Taxes 101
It’s no secret that everybody hates paying taxes, but it’s something we all have to do, so we might as well learn how taxes work so we can pay as little as possible.
But before I get into any of the specifics around taxes and some of the ways you can save money, let’s briefly explain the purpose of taxes and also address some common misconceptions.
What Are Taxes?
As most people know, taxes are how governments pay for everything they do. Though that is somewhat of a misnomer insofar as governments have a tendency to deficit spend, all the money paid in taxes goes to the government to fund public goods and services like parks, roads, schools, police departments, the judicial system, the military, and everything else.
One important thing to note about taxes is they are also a way for governments to incentivize economically desirable behavior. Tax codes will often be written to benefit those who invest in projects the government needs or deems important, such as energy or agriculture, so if you know where to invest your money, you can pay little to nothing in taxes because the government wants to encourage what it believes the country really needs.
A common misconception about the tax code is that it is designed to make you pay more in taxes or it is purposefully confusing to make it harder to save money. While the second point might be partially true as it perpetuates the need for tax attorneys and accountants, the tax code is actually designed to save you money.
Only 0.5% of the tax code is dedicated to raising your taxes, while the other 99.5% is devoted to various loopholes and deductions to save you money. That said, the tax code is undoubtedly overcomplicated, which makes it challenging to take advantage of those money-saving parts, but it’s still here to serve you, not hurt you.
With that out of the way, let’s start with the basics.
What Income Is Taxable?
Taxable income is just the amount of income you make that is subject to tax after deductions and exemptions, which I’ll touch on later. For both individuals and corporations, taxable income is distinguished from gross income, which is the total amount of money you make in a year.
Although your total income likely won’t be the same as your taxable income, it’s usually pretty close to your taxable income, so it will be a good reference for tackling the next step.
Tax Brackets
The first thing you should probably start with when digging into your taxes is your tax bracket because that will tell you what percentage of your income you are expected to pay each year. Depending on your income and filing status, you can be taxed at a different rate, so it’s important to know exactly where you stand.
There are seven different federal tax brackets ranging from 10% to 37% with the higher income earners paying incrementally higher rates. I won’t bother listing all the different income ranges corresponding to those rates as there are a total of 21 when you include the different filing statuses.
A quick google search is all you need to find your tax bracket, so don’t hold back if you are unsure what rate you’re expected to pay each year.
Filing Status
When you file your taxes, the default status is single, which could be considered the standard rate. However, you can also file as married or head of household.
When you file as married, the income range for the same seven federal tax brackets essentially doubles, meaning you can make twice as much and be taxed at the same rate as single filers. That may not actually be true if you and your spouse have similar incomes, but it can meaningfully lower your tax rate if your spouse doesn’t work or makes significantly less than you.
Head of household is a little more complicated and mostly applies to single parents, divorcees, or couples with dependents (children) who just prefer to file separately. If you contribute to at least half of the living expenses and have a dependent who makes less than $4,300 a year, whether that’s a child, relative, or unemployed significant other you support, you can claim head of household to get a higher range of income for the same tax brackets as single filers. And if you’re lucky, that could put you in a lower tax bracket, so it’s worth checking out if you think you qualify.
Federal Vs State & Local Taxes
The next important point to raise about taxes is the difference between federal and state & local taxes. This is important because you want to know your tax rate across the board, not just at the federal level.
The seven federal tax brackets I alluded to earlier apply to every American regardless of where they live. State and local taxes, however, are very different depending on where you are. As an example, many states, such as Alaska, Florida, Nevada, and a few others, have no state income tax. States like California, on the other hand, have nine income tax brackets ranging from 1% to 12.3%.
States with no income tax usually have other ways of balancing out the absence of money coming in with higher sales tax, property taxes, or, in the case of Nevada, an ungodly amount of tax revenue from the Vegas gambling, so it’s important to look at every state’s tax laws holistically rather than focus on one area where its taxes are low.
I don’t have time to get into every state and its respective tax laws, but understanding these differences exist and each state has its own unique taxes will be essential to fully understand how much you pay and where you can save.
