My son asked me about charitable giving and taxes yesterday. He is 18, working a job, investing, and out of the house for the first time in his life. This article is really for him, but I thought that as long as I’m writing it, I might as well put it up on The Small Investor so other folks can benefit as well.
Having an understanding of taxes is important as an investor. It is often said that it isn’t what you make, but what you keep that is important when it comes to investing. And doing things one way could end up costing you a lot more in taxes than doing it a different way. In this article we’ll discuss the basics of taxes and then some of the guidelines when it comes to reducing your taxes as an investor. Note that while I have learned a lot about taxes related to investing in the management of my own accounts, I am not an accountant or an expert at taxes. Even if I were, tax laws change all of the time, so any information provided may be outdated or incorrect. So, don’t take any action based on this information without verifying it through your own research or by checking with a CPA. Now that that is understood….
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Types of Taxes
There are a lot of different types of taxes you will pay. Most young people are familiar with sales tax since they’ve been paying it ever since they were five and they bought something with their Christmas money from Grandma. Sales taxes are charged by your state and local government, so they vary depending on where the item is bought. They are paid on items purchased (and sometimes services) and can vary based on the type of item. (For example, food may be taxed less or not at all, while things like alcohol and tobacco may be taxed extra.
For people who are working for someone else, there are payroll taxes. These are contributions you make towards Social Security and Medicare. Supposedly you’re funding a retirement pension and medical care in retirement, but in effect they are taxes. The employee pays half of these taxes out of his/her paycheck and the employer pays the other half. If you’re self-employed, you don’t get away with not paying these taxes. Instead, you get to pay both portions, so you’re rate will be twice what it is for some one working for someone else on a salary. (But don’t feel too bad. Since it is likely that as an employee you would be paid the extra portion if your boss didn’t need to pay the tax, effectively you are paying both portions in both cases.)
Theoretically you are putting money away for your retirement, but in actuality it all just goes to the general fund and gets spent, so putting money in does not guarantee that you will get anything back. So far, people have been paid. Those who receive Social Security have gotten about a 1% return on their “investment” and would have been far better off if they had been able to put the money in personal accounts and get market returns. (In fact, they wouldn’t have needed to put any other money away for retirement.) Those on Medicare have done really well, getting back far more than they paid in (which is why the program is very popular). Both programs have started collecting less in revenue than they pay out each year since the number of people retiring is going up faster than the number of people starting to work, so benefits will need to be cut or taxes raised in the near future. This would not have been a problem if the money had been invested since the funds needed to pay those retiring now would be sitting there, waiting for them, but Congress has spent any funds left over along the way, so this is not the case.
Another type of tax is property taxes. These are charged on things like land/homes and cars. These are typically paid yearly. For a home it is normally billed at the end of the year and for a car it is normally charged when you renew your registration. As a young person, you will probably pay property taxes on your car but you probably don’t have a home. Fear not, because your apartment landlord also pays property taxes, and you can bet that that cost is included in the rent you are charged, so you are paying property taxes on your living space as well.
Income taxes are charged on, well, income. When you make money, you are charged a tax on that income. There tend to be both federal and state income taxes (although some states do not charge a tax). To make things interesting and keep accountants employed, income taxes charge different rates based upon how the money was earned. For example, you tend to pay a higher rate for income earned from a job than you will for income made from selling a stock at a profit, but only if you hold that stock for a certain period of time. We’ll get into this more in a minute. Most of the rest of this article will be discussing federal income taxes. State income taxes follow many of the same rules as federal taxes, but, again, they vary so doing some research will be worth your time.
