200,000
Standard Deduction: $24,800
Taxable Income: $175,200 = ($200,000 – $24,800)
Fed. Taxes Due: $30,207 = ($29,211 + .24 * ($175,200 – $171,050)
SS Taxes Due: $8,537 = (.062 * $137,700)
Medicare Taxes Due: $2,900 = (.0145 * $200,000)
FICA Taxes Due: $11,437 = ($2,900 + $8,537)
Total Taxes Due: $41,644 = ($30,207 + $11,437)
Total Tax Rate: 20.82% = ($41,644 / $200,000)
If you want to play around with different scenarios yourself, there are many online calculators you can utilize including the one I used at smartassset.com. The summary below was pulled from their website utilizing the same parameters above to include $200,000 in household income, no state income tax, no children, and no retirement contributions.
FICA taxes are important to understand at a basic level because you pay them whether you like it or not. However, there is one key thing often overlooked concerning FICA taxes. They only apply to earned income. Let me explain.
Understanding Capital Gains
There are a lot of very smart people in the world that don’t bother with investing or understanding the basic differences in how income is taxed. This is not inherently a bad thing. You can become financially independent by putting your money in a savings account and never investing a penny. However, it will be MUCH harder and likely take MUCH longer because you are not leveraging the compound interest growth that investing can provide.
With that being said, if you are HENRY in the pursuit of FI and you don’t have a basic understanding of how unearned investment income is taxed differently than earned income, you need to pay attention.
Warren Buffet has commented in many interviews throughout the years that he pays less tax as a percent than his secretary. In fact, in a 2007 interview, Buffett noted that he took a survey of his employees and their tax rates in relation to his. The result? Buffet found that his employees paid an average tax rate of 32.9% while he paid a total tax rate of 17.7%. [1] Think about that for a minute. Warren Buffet, the billionaire, is paying ~ 15% less in taxes than his employees. How is this possible you may ask? Sure, there are a lot of tactics and techniques that Buffet (or rather his team of highly paid accountants) utilizes to reduce his taxes. However, the main driver behind Buffet’s comments stem from the taxes incurred on investments rather than earned income.
Before we get into the capital gains rates, it is important to first understand the difference between short-term and long-term capital gains.
Short-term capital gains tax is the tax paid on profits resulting from the sale of an asset that is held for less than a year.
Long-term capital gains tax is the tax paid on profits resulting from the sale of an asset that is held for more than a year.
Why does the difference matter? It’s simple. The tax rate for short-term capital gains corresponds to your ordinary income tax rate. The rate for long-term capital gains are taxed at a different rate. A more preferable rate. A lower rate.
The chart below outlines long-term capital gains tax brackets and rates for 2020.
There are a couple of key things to point out about capital gains taxes. I remind you that I am staying high level for today’s post, but these are still key points that should be recognized.
- The long-term capital gains rates are lower than ordinary income tax rates. This is obvious if you look at the chart above, but it bears repeating. The top bracket of 20% is a full 17% lower than the 37% top bracket.
- Capital gains taxes don’t just apply to the sale of financial assets like stocks. Real estate, collectables such as artwork and vintage cars, boats, jewelry, etc. are also subject to capital gains taxes. Some of these have separate rates and different rules may apply.
- Qualified dividends also qualify for long-term capital gains rates. Ordinary dividends on the other hand are subject to ordinary income rates. This is an important distinction when you get into the details, but we won’t today.
- Capital gains are considered unearned income. As a result, they are NOT subject to FICA taxes. No Medicare tax. No social security tax. None. Zero.
- Capital gains stack on top of ordinary income so you have to take this into account when you have ordinary income and capital gains. Specifically, you would need to take your ordinary income less your standard deduction plus your long-term capital gains to determine your capital gains taxes. This is a little more difficult to visualize so we will cover in future posts. Again, today I want to keep it high level.
