Tax 101: Back to Basics

Benjamin Franklin said, “Nothing is certain but death and taxes”. Taxes play a crucial role in shaping our financial landscape. Understanding their nuance is key to helping make informed financial decisions. To assist, we developed a primer on the basics, specifically how they impact your income and investments. We focus on Federal taxes, as each state has different tax laws, and we recommend familiarizing yourself with the specific laws that apply to your state.

What are all of the different rates?

Marginal Tax Rate: In progressive tax systems like those in the United States, higher income levels are taxed at higher rates. The marginal tax rate is the percentage of tax applied to each additional dollar of income within a specific tax bracket. For example, if your current income puts you in the 22% bracket, each additional dollar earned is taxed at 22% until you reach the 24% bracket. Only the income within each bracket is taxed at that rate, not your entire income.

Effective Tax Rate: The average rate at which your total income is taxed. It is calculated by dividing your total tax liability by your taxable income. This rate provides a clearer picture of your overall tax burden compared to the marginal rate, which only applies to income within each bracket.

Nominal Tax Rate: The tax percentage set by the government applies to a taxpayer’s income without considering deductions or exemptions. However, taxpayers rarely end up paying taxes at the nominal rate, due to various deductions, credits, and other factors. The nominal tax rate serves as a benchmark for understanding the system but rarely represents the actual burden for most taxpayers.

2024 FEDERAL TAX BRACKETS

What are the different types of income?

Ordinary income: This encompasses a wide range of earnings that most individuals receive throughout their daily activities. It is the bread and butter of taxation, forming the basis for calculating your tax liability. Let’s delve deeper into what constitutes ordinary income and explore some common sources:

Employment Income: The most common source of ordinary income is employment income, which includes salaries, wages, bonuses, commissions, and tips. Any compensation you receive from your employer in exchange for your services is considered ordinary income and is subject to taxation.

Self-Employment Income: If you are self-employed, income generated from your business activities falls under ordinary income. This can include profits from a sole proprietorship, freelance work, consulting fees, or income earned as an independent contractor.

Bonus Income: Taxation of bonus income is often misunderstood. Bonuses and other forms of compensation beyond regular salary are generally taxed as ordinary income. When you receive a bonus, it is added to your total income for the year and taxed at your applicable marginal tax rate. Employers typically withhold taxes from bonuses using the IRS’s optional flat rate method, which may result in higher withholding than your regular paycheck due to the supplemental income tax rate. While it is taxed at the same rates as ordinary income, it can create the illusion of being taxed higher due to the withholding method used by employers. It is important to ask your HR provider how they tax bonuses so that you can plan accordingly.

Rental Income: Income generated from renting out property, such as a house, apartment, or commercial space, is also considered ordinary income. This includes rental payments, lease agreements, and any additional fees or services related to the rental property.

Interest and Dividend Income: Interest earned from savings accounts, certificates of deposit (CDs), bonds, or other investments, as well as some dividends received from stocks or mutual funds, are categorized as ordinary income. These earnings are typically reported on your tax return and taxed accordingly.

Retirement Income: Distributions received from retirement accounts, such as pensions, annuities, traditional 401(k) withdrawals, Required Minimum Distributions and Social Security benefits are all forms of ordinary income.

Miscellaneous Income: Other sources of ordinary income may include alimony, royalties, gambling winnings, and prizes. These types of income are typically reported on your tax return and taxed based on the relevant tax rules and regulations.

Your tax rate on ordinary income is determined by your taxable income level and the corresponding tax brackets. Understanding how these factors interact can help you manage your finances and make informed decisions to minimize your tax liability.

Capital Gains

A capital gain refers to the increase in value of an asset such as stocks, bonds, precious metals, and real estate. If an asset is sold after owning it for less than a year, it is considered a short-term capital gain and taxed at your ordinary income rate. If the asset is held for over a year, it is considered a Long-Term Capital Gain and is taxed at a different, typically lower rate.

