Simon Says #5 - Learn to Utilize the Tax Code to Your Advantage



Matt Simon

Hello friend, and welcome back to Simon Says.


If you’d like to read any past issues of Simon Says, you can find them all here.

Today’s topic is tax basics! As the saying goes, the only certain things in life are death and taxes. Understanding the basics of taxation can help you navigate this inevitable part of life with more confidence and clarity.

 

Unfortunately, most people fail to grasp the intricacies of the tax code, largely due to the fact that most schools don’t teach the basics. To make matters worse, the U.S. tax code is incredibly complex, with tons of rules and regulations that can make it difficult for even the most seasoned tax professionals to understand.

 

However, those who take the time to understand the tax code and the incentives it provides, stand to keep more of the money they make than those who don't, regardless of the industry they work in. 

Earned, Unearned, & Ordinary Income



First thing you need to know is that money is taxed differently depending on where it's from.

 

Earned Income = wages or salary you get from working for someone else, yourself or from a business you own.

 

Unearned Income = other sources of income such as: interest in a bank account, dividends from an investment, or capital gains from selling an investment at a profit.

 

Earned income is generally subject to both Federal and State income tax as well as Social Security and Medicare taxes, but the amount of tax depends on your income level and tax bracket. Unearned income is also subject to Federal and State income tax but may be taxed at a different rate than earned income. We have a progressive tax system with higher earners paying a higher percentage of their income in taxes.

 

Here’s a hypothetical example: Let’s say you buy stock in Simon’s Smoothies at $100/share. If the price of the stock goes up to $110/share, you’re sitting on unrealized capital gains, which as of now are not taxable. But once you sell your position and make the $10 profit, that $10 gain has now been realized and is considered taxable income to you.

Capital gains are divided into 2 categories, long-term or short-term. If you held your stock in Simon’s Smoothies for more than one year before selling, then your capital gains will be considered long-term, and will be taxed at a lower rate ranging from 0-20%, depending on your income level. If you sold your investment within one year or less, this short-term capital gain is taxed at the same rate as earned income (wages), which means it can be subject to federal income taxes that range from 10% to 37%, again, depending on your income level.

 

Additionally, other types of unearned income, such as interest and dividends, are taxed the same as salary or wages. This places them all in a category called Ordinary Income, which refers to all income that gets taxed at the ordinary rates and includes nearly everything except long-term capital gains. It’s important to understand the tax implications of different sources of income to ensure that you're making the right investment decisions and keeping your hard-earned money in your own pocket, as much as legally possible.

W2 vs. 1099 Income

 


If you’re an employee, every year you’ll receive a W-2 form that shows your total wages and taxes paid. If you're self-employed or work as an independent contractor, you'll receive a 1099 form reporting your business income. Self-employed individuals are responsible for paying their own taxes, including Social Security and Medicare taxes, which are generally withheld from a w2 employee’s paycheck.

 

As a w2 employee, being that taxes are typically withheld from your paychecks automatically, this means that the money you receive in your direct deposit or in your paycheck is post-tax or after-tax money. On the other hand, if you were to start a small business that sells smoothies, none of the money you receive from customers has taxes withheld automatically. You are responsible for recording your income and paying the correct tax owed on it. This means the money in your register is pre-tax or before-tax money.

 

Let's say your smoothie shop needs to purchase a new computer to sell items online. As the business owner, you can buy the computer with these before-tax dollars. This has the effect of lowering your total income for the year and ultimately the total taxes you’ll owe. If an employee of your business wanted to buy a new computer for personal use, they would have to use the money they receive from their paycheck which, as we said before, has already been taxed.

 

The chart below shows it very clearly. Employees get paid, taxes come out, then they can buy things they need to survive. Businesses get paid, buy things they need to survive, and then pay taxes.

MyPersonalFinanceBlog. (2021). Earned Income vs. Unearned Income: What’s The Difference? Retrieved from https://mypersonalfinanceblog.com/2021/08/02/earned-income-vs-unearned-income-whats-the-difference/

Deductions, Write-Offs, & Credits

 

 

Tax Deductions and Write-Offs are the same exact thing, with both turning post-tax money into pre-tax money. Let’s say you make a $6,000 contribution to your Traditional (not a Roth) retirement account, which gives you a deduction for doing so. That contribution gets treated like a business expense does for a business, as it is considered to have been made with pre-tax dollars. So if your taxable income is $100,000 but you contribute $6,000 to your Traditional IRA, then your taxable income will be lowered to $94,000, which in turn lowers your tax bill.

 

Tax deductions can be received not just for contributions to retirement accounts but for multiple reasons such as age, disability, and even for buying alpacas. On top of that, everyone receives what is called the standard deduction, which is $13,850 for every individual in 2023. Let’s say you make $100,000 at your w2 job this year. If your employer withheld taxes at a 20% rate, this would be $20,000 in taxes paid, but in reality, you won’t owe taxes on the full $100,000 because of deductions. In this case, when you go to file your taxes, your taxable income isn’t $100,000, but is only $80,150 due to the standard deduction and the retirement account contribution.

 

To keep it simple, we’ll say your effective tax rate comes to 20% after calculating Federal and State, Social Security, and Medicare taxes. That comes to $16,030 owed in taxes compared to the $20,000 you already paid throughout the year, resulting in an overpayment of nearly $4,000. This is how deductions can help lower your present tax bill and it’s the reason most w2 employees receive money back during tax season.

 

Tax Credits on the other hand work a little different. Take a look at the above example with gross income of $100,000, taxable income of $80,150, and a total tax bill of $16,030. As I just explained, a tax deduction will lower your $80,150 of income subject to taxation, but a tax credit will directly lower your tax bill of $16,030. If you receive a $1,000 tax credit, then your tax liability decreases to $15,030, whereas if you receive a $1,000 deduction, your tax liability only decreases to $15,830 ($79,150*20%). Deductions lower your taxable income, while credits directly lower the taxes due and thus provide more relief to the taxpayer.

No one likes paying taxes, but it’s something we’re all forced to do. We often hear about the loopholes and the unfairness in our tax code, but much of this is resentment by those who misunderstand the way our tax code works.

 

The government uses the tax code to incentivize us to do what they can't do on their own. That includes things like having children, investing in real estate, providing services in disaster areas, and much more. People often think these incentives only benefit wealthy individuals, but they're available to everyone regardless of race, gender, or education level. The only problem is that it’s up to you to learn about them.

 

If anyone has any basic tax questions, feel free to book a call with me to learn more. I’m not an accountant, but I’d be happy to refer you to one or speak directly with your current accountant if needed.

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Financial Professionals do not provide specific tax/legal advice and this information should not be considered as such. You should always consult your tax/legal advisor regarding your own specific tax/legal situation.



This information is a general discussion of the relevant federal tax laws. It is not intended for, nor can it be used by any taxpayer for the purpose of avoiding federal tax penalties. This information is provided to support the promotion or marketing of ideas that may benefit a taxpayer. Taxpayers should seek the advice of their own tax and legal advisors regarding any tax and legal issues applicable to their specific circumstances.



Matt Simon is a Registered Representative and Investment Advisor Representative of Securian Financial Services Inc. Securities and Investment Advisory services offered through Securian Financial Services Inc. member FINRA/SIPC. Mid Atlantic Resource Group, LLC is independently owned and operated. 1800 Route 34, Blg 2 Ste 201, Wall NJ 07719. 561053 dofu 04/2023