9) Short Primer on Income Taxes
Have you ever been confused with taxes and tax terms such as: dividend tax, capital gains tax, social security tax, wage tax, gift tax, estate tax, generation skipping tax, and many more? Taxes are complicated and convoluted. There are tax books and tax degrees. Professionals spend their careers working on taxes.
Many decisions we make can be impacted by taxes so it’s important to have a basic understanding. Let’s start with income taxes.
We file an annual tax return to report income and claim deductions. It is due on April 15th following the close of the calendar year. You can file a six (6) month automatic extension up until April 15; however, you need to pay what you believe you owe with the extension.
Income that is taxed usually falls into the following types or categories-
1) Wages and Salaries- highest Federal rate Federal of 37% along with various state and local taxes. These taxes are typically automatically withheld by your employer on each paycheck. In addition to income tax, we pay along with our employer a Social Security tax and Medicare tax (7.65% by each party) on wages and salaries.
2) Dividends (payments from companies) –highest Federal rate of 20% along with various state and local taxes. High income taxpayers pay an additional Medicare sur-tax of 3.8% on dividends (Affordable Care Act).
3) Capital gains (a gain is the difference between what you paid for an asset such as stock versus what you sell it for). Short-term gains (assets held less than a year) are taxed at the same rate as wages and salaries. Long-term gains (assets held for longer than a year)- highest Federal rate of 20% along with various state and local taxes. Capital gains and capital losses can be combined with the net result either a net gain or net loss. High income taxpayers pay an additional Medicare sur-tax of 3.8% on net capital gains (Affordable Care Act).
4) Interest Income
5) Rental Income
6) Self-Employment- earnings from businesses/ventures
7) Other- gambling winnings, lottery winnings other income such as retirement payments and Social Security payments.
Note items 4 through 7 taxed at highest Federal rate of 37% along with various state and local taxes.
Taxpayers can claim various deductions from their income listed above - adjusted gross income (AGI) by either claiming the higher of a standard deduction ($27,700 for married filing jointly) or by itemizing (claiming several individual deductions). Below is a sampling of various itemized deductions. Please note that there are various rules and limitations associated with them.
1) Health costs
2) Payments for mortgage and investment interest on loans
3) Payments for real estate taxes and state income taxes
4) Payments to charities
There is a perverse tax known as “the alternative minimum tax.” This is a separate way of calculating your tax liability that was implemented many years ago to prevent people from paying zero income taxes because of very high deductions. It is a complicated system but still in existence. Thankfully its impact has been reduced in recent years.
The Internal Revenue Service wants taxpayers to pay taxes as they earn income. Taxpayers are not allowed to wait until the end of the year to pay their taxes–if this happens there can be interest and penalties. Taxpayers earning wages and salaries normally have taxes automatically deducted from their paychecks. Taxpayers who do not have wages and salaries but earn income through dividends and interest income must pay estimated quarterly tax payments.
For those curious, below is a link to an article on the history of the income tax (Abraham Lincoln implemented the first income tax) :
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