Tax Brackets 102

Brackets

In the last installment, we ran through the basics of how marginal income tax brackets work in the US and the way that many people misunderstand the concept. Today, we’ll cover the related concepts of tax brackets for capital gains and dividend income. Many people I know don’t really ever deal with these two concepts because their income comes from a W-2 (a.k.a. paid by their employer), but for the wealthy these are often their primary forms of income. Many people aspire to be able to afford to shop like the wealthy, but really we should start by aspiring to earn the way that they do.

What’s the advantage of this different type of income?

It’s two-fold:

  • Unlike wage income where you spend your time and effort to earn money, capital gains and dividends are earnings produced by assets that you own. They’re essentially a way for your money to do the work for you and produce more money, often with little or no time or effort from you after the investment has been made. Doesn’t that sound nice?
  • In these United States of America, and much of the “Western” world, this type of income is taxed at much lower rates than “wage” income. We could get all political and debate why that is or how it should be, but F That Noise, let’s learn the rules as they exist and then figure out how to make them work for us instead of against us.

Capital Gains

At its core, a capital gain is very straightforward; if you buy an asset and later sell it (the sale price) for more than you paid (the cost basis), then you’ve realized a capital gain. An unrealized gain is when the value has gone up, but you haven’t sold it yet; that’s not taxed until it becomes realized.

What are we talking about here when we say “assets”? Some examples everyone will be familiar with are property: like a car, house, or piece of land; or investments: like a stock or a mutual fund. All of these could produce capital gains. However, I’m wary to include cars in that list because they almost always drop in value. Technically, still an asset, but I prefer to think of assets as purchases that will likely go up in value or produce income (or both). All other purchases I tend to think of as “expenses”. I think this is a good mental framework so you can work to shift your purchases from mainly expenses to mainly assets, thereby increasing your income. Think of your finances like a business- expenses are the things you have to pay for to keep the lights on, but assets are like your employees that are going to work hard on your behalf and bring in more income!

So, an important consideration for tax purposes is whether your capital gain is short or long term. Again, this is pretty straightforward in most cases:

  • Short Term– you owned the asset for a year or less.
  • Long Term– you owned the asset for more than a year.

Short term gains are taxed at the normal, “ordinary” income rate that we discussed in Tax Brackets 101, so there isn’t really any advantage there. However, long term gains are generally taxed at a lower rate (with a few exceptions we’re not getting into here). The table below will show how the tax rates vary.

Dividends

Dividends are a pretty neat little function of capitalism and I think once you get going on this, you’ll find them as exciting as I do. When you hold ownership in a company, which for the purposes of this discussion would come from owning shares of stock (either individually or in a mutual fund), the company may elect to distribute some of its profits to you as the owner. Meaning all you need to do is own the stock and they’ll just go ahead and send you some cash money! Now, not all companies choose to do this, but the most recent stat I could find was that 405 of the 500 (81%) largest, publicly traded US companies pay dividends; so it’s pretty common.

The frequency of dividend payments varies from company to company and mutual fund to mutual fund, but some common options include once per year and once per quarter. They’re usually pretty consistent with their frequency and the amount of the payment (represented as a percentage of total value), but may elect to change these. In fact, for investors that target dividend paying stocks, they often look for companies that have consistently paid dividends over many years (never opted to stop paying them) and have consistently increased the amount of their payments over time. (Google “Dividend Aristocrats” for more). When I first got really going on investing back in 2013, this was the type of approach that appealed to me, but I’ve since moved to a focus on low-fee, broad index fund investing. More on that in a future article.

For tax purposes, it’s important to differentiate the two different types of dividends:

  • Qualified Dividends- This is the type that we’re looking for because (as you’ll see below) the tax savings are excellent. For a dividend to be qualified, it needs to meet the following criteria, as described on Investopedia:

“They must be issued by U.S. corporations publicly traded on major exchanges, such as Dow Jones or NASDAQ. Additionally, the investor must own them for at least 60 days out of a 121-day time frame, known as the holding period. Certain characteristics can exclude dividends from being qualified, such as if they are part of an employee stock ownership plan (ESOP), or if they are issued by a tax-exempt organization.”

