We realize that tax time is never fun. But, part of the reason it’s no fun is that no one ever helped us understand the fundamentals of income taxes in the United States.
The Federal government (states generally do as the feds do) has three ways they look to tax our income:
1) Tax on Ordinary Income – think your paycheck: salary, wages, tips, severance, commissions, etc. The U.S. uses a system of marginal tax rates ranging from 10% to 39.6% (for tax year 2017 – the tax return due in April of 2018).
2) The Alternative Minimum Tax (AMT) – everyone must compute AMT along with Ordinary Income Tax, and surprise, you pay whichever amount is higher! AMT started in the 1960s to make sure that high-income earners (with a lot of tax deductions and/or tax credits) paid their share of taxes – it now affects millions of Americans.
AMT uses a rate of 26%, but that rate is applied to a larger amount of taxable income – among other things, deductions for state income tax and property taxes are added back in and the spread on exercise of ISOs (incentive stock options) is included.
3) Tax on Capital Gains – any time you sell an asset (a stock, a mutual fund, a house, etc.) for more than you paid for it, you owe tax on the gain (unless it was done in a tax-advantaged account like a 401k or IRA).
If the sale occurs one year or less year after you bought the asset (a short-term gain), you’ll pay ordinary income rates on the gain - the same as on your paycheck. But, if that sale is a year and a day or more after you bought the asset (a long-term gain), then you’ll only pay 15% on the gain.
So, at the end of the day…Ordinary Income taxes sort of are what they are – “the more you make, the more they take”. AMT is just simply bad. And, long-term Capital Gains treatment is very, very, very good.
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