Capital Gain	Definition	Tax Rate
Short-Term	Derived from assets (stocks, bonds, real estate, etc) that are held for less than one year before they are sold.	Taxed as Ordinary Income
Long-Term	Derived from assets that are held for more than one year before they are sold.	0%, 15%, or 20% depending on income and filing status

Capital Gains Rates

Often misunderstood is the impact that filing status and income have on capital gain rates. For example, in 2024 for Married Filing Jointly, the capital gains tax rate is 0% for income up to $94,050, 15% for income above $94,050 but below $583,750, and 20% for any income above that. For individuals earning $250,000 or more if married and $200,000 or more for single filers, an additional 3.8% tax is levied on capital gains. This is referred to as the Net Investment Income Tax.

Can my capital gains push me into a higher tax bracket?

An individual’s ordinary income has an impact on the rate that is applied for long-term capital gains. However, the reverse does not apply, and the amount of capital gains recognized in a given year does not impact an individual’s ordinary income tax bracket.

For Example: Andrew is a single filer with a MAGI of $140,000 in 2024, he plans to sell a stock with a $30,000 long-term capital gain. If he sells, the tax Andrew owes on ordinary income will not be impacted.  This sale will result in a $4,500 tax on the capital gain at a rate of 15%. While the sale won’t affect

Andrew’s tax on ordinary income, it will make him ineligible to contribute to a Roth IRA in 2024 and could impact his eligibility for certain deductions and credits.

What impacts can an increase in Adjusted Gross Income Have?

Although your marginal tax bracket is not impacted by realized capital gains, your Adjusted Gross Income (AGI) amount is impacted by both ordinary income and capital gains. This is important to understand, as AGI has an impact on many areas of the tax code. .

Phase –Out of Tax Deductions and Credits: Certain deductions and credits, such as the Child Tax Credit or the eligibility for Roth IRA contributions, may begin to phase out as your AGI increases.

Impact on Social Security Benefits: If you receive Social Security, a higher AGI could affect the taxation of those benefits. Up to 85% of your benefits may be taxable.

Medicare Premiums: Higher income can result in increased premiums for Medicare Part B and Part D, being subject to income-related monthly adjustment amounts (IRMAA).

Student Aid Eligibility: For families applying for financial aid for college, a higher AGI can impact eligibility for need-based financial aid, potentially reducing the amount of aid available.

Investment Income Tax: Increased income might also subject you to additional taxes, such as the Net Investment Income Tax (NIIT) if your modified AGI exceeds certain thresholds.

Insurance Subsidies: If you purchase health insurance through the Health Insurance Marketplace, a higher AGI may reduce or eliminate your eligibility for premium tax credits.

State Taxes: Depending on your state’s tax laws, an increase in AGI could affect your state tax liability, potentially leading to a higher state tax rate or reduced deductions.

Understanding the tax implications for various financial planning and investment strategies can help you make informed decisions. Compass does not employ a CPA, and we do not prepare taxes, but we specialize in tax planning and can help model tax ramifications from the various financial decisions you make throughout the year. We will work directly with your tax advisor to help build a tax-efficient strategy tailored to your goals and circumstances. Here are some common questions we help answer:

Should I sell stock in my taxable account, or take distributions from my IRA?
What impact will taking distributions from my IRA have on my taxes?
We sold an investment property, what is my tax bill going to be?
Should I be doing ROTH conversions?
Should I be paying estimated taxes?
Does my income impact my healthcare subsidies?
How much income can I recognize before Medicare costs increase?

For many families, taxes are their largest annual expense, so effective tax planning is a crucial component of a financial plan.  Please let us know if you would like us to review yours.    

APPENDIX :

Not only is the tax code overly complicated, but the actual tax documents can be confusing and cluttered. To simplify things, we highlighted sections of a 1040 tax form to explain commonly used boxes so that you can better understand your own return.  

_{Compass Wealth Management LLC is a SEC registered investment advisor, clearing transactions primarily through Pershing Advisor Solutions and Pershing LLC subsidiaries of Bank of New York Mellon Corp. This letter is written by Compass for the benefit of its clients and does not necessarily represent the opinions of its affiliated organizations. It is based on information believed to be reliable, but which is not guaranteed to be correct. Nothing herein shall be construed to be a solicitation to buy or sell securities, indicate that past performance is predictive of future returns, or recommend individual investments.}