The first thing to understand about income taxes is that most of the time, taxes are not assessed at a fixed rate. Instead, they are what is known as “graduated” or “progressive.” The first money you earn is taxed at a lower rate than money earned later. The reason for this is the idea that you need a certain amount of your income for basic needs, but beyond that you don’t need the money so you can pay out more of this excess. People who make more can, therefore, pay more since the extra they make is not needed for necessities, or so the idea goes. According to the IRA, the tax rates for 2019, if you’re not married and filing as a single person are:
|$0 – $9,700||10%|
|$9,701 – $39,475||12%|
|$39,476 – $84,200||22%|
|$84,201 – $160,725||24%|
|$160,726 – $204,100||32%|
|$204,101 – $510,300||35%|
One mistake people make is thinking that if they make more money and fall into a higher tax bracket, their taxes will increase dramatically. This is not the case. Instead, the first money you make is taxed at the lowest rate, then money you make over the bracket limit is taxed at the next higher rate, and so on. For example, if you made $125,000 per year, the first $9700 would be taxed at 10%, then the amount between $9701 and $39,475 would be taxed at 12%, and so on. So, if you made $39,475, you would pay $970 + $3573 = $4543 in taxes. If you made $39,486, putting you into the next higher tax bracket, you would only pay about $2 more in taxes. It wouldn’t be like you were paying hundreds more because of moving into the next bracket.
This isn’t to say that knowing your tax bracket isn’t important. If you make a certain salary, any additional money you make will be taxed based upon the tax bracket you’re in. So, if you’re in the 12% tax bracket and make $100 in overtime, you’ll pay an additional $12 in taxes. If you are in the 24% tax bracket and make the same $100 in overtime, you’ll pay out an additional $24 in taxes. You might think twice about taking the extra work if you’re in this higher bracket since you’re only keeping about 75% of the money you earn (and that doesn’t count payroll and state taxes).
The Standard Deduction
So, now you may think that all you need to do to figure out your taxes is to add up all of your income and use the table above. Unfortunately, it isn’t that simple. There are things called deductions, which is a certain amount of your income that is not taxed. You figure out your total income, subtract off deductions, and then use the tax rate table. For example, if you made $100,000, but then had $25,000 in deductions, you would pay taxes as if you only made $75,000.
The idea behind deductions is that you shouldn’t be taxed on money you really need or that you use for something that benefits society somehow. For example, a society may decide that you shouldn’t be taxed on money you use for medical expenses, food, reasonable shelter, education, childcare, and so on up to a certain amount. They also want you to do things like give to charity and put in solar panels, so they may not make you pay taxes on money used for those purposes. You therefore subtract the cost of these things off from your income before you figure out your taxes. (To learn how society could be much more effective at providing for those in need through private charities than public welfare and how we could easily transition to such a system, check out The Conservative’s Welfare Plan.)
Note that you generally need to prove that you used the money for these purposes. At least, you need to be ready to prove it should anyone ask. As you could imagine, it would be a royal pain to figure out how much you spent on things like food each year. Even if you did, it wouldn’t just be a matter of adding up your food costs as you went or guestimating based upon your groceries bills and meals out. You would need to be able to prove that you spent that money on food should the IRS come asking through a tax audit. This would mean that you’d need to have receipts for the money you spent on food.
To make things easier, the government allows individuals instead to use what is called the standard deduction. This is an amount that you can deduct without needing to show that you actually spent that much on things like food. In fact, you don’t even need to actually spend that much. You just get to reduce your income by the standard deduction regardless of what you spent the money on.
Initially the standard deduction was fairly low, so you would only take it if you were in a low or middle-income bracket and/or didn’t have many expenses that were deductible. If you were in a higher income bracket and did a lot of things like donate to charity and use your car for work, it would be worth it to save up receipts and actually report the real amount on your taxes since that would be higher than the standard deductions. In recent years, however, the standard deduction has been increased and many things that were deductible in the past no longer are. This was done to make taxes simpler by having more people just take the standard deduction. This is really a win for the taxpayer, although those who have seen some of their favorite deductions go away may not feel like it.
In 2019, if you were single, the standard deduction was $12,200. This means that if you made $12,200 or less, you would effectively have no income and pay no taxes. If you made $30,000, you would reduce your income by $12,000, so you would only pay taxes on $17,800.
Look at the effect this has on tax brackets as well. If you make $40,000 per year, you would be in the 22% tax bracket before the deduction, but your income would only be $27,800 after the deduction, meaning that you would still be in the 12% tax bracket. Maybe it would be worth it to work that overtime after all.