Property Taxes
I briefly mentioned property taxes earlier, but it’s a topic worth diving further into. While homeowners will be acutely aware of the concept of property taxes, it’s an expense frequently overlooked, despite it accounting for a sizable portion of what a lot of people end up paying in taxes every year.
Property taxes are essentially real estate taxes based on the assessed value of your real estate and usually come in the form of monthly fees along with a mortgage payment.
One major critique of property taxes—aside from them being taxes—as that they are based on assessed values of your property, which is another way of saying you’re taxed on unrealized gains or losses of your real estate (your home). The reason this is bad because real estate has a tendency to skyrocket in value, which would lead to a dramatic increase in one’s property taxes, but owners of that real estate usually don’t make any actual money from that asset appreciation unless they sell.
The value of your home might shoot up, but you don’t get any of the money until you sell it, so taxing you on that increased value, especially when the value could fall the next year, is a bit unfair.
On a more positive note, paying property taxes gives you the opportunity for a hefty deduction. With the most recent tax code overhaul, a $10,000 deduction limit per year was added, but anything under that dollar value can be deducted from your taxable income. Anything over that $10,000, however, will technically be taxed twice: once by the state as property tax, and once again by the federal government as income tax.
That being said, tax deductions aren’t always this depressing.
Deductions
Before getting back into specific deductions, there are two ways any taxpayer can choose to tackle their deductions: The standard deduction, which is a fixed amount all taxpayers can deduct from their taxable income (depending on their filing status), or an itemized deduction, which includes specific expenses (like property taxes) you are allowed to add together and deduct.
Itemized deductions can include things like charitable contributions, money already paid toward state and local taxes, or interest payments on a mortgage. Itemized deductions are more uniquely tailored to someone’s actual expenses and are generally favored by taxpayers in higher-income brackets as it allows them to deduct more than the standard deduction, which is usually around $13,000.
If you have a relatively low income, itemizing deductions can actually be pointless as the standard deduction (which takes no time and effort) can save you more money. Not everybody has enough itemized deductions each year to surpass $13,000, but the more you make, the higher the chance you can deduct more than $13,000, meaning it’s worth it to take an itemized approach.
Now, while the standard deduction doesn’t really need any more explanation, let’s detail some of the most common itemized deductions. I already alluded to some examples like charitable donations, state and local taxes, and mortgage payments, but there is a lot more you can deduct.
Perhaps the easiest expenses you can add to your itemized deductions are work expenses, which include any work-from-home expenses. Whether it’s new work clothes, office supplies, your computer, ink for your printer, wifi, or part of your rent because of a home office, there are innumerable work expenses that can slowly add up to thousands of dollars each year.
Another deduction many people overlook is work meals. If you ever go out to eat at lunch, dinner, or any other time and spend a good portion of that meal talking about work, you can add that to your deductions. Sometimes it’s easy to play fast and loose with the classification “work meal,” but as long as you think an auditor would agree, there’s no reason not to include it.
If you are self-employed, the verbiage to remember around deductions is something that is tax deductible must have a business purpose, be ordinary for your industry, and the expense must be necessary. I say this because although there are certain obvious deductions, there is technically no limit to what you can deduct as long as it meets those basic criteria.
This means things like gas, vacations, phone bills, subscriptions, books, and everything in between can hypothetically qualify as a deduction depending on the circumstances.
Tax Receipts
On a related note, if you get into the habit of tracking your deductions, you should also get into the habit of saving your receipts for all those deductions. It would be nice if the IRS simply took us at our word, but that doesn’t always happen. Most people don’t end up getting audited, but if you do, you want to make sure you have the proof to back up all those deductions you claimed.
The general rule is to hold onto all your relevant receipts for 5-7 years, but if you make it two years without being audited, you’re probably in the clear. That said, it’s never a bad idea to play it safe and you can always create a folder on your computer to store receipts digitally so it doesn’t take up any space.
