Quick Primer on the Income Tax

Quick Primer on the Income Tax

Even if you do not do your own taxes, it is still a good idea to have a basic understanding of how the US system works. So here are some of the general principles to keep in mind:

Income: There are two kinds. First there is ordinary income, which includes a long list of items. They include wages, bonuses, interest, dividends, pensions, alimony, IRA distributions and so on.

Next, there is capital gains income. This is the profit made from selling a capital asset, such as a stock, bond or real estate.

Rates: The US system is based on progressive tax rates. This means that they increase as you generate more income. The idea is that it is a much fairer approach.

For ordinary income, the rates are:

  • 10%, 15%, 25%, 28%, 33%, 35% and 39.6%

The rate is applied based on your filing status and gross income. So this is what it looks like for a single person:

  • 10% on taxable income from $0 to $9,075, plus
  • 15% on taxable income over $9,075 to $36,900, plus
  • 25% on taxable income over $36,900 to $89,350, plus
  • 28% on taxable income over $89,350 to $186,350, plus
  • 33% on taxable income over $186,350 to $405,100, plus
  • 35% on taxable income over $405,100 to $406,750, plus
  • 39.6% on taxable income over $406,750.

Thus, if you have gross income of $30,000, then the first $9,075 will be taxed at 10% ($907.5) and the remaining $20,925 will be taxed at 15% ($3,138.75). In all, you will pay a tax of $4,046.25 and your average tax rate will be 13.5% ($4,046.25 divided by $30,000).

Now, if you have long-term capital gain income, then there is a different tax schedule: 0%, 15% and 20%. Long-term means that you have held onto the asset for over one year. If not, the income will be taxed at your ordinary tax rates.

But if you have a long-term capital gain, you pay no taxes if you are in the 25% bracket for ordinary income. After this, you pay 15% until you reach the 39.6% bracket, which is when you pay a 20% capital gain tax rate.

The lesson here: As much as possible, you want capital gains income!

Withholding: The US has a pay-as-you go system. In other words, you pay income tax when you earn the income. For most people, you do not have to deal with this. Instead, your employer will use a process called withholding, which means a certain amount of taxes will be taken out of each paycheck.

But if you have a large inflow of income, such as from the sale of shares, you may have to pay taxes — on this amount — directly to the IRS through an estimated payment.

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Tom Taulli

Tom Taulli (Ventura, CA) is founder of the online investment company WebIPO and is the author of The Streetsmart Guide to Short Selling. 10 Illustrations

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