So a common sense approach would be to buy shares of the qualifying type and hold them for the long term, which will guarantee passing the time frame qualification. My go-to is investing in VTSAX which is a broad index fund of all US companies and is almost entirely qualified dividends. You can check the dividends of all Vanguard funds here.

  • Non-Qualified Dividends- Real basic: these are any dividends paid which do not meet the qualifications from above. Certainly, you wouldn’t want to turn down non-qualified dividends, just like you wouldn’t want to turn down a raise or bonus to avoid the taxes. However, it’s important to be aware of the distinction between the two types. Non-qualified will be taxed at your regular “ordinary” income rate, not the lower rates shown in the last column of the table below.

Brackets

Income Range, Married Filing Jointly Tax Rate on Ordinary Income Tax Rate on Long Term Capital Gains and Qualified Dividends
$0 to $18,650 10% 0%
$18,650 to $75,900 15% 0%
$75,900 to $153,100 25% 15%
$153,100 to $233,350 28% 15%
$233,350 to $416,700 33% 15%
$416,700 to $470,700 35% 15%
$470,700+ 39.6% 20%

I don’t know about you, but I look at this chart and say “Hot damn! I want me some of them gains and dividends!” Okay, maybe I don’t actually say that out loud, that’d be a little weird…But, seriously, the difference is huge! Income from the right column is being taxed at least 10% less and taxed as much as 20% less in some brackets. If you can gradually shift your source of income from the middle column to the right column, you’ll be taking home a significantly larger chunk of it and paying less to Uncle Sam.

Uncle Sam I Want Your Money

Another important thing to note is that there are a number of different types of accounts that are tax “advantaged” because they shelter your earnings from taxes. These are accounts where the government is encouraging us to save for things like retirement (401Ks/403Bs, IRAs, 457s, etc.) or sending children to school (529s) or paying for medical expenses (HSAs).

We’ll be talking about the nuts and bolts of these plans in future articles, but for now just let me say: Take advantage of these as much as possible! You’ll reduce the amount of money you pay in taxes and wind up with significantly more value over time.

An example calculation

Let’s run through a real life example to show how these brackets can work when you have both ordinary income and capital gains/dividends. In this case, the gains or dividends get added on top of your ordinary income to determine what bracket they’re taxed at. This example will ignore some of the more complicated things like deductions, exemptions, and state taxes, but should give a good idea of how the taxes work.

A married couple is currently working regular old jobs for a combined salary of $75,000 per year. As we learned in Tax Brackets 101, they’ll pay:

  • $1,865 (10%) on their first $18,650 of income
  • $8,452.5 (15%) on the rest of their income

This is a total of $10,317.50 in taxes and $64,682.50 that they take home. Now let’s assume that they’re living off of an even $50,000 of that take home pay and invest the rest…

After some time, their investments have grown and they’re now earning $25,000 per year from the combination of dividends paid out and capital gains on shares that they sell. While they’re still getting $75,000 in salary, they’re actually earning a full $100,000 each year. How is this taxed?

  • The $75,000 of ordinary income is taxed just like before, meaning $10,317.50 of taxes.
  • The $25,000 of dividends and capital gains goes on top of that and moves into the next tax bracket. This means:
    • The first $900 of dividends/gains takes them up to the top of the 2nd bracket (up to $75,900) and so it’s taxed at 0% (this is the second row in the brackets table).
    • The next $24,100 of dividends/gains are in the third bracket and are taxed at 15%.
    • In total, they pay $3,615 on that income and keep $21,385.

So the couple is now paying $13,932.50 and taking home $86,067.50. If the $100,000 were all ordinary income, this would have been $16,477.50 of taxes, $2,545 higher! By investing, this couple has increased their take home pay by $21,385 without ever getting a raise at work and they’re keeping a larger proportion of their earnings than they would if they had raises equal to their investment income.

Now, let’s look at the really powerful stuff. Our dynamic duo continues to sock away their excess money each year; living off of $50,000 and investing the rest back into the market. Each year, (on average) they’re going to be earning a little bit more, which means they’re investing even more. This acts like a snowball rolling downhill and growing bigger and bigger until one day, their investments are producing $50,000 in dividends and capital gains.