The last point about receipts to keep in mind has to do with deductions that could be more up in the air. Work meals and business vacations, for example, depend very much on the circumstances and aren’t intuitively understandable the way a new stapler is. Because of that, you’ll want to add notes to your receipts to ensure the context is appropriate and warrants a lawful deduction.
Child Tax Credit
One of the newest additions to the tax code in the same ballpark as deductions is the child tax credit. This was implemented in response to the pandemic, but it’s very possible it sticks around, so I think it’s worth mentioning. After all, the most permanent thing in the world is a temporary government program.
With the child tax credit, families with qualifying children can get a significant tax break—$3,000 for each child between the age of six and 17 and $3,600 for each child under the age of six. To qualify, your child must be, predictably, under the age of 18, provide no more than half of their own financial support, live with you for more than half of the year, and be a US citizen.
Other qualifications rest on the parent or guardian’s end with a married filing income under $150,000, head of household filing income under $112,500, or a single filing income under $75,000. However, if you have a higher income, you can still apply for a partial credit.
Exemptions
Exemptions are similar to deductions in that they exclude all or some income from taxation, but there are still some differences to point out. The key difference is a tax deduction is a portion of taxable income that may be excluded from taxation when certain conditions are satisfied, while a tax exemption constitutes income that is not subject to taxation in the first place.
Most taxpayers are entitled to various exemptions to reduce their taxable income and certain individuals and organizations are completely exempt from paying taxes, such as churches, charities, or other public good organizations.
The exemption most frequently applied to the average person is a dependent exemption, which refers to the income you can exclude from taxable income for each of your dependents. Prior to tax year 2018, you could exclude $4,300 from your taxable income for each dependent, but claiming dependents no longer provides an exemption of any income from taxation due to the child tax credit.
The last exemption example I’ll share is the spousal exemption, which says a married couple filing a joint tax return can claim an exemption for both spouses of $3,950 each. The amount of the exemption is lowered if the couple has a total income greater than $305,050, phasing out completely at $427,550.
With most of the tax basics now out of the way, let’s transition into the investing side of taxes.
Capital Gains
The tax on everyone’s mind when it comes to investing is capital gains. This is how much you have to pay on the money you make from any of your investments, whether that’s from stocks, bonds, crypto, a house, or any other financial asset.
On the federal level, there are three different long-term capital gains tax rates, where long-term refers to investments held for at least one year. The first rate is 0% for anyone with a filing income under $41,675, the second is 15% for anyone with a filing income under $459,750, and the last is 20% for anyone with a filing income above $459,750.
As for short-term capital gains, there are seven different rates ranging from 10% to 37%. Each tier’s max yearly income is roughly as follows: $10,000 for 10%, $40,000 for 12%, $86,000 for 22%, $165,000 for 24%, $209,000 for 32%, $524,000 for 35%, and any income over that is 37%.
Because governments want to encourage long-term investment, tax rates on short-term gains are considerably higher, but this won’t be of any concern to you if you are a buy-and-hold kind of investor.
What will be of concern to each investor, though, is their state capital gains rate. Much like any other type of tax, capital gains taxes vary from state to state and are added onto any federal taxes you pay.
There are a number of states that don’t have any capital gains taxes, but most states have rates between 2.90% and 13.30%, so double check your state’s rate to see what you have to pay on top of the federal rate.
Tax Loss Harvesting
One trick every investor should be aware of is how to harvest a tax loss to lower their taxable income. Say, for example, you made $10,000 in realized gains from the stock market, but you also have another investment you haven’t realized that is down $5,000. You could actually realize that loss to deduct $5,000 from your capital gains that year.
Normally, you can only deduct a total of $3,000 in capital losses each year—although any losses beyond that can technically be deducted in subsequent years—but if you’re sitting on a large number of capital gains, tax loss harvesting is a great way to offset some of those taxes you would have to pay.
This is a handy trick if you want to game the system a bit because you can always buy that asset back to continue your long-term investment after realizing the loss for tax purposes. The only caveat is that you have to wait at least 30 days to buy it back, which is known as the wash sale rule.