Having a standard deduction makes things easier, but what if you had a lot of medical bills, gave a lot of money away to charity, or had other deductions that added up to more than $12,200? The answer is that you can reduce your income even more if your deductions are more than the standard deduction, but to do so you need to do what is called “itemize.” This means that you do need to save receipts and add up all of your deductions, which obviously means a lot more work on your part.
For most young people just starting work, the standard deduction will be greater than the amount you would be able to deduct if you added everything up, so you won’t need to worry about itemizing. Later in life if you have a lot of medical expenses, are giving a substantial amount to charities, and are paying for other things that are deductible, you may be able to save more on taxes if you itemize. Once you get to that point, it makes a lot of sense to hire an accountant to help guide you on what is deductible and to figure things out since it gets really complex. (If you want to get rid of all this complexity and not need to file income taxes at all, check out The Fair Tax. You can read more about it in A Tax You Should Support – The Fair Tax or 10 Reasons Why You Should Like the Fair Tax or go to www.fairtax.org.
Because of the standard deduction, there is no reason to keep track of things like charitable giving because you will not need to show proof of these things for your taxes. Just give because you want to give and don’t worry about the tax consequences. The same goes for medical expenses, college expenses, and other things that may be deductible but which are not worth the trouble.
Sometimes there are things that the government really wants to encourage and therefore they create a tax credit to bribe you to act as they want. If you ever have the choice between a tax deduction and a tax credit, go for the credit. This is way better than a deduction since, instead of reducing your income by the amount of the cost, you can actually reduce your taxes by the amount of the credit. For example, if you owe $2400 in taxes and the government is allowing you to get a $1000 tax credit for putting in new energy efficient windows, you would only need to pay $1400 in taxes. Note that in The Conservative’s Welfare Plan a tax credit is used for donations to charities that take care of things that replace the need for government welfare, such as providing food or shelter to the poor.
Many times you can take a tax credit even if you don’t itemize. The government wants you to do whatever it is so much that they’ll let you take the standard deduction and then add the tax credit on top of that. Always keep your eyes open for tax credits since they are tax saving gold.
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Capital Gains Taxes
When you buy something and then sell it for a higher price later, that is called a capital gain. This could be shares of stock, a painting, or a home. For whatever reason the government sees capital gains, particularly if made from a home or a long term investment, as good and worthy of lower tax rates than income from a job. They therefore tend to tax capital gains at lower rates than work salary income or even not at all.
Capital gains tax rates can have huge effects on the taxes you pay and are important for an investor to understand.
Buying stocks for along periods of time is seen as investing, where buying stocks and trying to make a quick buck is seen as speculating or gambling. The government wants people to invest, but see fast money from speculating as evil. Capital gains rates change fairly often but in general money invested for a long period of time is taxed at a lower rate than money invested for a short period of time. Capital gains tax rates can have huge effects on the taxes you pay and are important for an investor to understand. A great article on capital gains rates is provided here.
Currently, if you hold a stock (or other asset) for less than a year and sell it for a profit it is called a short-term capital gain. The income you receive from the sale would then be treated as regular income and just added on. So, if you make $60,000 per year after deductions and make $10,000 selling a stock that you held for four months, it would be like you had a salary income of $70,000 and you would pay 24%, or $2400 additional, in taxes on the gain. If instead you held the stock for 1 year and a day, you would pay long-term capital gains rates on the sale. Right now, that would be 15%, or $1500. This means you’d save $900 in taxes just by waiting an additional six months before selling.
But what if you held one stock for 15 months and made a $10,000 gain, but then sold another stock you had held for 13 months for an $8,000 loss. Obviously, you only made $2000 in total income since you made a profit on one stock but had a loss on the other. Luckily, things work exactly as you would think and you would only be taxed on the $2,000 gains. This is actually a tax strategy you will want to employ: If you have a gain and you have losing positions that you are ready to sell, sell both stocks in the same tax year so that you can save on taxes. This is called loss harvesting.
