Year after year, we reach out to our tax preparers or log back into our tax software to file our taxes. Many of us go through most of our lives without having a basic understanding of how we are taxed and why certain things trigger different tax consequences.
By better understanding some of these fundamental tax principles, you can learn ways to spend less on taxes each year, make smart money moves, and build sustainable wealth for the long term. Here, we will go through five of the most common federal tax concepts taxpayers face and offer insights into ways you can help reduce your tax bill.
Income Tax Rates
The United States utilizes a 'progressive tax system' to determine how much of your salary and wages are subject to being taxed by Uncle Sam, which means the more you earn, the greater the percentage you pay in taxes. The system is stair-stepped – each step (known as a 'tax bracket') is taxed at a higher and higher rate, and once you fill up a bracket, your next dollar gets taxed at the higher rate. Therefore, the tax you owe is the summation of each of the brackets in which you have income.
But what does all of this mean? Let's say you have a taxable income of $150,000, which includes all of your income subject to taxation after deductions are applied. If you file your taxes as Single, you would be in the 24% marginal tax bracket for 2024.
A common misconception about our tax system is that you can calculate the tax you owe by multiplying your tax bracket by your income – in this case, 24% of $150,000, equating to $36,000. However, the true nature of tax rates is that there are tiers, and different amounts of your income are taxed at different rates. Therefore, using the example above, your taxes owed would actually be broken down as follows:
Your first $11,600 is taxed at 10%,
Your next $11,600 to $47,150 is taxed at 12%,
Your next $47,150 to $100,525 is taxed at 22%, and
Your remaining $49,475 is taxed at 24%.
In this situation, your total tax bill would be $29,042.50 – significantly less than $36,000.
Now that you have calculated how much you owe, you can use this number to find your 'effective tax rate.' This is an average rate calculated by dividing the total tax paid by your taxable income. In this case, $29,042.50 divided by $150,000 brings you to an effective tax rate of about 19.36%. That means that for every dollar you earn, you pay an average of about $0.19 in taxes.
As financial planners, understanding your tax rates (both marginal and effective) gives us a snapshot of your overall tax picture and allows us to tailor lots of different strategies to you, including:
Contributions to traditional (pre-tax) versus Roth retirement accounts,
Roth conversions,
Retirement account distributions,
Taking advantage of tax deductions and credits,
Tax loss and capital gains harvesting,
Gifting strategies and legacy planning,
And so much more!
Income Tax Deductions
Tax deductions are provisions in the tax code that allow you to subtract specific amounts from your gross income, therefore reducing the amount of your income subject to taxation. In other words:
Income – Deductions = Taxable Income
For example, let us say your total income is $200,000, and you have $50,000 worth of deductions. Assuming you file your taxes as Single, below is a simplified side-by-side of your tax liability with and without the tax deductions:
$50,000 Tax Deduction | No Tax Deductions | |
Total Income | $200,000 | $200,000 |
Tax Deductions | -$50,000 | |
Taxable Income | $150,000 | $200,000 |
2024 Tax Rate | 24% | 32% |
Taxes Owed | $29,042.50 | $41,686.50 |
Taking $50,000 worth of deductions reduced the amount of income subject to taxation, brought you to a lower tax bracket, and reduced your tax bill by more than $12,500!
There are two types of deductions: above-the-line and below-the-line deductions. 'The line' refers to Line 11 (Adjusted Gross Income) on a 1040 tax return. Therefore, any deductions taken while filling out your tax return before arriving at Line 11 (hence above Line 11) are above-the-line deductions. Meanwhile, deductions taken after Line 11 are below-the-line deductions.
Above-the-line deductions, sometimes called 'adjustments,' are subtracted from your gross income to arrive at your adjusted gross income and are generally considered more favorable than below-the-line deductions. Most of these deductions pertain to business-related expenses and activities that produce income for the taxpayer. However, certain deductions are permitted for all individuals, such as IRA contributions, health savings account contributions, student loan interest, and educator expenses.
Below-the-line deductions are primarily comprised of 'itemized deductions.' They are subtracted from your adjusted gross income to arrive at your taxable income. In addition, you can only itemize your deductions if their total exceeds that year's standard deduction.
Itemized deductions are reported on Schedule A of your tax return and include:
Medical and dental expenses in excess of 7.5% of your Adjusted Gross Income,
Taxes paid by you to state and local governments up to $10,000,
Interest paid (e.g., mortgage interest and points),
Gifts to charities,
Casualty and theft losses from a federally declared disaster, and
Miscellaneous itemized deductions.
Income Tax Credits
Whereas tax deductions reduce the amount of your income subject to taxation, tax credits are subtracted from your tax liability and directly reduce your tax bill.
For example, let us say you earn a salary of $200,000, take $50,000 worth of deductions, and receive a $10,000 tax credit. Your calculated tax liability with and without the credits is the following:
$50,000 Tax Deduction, $10,000 of Tax Credits | $50,000 Tax Deduction, No Tax Credits | |
Total Income | $200,000 | $200,000 |
Tax Deductions | -$50,000 | -$50,000 |
Tax Deductions | $150,000 | $150,000 |
2024 Tax Rate | 24% | 24% |
Calculated Tax | $29,042.50 | $29,042.50 |
Tax Credits | -$10,000 | |
Taxes Owed | $19,042.50 | $29,042.50 |
Tax credits come in two varieties:
Nonrefundable credits can be applied to the current tax year or, in some cases, carried back to an earlier year, carried forward to future years, or both. They can reduce your tax liability to zero, but they cannot generate a tax refund.