Wash Sale Rule
In plain English, the wash sale rule is a way to prevent people from abusing the tax loss harvesting rule. As previously mentioned, selling assets at a loss can afford you certain tax advantages, so the wash sale rule simply adds conditions to those advantages to prevent investors from excessively gaming the tax code.
The conditions are fairly straightforward and essentially say you can’t buy a stock or security substantially similar to the one you sold within a certain period of the sale. An example of this would be selling AAPL to buy MSFT or selling F to buy GM. The wash sale rule also applies throughout a 61-day period beginning 30 days before the sale and ending 30 days after the sale, so you won’t be able to outsmart the IRS by buying MSFT a few days before you sell AAPL.
Now, although your broker will track potential wash sales in any account registered with them, you are expected to track any wash sales across all your accounts to ensure no violations of that rule take place, which is likely not something most people do, but it’s technically required.
Bottom line, the wash sale rule complicates tax loss harvesting, but it’s still fairly easy to do. Just avoid buying anything similar to what you want to sell before harvesting the loss.
Trader Tax Status
If you are a frequent trader who would like to earn an exemption from the wash sale rule, you can apply for trader tax status. If you qualify, not only can you freely buy and sell securities without worrying about how the wash sale rule might affect you, but you can practice mark-to-market accounting, which means you don’t even have to sell everything you own at the end of the year to claim it as a loss. You simply mark the market price on the last trading day of the year and act as if you realized all your investments. This allows you to deduct any paper losses even if they shoot back up a few days later.
Another advantage of trader tax status is the IRS views all your losses as ordinary for tax purposes, meaning you are no longer limited to the $3,000 capital loss deduction limit. Hopefully that is never of any use to you, but if you have a really bad year, you’ll definitely want to take advantage of it.
After hearing about all these advantages, a lot of people might be itching to apply for trader tax status, but it is exceptionally hard to earn. Many people make a distinction between investors and traders, but by default, the IRS does not. Whether you make three trades a year or three hundred, the IRS looks at your trades and any gains or losses the same way for tax purposes.
Even if someone makes dozens of trades a month, the IRS will consider them an investor if they primarily seek income from dividends, interest, and capital appreciation. To be considered a trader, your trading activities must be substantial and regular. These terms are intentionally vague, but it usually means you have to be a professional day trader who earns a living from consistent intraday trading.
Carried Interest
The last tax secret I wanted to share is perhaps even more niche than the trader tax status, but it’s much more relevant to understanding some of the socioeconomic dynamics within the country.
The carried interest tax loophole is an income tax avoidance scheme that allows private equity, hedge funds, and any entity or person who manages investments for others to substantially lower the amount they pay in taxes. This is because the loophole allows them to claim large parts of their compensation for services as investment gains, and that allows them to be taxed at the capital gains tax rate, not the income tax rate, which is substantially lower.
Carried interest is effectively a payment for investment services that is taken from the profits of the money managed for investors. The investors pay the entity managing their money carried interest out of their investment profits, so the idea is that their income is technically derived from capital gains.
This means that private equity managers, hedge funds, and the like pay a lower marginal tax rate on the carried interest income than the average worker pays on their income.
All that being said, if you manage investments for a firm or as a private office, taking advantage of the carried interest loophole will significantly reduce what you pay in taxes.
Conclusion
Hopefully, all this information about taxes was digestible, or at least as digestible as anything about taxes can be. Whether you enjoy learning about taxes or not, it’s a system worth understanding because it’s just something you can’t escape. Benjamin Franklin once said, “nothing can be said to be certain, except death and taxes.”
There’s nothing wrong with hating taxes, in fact, it’s one of the few things that can bring just about anyone together, but the more you know about them, the more you can save. Learning the basics about taxes, deductions, and any loopholes that apply to you can quickly translate into substantial savings. And although I touched on a number of the ways you can save money on your taxes, there are countless more that are worth looking into or discussing with a professional tax advisor.
Always remember that it’s your civic duty to pay as little in taxes as legally possible. Anything beyond that is just money you’re letting the government steal from you. Inform yourself so you can save yourself and learn how to make the tax code work for you.