If this is on top of their regular salary, they’ll continue to pay taxes on it, as we saw above.

However, that money coming from the investments is enough to pay for their annual expenses, they don’t actually need their salary anymore. This is what’s meant by the term “Financially Independent”. This couple no longer needs to work to afford their lifestyle and could quit their jobs if they want to. Look again at row 2 from the brackets table:

Income Range, Married Filing Jointly Tax Rate on Ordinary Income Tax Rate on Long Term Capital Gains and Qualified Dividends
$18,650 to $75,900 15% 0%

If they quit and are only making $50k from their investments, they have a 0% tax rate and get to keep all of it. To walk home with $50k after taxes with ordinary income, they’d need to make about $7700 more.

Wrap Up

That was a lot of numbers and hopefully you haven’t given up on me. Really there are just two main takeaways from this example:

  • The tax savings when your income comes from dividends and/or capital gains are significant when compared to earning ordinary income.
  • Pouring your savings (tax and otherwise) back into investment accounts will continue to increase the amount you earn at these lower tax rates and eventually you’ll reach the point where you no longer need to even earn an ordinary income. You could quit your job and just live off of the investments. That’s why buying assets is so powerful.

By purchasing assets instead of expenses, especially earlier in your life, the dividends and gains that these assets provide will continue to snowball over time. At first, a couple percent in returns may only be a few dollars here and there and it might not even seem worth it. However, before you know it the earnings on these investments can snowball into thousands of dollars every year. Invest for the long term and watch those returns continue to pile up.

Further Reading

  • As before, you could head straight to the source of the IRS Tax Code and dig through all of this in more detail, but I’ll warn you, it’s pretty dry…
  • I’d definitely suggest you check out this great post from Jeremy at Go Curry Cracker where he discusses a more advanced approach where an early retiree can essentially never pay taxes again, thanks to the sorts of unique tax rules we’ve discussed.
  • There’s a great book called The Millionaire Next Door which talks about the habits of people that have built real wealth. Unlike the common perceptions of flashy, big spenders, most actual millionaires got to where they are through frugality and sound investment in assets, rather than expenses. The book is a little old now, but the lessons (as they say) are timeless.

Actionable Steps

  • Invest in assets– we all make choices every day on where our money will go, but often it’s a fairly mindless process of forking over hard-earned cash for items or experiences that we think will make us happy. Weeks or months later, we’ve often entirely forgotten about the things we bought. Instead, think about increasing the portion of your money that you “spend” on assets- things like real estate and index funds. If you invest for the long term, these assets will continue paying you for the rest of your life, long after the gadget that you would have bought has found its way to the dumpster.
  • Pay down debt– this is a bit of a disclaimer that if you’ve got outstanding high interest debt, like a credit card balance, you need to pay it down before worrying about increasing your investment income. Think of it this way, while an index fund may give you 7% return per year, paying off your credit card is a guaranteed return of the 20% or more in interest that you would have been paying. DO THIS FIRST!
  • Look at ways to reduce your taxes– As covered in this article, changing the source of your income can mean reducing the rate that it’s taxed at. You can also reduce your taxes by changing your marginal tax bracket. How? By reducing the amount of “taxable” income, while still earning the same amount of money. I’m not talking about lying to the IRS, but rather investing in pre-tax accounts like your 401k/403b at work, your HSA (if eligible), and a pre-tax IRA (if below the income limit).
  • Invest your tax savings–  every year around tax season, there’s a huge boost in sales for things like big screen TVs as people rush to spend their tax refund check on something they’ve been wanting. Hell, there are even services that will charge you a fee so you can get that refund money a few days early and spend it immediately (this blows my mind, btw). Don’t be one of these people! If you have a refund, use it to pay down your debt or (if you’re debt free) maybe top off your annual IRA contributions ($5,500 limit for 2017). That TV is just going to sit their tempting you to waste your time on reality television, while the investment will keep working and earning money for you for the rest of your life.
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