- There is an additional tax to consider which is the net investment income tax, or NIIT. This is an additional 3.8% tax related to net investment income. I don’t want to get into this in today’s post, but it is important to consider since it is driven by your investment income relative to your modified adjusted gross income (MAGI). For many HENRYs, out there this may come into play when you realize gains on appreciated financial assets.
Let’s now look at a basic example of how long-term capital gains work.
Let’s use a derivative of our previous scenario. Instead of $200,000 in earned income, let’s assume the same $200,000 will be attained through the sell of appreciated stock held for more than one year. We are also going to assume there is no other earned income and taxes are calculated using the married filing jointly capital gains rates.
Purchase Price: $100,000
Sale Price: $200,000
Capital Gain: $100,000 = ($200,000 – $100,000)
Taxes Due: $3,000 = ($100,000 – $80,000)*.15)
Profit After Tax: $97,000 = ($100,000 – $3,000)
Total Tax Rate: 3% = ($3,000 /$100,000)
3% effective tax rate on $100,000… For those less familiar with capital gains, do I have your attention yet?
You may be thinking… wait it minute Henry! This is a false equivalent. $100,000 of the $200,000 was likely ordinary income that was previously taxed at ordinary tax rates and then invested. I can’t disagree so let’s look at a slightly revised scenario. Let’s assume you sell $300,000 in appreciated stock with an initial purchase price of $100,000. Now you have $200,000 in unearned income.
Purchase Price: $100,000
Sale Price: $300,000
Capital Gain: $200,000 = ($300,000 – $100,000)
Taxes Due: $18,000 = ($200,000 – $80,000)*.15)
Profit After Tax: $182,000 = ($200,000 – $18,000)
Total Tax Rate: 9% = ($200,000 / $18,000)
This example aligns more closely with our previous example of $200,000 in earned income. If you recall, the effective rate for federal was 15.10%. In addition, there was an additional 5.72% in FICA taxes for a total of 20.82%.
Think about that for a minute, the difference between $200,000 in earned income and $200,000 in unearned income is almost 12% less in taxes. This is using a scenario where you aren’t even tapping into the arbitrage between the top ordinary tax bracket and the top capital gain bracket. The higher your income, the more advantageous the long-term capital gains rates become. This in part is why Warren Buffet can pay less taxes as a percent relative to his employees to include his secretary. This is why many highly compensated individuals including CEOs prefer to take no salary and be compensated in stock or options. Less earned income = less taxes. Simple as that.
Conclusion:
Although taxes can be a painfully boring subject to many, understanding the basics of taxes can have a profound impact on your ability to build and preserve your wealth. This takes me back to the title of my post. There is a reason top executives choose to take a $1 salary or less. The chart below outlines maximum capital gains and individual ordinary income tax rates since the 1950’s. Notice the variability in individual income tax rates but the relative stability of capital gains rates? Why do you think that is?
Image Source: https://www.taxpolicycenter.org/briefing-book/how-are-capital-gains-taxed
Stock growth and capital gains are a lot more attractive because they are taxed more favorably.
Of course taxes get a lot more complicated, and there are all kinds of complicated tax strategies. However, at the heart of it is the different tax structures for earned vs. unearned income. You see a lot in the media about tax rates, tax cuts, tax hikes, etc. It is also a core talking point of politicians. You will also see a lot of executives proudly publicizing that they take a $1 salary or no salary at all. Don’t be fooled. The rich stay rich for a reason.
You will hear plenty of talk about changing individual income tax rates. You won’t hear a lot about raising capital gains rates to align more closely with ordinary tax rates. There is a reason, and if you understand that reason, you too can take advantage.
Regards,
Henry
Note: The information published in this post is for informational and entertainment purposes only, and does not constitute accounting, tax, investing, or other professional advice. All examples provided were for entertainment and illustrative purposes only. Readers should not take action on any information within this post. Readers should instead seek advice from a tax professional.
References:
[1] https://www.fool.com/taxes/2020/09/25/why-does-billionaire-warren-buffett-pay-a-lower-ta/
[2] https://www.businessinsider.com/ceos-who-take-1-dollar-salary-or-less-2015-8