Taxes. A topic almost everybody deals with, and hardly anybody understands. Kind of like how I feel about my car…. I drive it every day but have no idea how it really works (besides me just putting gas in it). While we all have an opinion about taxes, and might even use it as our compass come election day, how much do you really know about taxes? Besides the fact that you hate paying them. That’s what I thought….let’s dig in.
Did you know that there are 12 different types of tax in the IRS tax code? Generally speaking, you can boil all these different types of taxes into three main categories: taxes on what you earn, taxes on what you buy and taxes on what you own. For the sake of this blog, and to not put you to sleep, we will focus on two main taxes that are relevant to the world of personal finance: income tax and capital gains tax.
Income tax* is the tax paid via wages, salaries, dividends, interest, or other forms of income an individual or household earns. Think of this as trading time for money. In the situation of investments, this “trade” is seen as dividends or interest earned. These situations fall under the classification of ordinary income tax and have their own marginal tax bracket according to the income earned in your household. Capital gains tax* is the tax paid on personal property which includes stocks, bonds and other securities assets. When the value of one of these securities goes up, and it is sold realizing a capital gain, a tax is owed on this gain. Capital gains have their own flat tax bracket according to the income earned in your household.
Knowing the difference between these two types of taxes can be very powerful when doing strategic financial planning. Your income tax bracket may be higher than your capital gains tax bracket and vice versa. Knowing these rates, and what they apply to, can be helpful when planning for passive income whether working or retired. If you had the opportunity to choose a lower tax bracket, would you?
Almost every decision with regards to “investing” should be first seen through a tax lens before being acted on. Making contributions to a Traditional vs Roth IRA is a tax decision: tax deduction now or tax-free withdrawals later? Deciding which securities to sell is a tax decision: can you use a wash sale to help minimize capital gains already realized or rebalance portfolios to harvest losses to offset future gains? Purchasing an annuity contract is a tax decision: choosing to pay ordinary income and not capital gains on profits when withdrawn. Deciding which assets to designate as an inheritance for future generations is a tax decision: selling a stock to generate capital later in life versus allowing the stepped-up cost basis to avoid capital gains owed at death for future generations.
Harnessing the power of the tax code to work in your favor can enhance a strategic financial plan. Just like you may not want to know the difference between how an electric vehicle and internal combustion engine work, you should at least know that one has to be plugged in overnight and one does not. With regards to your taxes, you may not want to know every nuisance of your tax return that you sign every year, but you should know if there is a legal (and ethical) way to avoid them.
*Source cited: Tax Foundation www.taxfoundation.org
Kimberly Enders CFP® CWS® CERTIFIED FINANCIAL PLANNER™
Enders Wealth Management
37800 Van Dyke Ave, Suite 125
Sterling Heights MI 48312
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