Capital gains rates for long-term investments are also currently based on your income level. These are provided in the table below. Note that if you make less than $39,375 per year, you will actually not owe any capital gains taxes, so it is a great time to invest when you make a low income. Unfortunately, most people in low income brackets don’t have enough free cash flow to invest.
|$0 to $39,375||0%|
|$39,376 to $434,550||15%|
|$434,551 or more||20%|
Don’t let taxes drive your decisions after you invest, only before you invest
One common mistake is to make investment decisions based on taxes that result in losing money or making less money that you would if you just paid the taxes. In the example above, you would end up paying $900 extra in taxes because you sold a stock after owning it for only 4 months instead of holding it for more than a year. If this were $20,000 in stock, a move down of 10% would result in a loss of $2000, which is far more than the $900 that would be saved in taxes through waiting the extra 8 months. It is routine for individual stocks to move up or down by 20-30% or more in very short periods of time. If there are good reasons to sell a stock, don’t let taxes keep you from doing so.
That said, there are ways of investing that result in lower taxes and that will make a big difference over time. It is wise to choose to invest in ways that result in lower taxes even though you should not make individual investment decisions based on saving money in taxes. For example, because you’ll pay less in taxes if you make long-term gains, you should choose to buy into companies with the expectation of holding them for long periods of time, like 10 or 20 years, rather than just planning to hold a company for a few months for a quick profit.
The good news is that it is a lot easier to do well when investing if you invest for long periods of time anyway because then you don’t need to be right about when the market or a particular stock will go up in price, just that it will go up in price at some point over the next decade. If you are investing in mutual funds, you should choose those that invest in whole markets like “the US stock market” or “International Large Caps” rather than buying segment ETFs like technology or health care and trying to hit the cycles just right. In choosing individual stocks, you should choose companies that you expect to do well over a long period of time rather than buying companies because you expect them to go up in price soon based upon the stock’s price movements. Luckily, you will most likely will do a lot better making long-term investments than you will trying to time market segments or buy and sell stocks based on price swings.
The type of accounts in which you buy different types of assets should definitely be a consideration based on taxes. If you are buying income investments that pay regular interest payments or dividends, like utility stocks and corporate bonds, but you don’t need the money right now and are planning to reinvest it anyway, put these investments in your tax-sheltered accounts like IRAs and 401ks. In your taxable accounts, put long-term growth stocks that pay little in dividends since you won’t need to pay capital gains taxes on these investments until you sell them. If you’re buying mutual funds in taxable accounts, buy funds like index funds that have little “turn-over” (don’t buy or sell the stocks within the fund too often) so that they don’t generate a lot of gains and make a lot of distributions on which you’ll need to pay taxes. If you want to hold funds that do trade actively, put them in a tax-sheltered account.
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Investing in this way will make a big difference. The reason is that, if you’re being taxed on your interest payments and capital gains each year, you’re seeing money taken out of the account constantly. Not only does this reduce your returns by the amount of the taxes you’re paying, but it also removes the interest and gains that you would have gotten in the future on the money that is taken out for taxes. For example, if you’re getting 10% interest on $1000 and reinvesting the interest, without taxes you’ll have $1100 after the first year and get $110 in interest the second year. If you are paying out 50% in taxes, after the first year you’ll only have $1050 invested and only get $105 the second year.
Without taxes, your money in this example would double every 7.2 years. With taxes, it would only double every 14.4 years. This means that over a 50 year period, your $1000 would double six times without taxes, turning into $64,000. If you’re taxed at 50% then, you would end up with $32,000. In contrast, is it is taxed every year, it would only double about 3.5 times over the same period, resulting in a value of about $12,000 at the end of the period. That extra $20,000 comes from interest on money that wasn’t taxed each year and therefore allowed to grow.
Finally, if you do choose to invest in individual stocks, if you’re buying growth stocks you should generally hold these in your taxable accounts. This is because you are able to somewhat control when you take a gain (particularly if you’re investing for long periods of time) or a loss. You can therefore do loss harvesting to offset gains that you do take while letting your winners ride untaxed into the future. If you’re investing in tax-sheltered accounts like an IRA or 401k and you have a losing stock, you will not be able to take advantage of the loss to offset gains. For this reason, hold mutual funds in these tax-sheltered accounts, which will generally go up in price over time and result in a capital gain if you hold them for long periods of time, and hold individual growth stocks in your taxable account. If you have stock that pay a large dividend, however, hold these in the tax-sheltered account to avoid paying taxes on those dividends.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.