Refundable tax credits can only be used to reduce or eliminate your current year's tax bill, but they can also generate a tax refund.
Some commonly utilized tax credits include:
Foreign Tax Credit,
Child Tax Credit,
Child and Dependent Care Credit,
Credit for the Elderly or the Disabled,
American Opportunity Tax Credit,
Lifetime Learning Credit,
Retirement Savings Contributions Credit (Saver's Credit),
Residential Clean Energy Credit,
Energy Efficient Home Improvement Credit,
Electric Vehicle Tax Credit,
And much more!
Capital Gains/Losses
Capital gains or losses refer to the increase or decrease in the value of a capital asset upon its sale. Put another way, a capital gain is when you sell an asset for more than you paid, while a capital loss is when you sell an asset for less. Capital assets include most properties you own, such as stocks, bonds, houses, furniture, vehicles, etc.
To 'realize' the gain or loss of an asset means you sell the asset and lock in the tax consequence. The tax implications for selling property depends on a couple of factors, namely:
How long have you owned the asset?
Did you sell it at a gain or loss?
What kind of asset is it?
Your holding period (the length of time you owned the asset) can either be short-term or long-term. If you hold onto an asset for a year or less, this is considered a short-term holding period. If your holding period is greater than a year, this is a long-term holding period.
Capital Gain/Loss | Holding Period |
Short-Term Capital Gain/Loss | ≤ 1 Year |
Long-Term Capital Gain/Loss | > 1 Year |
Whereas short-term capital gains are taxed at your ordinary income tax rate, long-term capital gains receive preferred tax treatment. Depending on your filing status and income, your long-term capital gains could be taxed anywhere between 0% and 20%.
For example, let's say you sell a stock with a gain of $1,000, file your taxes as Single, and make $150,000 of taxable income. If you held the stock for less than a year and sold it, you would pay an additional $240 in tax because that gain would be taxed at your highest marginal tax rate – 24% in this case. In contrast, if you held the stock for over a year, your long-term capital gain rate would be 15%, and you would be taxed $150. In the grand scheme of things, a $90 difference in taxes may not seem like much, but the larger the gain, the more you will appreciate the difference in tax treatment.
Additionally, capital losses can be used to offset gains, thus reducing the taxes owed on the gain. Also, if your realized capital losses exceed your gains in a given tax year, the IRS will let you use those losses to offset your income by up to $3,000. If your net losses exceed $3,000, the IRS will let you carry them forward to the next year.
Lastly, most capital assets are subject to the standard capital gains rules. However, there are a few exceptions where long-term capital gains may be taxed at a rate greater than 20%. The most common is the sale of collectibles at a gain. Collectibles include things like precious metals, gems, stamps, coins, rugs, antiques, artwork, historical objects, etc. These are taxed at your marginal ordinary income tax bracket up to a maximum of 28%.
Dividends
The board of directors of a corporation meets periodically to discuss high-level decisions for the company. In these meetings, they will often decide whether or not to pay a distribution of the company's earnings to its shareholders. This distribution is typically paid out quarterly and comes in the form of cash or additional shares of stock. These distributions are called either 'cash dividends' or 'stock dividends.'
For tax purposes, dividends come in two varieties: qualified and non-qualified (ordinary).
Qualified dividends are taxed at long-term capital gains rates, while non-qualified dividends are taxed at your ordinary income tax rate. To be considered a qualified dividend, it depends on a couple of factors – most notably, how long you held the investment. This is a little bit more complicated than holding periods for capital gains and is outside the scope of this article. Talk to your financial advisor or tax professional if you have questions about determining qualified versus non-qualified dividends.
If you are looking for a financial advisor to help you craft a plan, check us out! You can schedule a complimentary, no-obligation call with us here.
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About the Author
Holzberg Wealth Management is a family-owned and operated financial planning and investment management firm based in Marin County, CA. As your financial advisors, we serve you as a fiduciary and are fee-only, so we never receive commissions of any kind. We help individuals and families like you in the greater San Francisco Bay Area and virtually nationwide with the financial decision-making process to organize, grow, and protect your assets.
** This writing is for informational purposes only. The author and Holzberg Wealth Management do not guarantee or otherwise promise any results that may be obtained from using this report. No reader should make any investment decision without first consulting their financial advisor and conducting their own research and due diligence. These commentaries, analyses, opinions, and recommendations represent the personal and subjective views of the author and do not constitute a recommendation, offer, or solicitation to make any securities transaction. The information provided in this report is obtained from sources that the author believes to be reliable. External links to third parties are being provided for informational purposes only. Holzberg Wealth Management is not affiliated with the third-party websites linked to, unless otherwise explicitly stated, and does not constitute an endorsement or approval by Holzberg Wealth Management of any of the third party’s products, services, or opinions.