Estimated reading time: 8 minutes
Yes, it’s true what they say: the only guarantees in life are death and taxes. Of course, we’d all like to ignore both truths, but since we’re at year-end, taxes will be due before we know it, making it time to start making sense of tax terminology so you can put those taxes in their place.
Understanding tax terminology will help you in the long term — no matter when Uncle Sam comes calling. If you’re planning on retirement (hopefully someday), it’s important to understand how much money to pull from which investments to minimize your taxes. The ultimate goal is to live on the income you need but to minimize the taxes you owe on that income.
Want to know what I mean? Say you need $50,000 in retirement (maybe you want to buy a car or make a home improvement). If you pull that amount from your 401(k) or Traditional IRA, you’ll have to pay taxes on that $50,000. If you pull half from your 401(k) or Traditional IRA, and half from your Roth IRA, you won’t have to pay taxes on $25,000 from the Roth IRA distribution (as long as you’re 59½ or over and the account is at least five years old, making it a tax and penalty-free distribution) — this makes for a significant tax-savings! The bottom line, it’s important to know which bucket to access when you need your money in retirement and want to minimize your tax penalty.
I know, I know, thinking about your taxes is about as much fun as going to the dentist! If you’re already starting to drift, I’ll do my best to keep this guide to tax terminology (somewhat) short-and-sweet.
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Tax Terminology: Progressive and Regressive Taxes
Our Supreme Tax Collector (AKA: the IRS) breaks taxes down into categories, and it’s up to us as investors to understand how they affect us. The first way they break down taxes is by progressive taxes and regressive taxes.
First, let’s take a look at Progressive Taxes. These taxes affect higher-income earning individuals more than lower-income individuals. This is because there’s more money being taxed, being that these high-earners are in a higher tax bracket.
This Progressive Tax includes:
- Personal Income
- Gift Taxes
- Estate Taxes
Since there’s a Progressive Tax, of course, that means there are Regressive Taxes too. These taxes tend to have a more significant effect on lower-income individuals because the tax represents a higher percentage of their overall income.
This Regressive Tax includes:
- Excise (taxes paid on a specific good, like gasoline)
What you also need to be aware of is that there are three main categories of income, and the reason you need to know is that the IRS treats them differently.
Tax Terminology: Earned Income, Passive Income, and Portfolio Income
The next step to understanding tax terminology is to look at the definitions of income. The IRS (as you well know) taxes any income you receive. Depending on the amount and the type, it may affect your tax bracket. A tax bracket is simply the category you fall into that determines the percentage of income tax you owe.
The different types of income taxes are:
Earned Income: This income type is taxed at your current tax bracket and includes:
Passive Income: This income type covers earning situations where you aren’t actively involved (like work). Passive income includes:
- Limited Partnerships
- Rental Property
Portfolio Income: This is the type of income resulting from the sale of your securities. It may be taxed at your current tax-bracket (and could even be at a lower rate depending on how long you’ve held the securities). Portfolio income includes:
- Interest Income
- Capital Gains
If you just can’t wait to know how much your investments are taxed, you are more than welcome to head on over to irs.com and explore their full database of tax terminology and parameters. I’m sure all your questions will be answered! (Although it will likely create a few more questions as well!)
Now there’s one area where you don’t need to pay income tax: gifts ($15,000 annual exclusion) and inheritances ($11.7 million lifetime exclusion in 2021)! Under tax terminology, these aren’t considered income. That said, you should work with your tax professional to understand the guidelines and definitions of “gifts” and “inheritance,” so you don’t get in trouble.
Tax Terminology: Interest Income
Let’s talk a bit about Interest Income when it comes to bonds. Interest income can vary in correlation to the type of bond you may hold and its taxation.
Bonds are a different kind of investment animal, being that the interest from bonds may or may not be taxable. Here are the differences between the type of bonds. It’s important to familiarize yourself with the bond-related tax terminology, whether you currently have them or are thinking of purchasing them with future tax-free income in mind.
Corporate Bond Interest: This interest is taxable on all levels, meaning federal, state and, local, where local state taxes exist.
Municipal Bond Interest: This interest is tax-free on a federal level, though you can be taxed on both the state and local level.
U.S. Government Securities Interest: These are taxable on a federal level but are exempt from state and local taxes. These include:
Though T-bills, T-STRIPS, and zero-coupon bonds don’t generate interest, you must know the difference between what you purchased it for, and what you ended up receiving at maturity. The difference in these two numbers is considered interest, and that interest is what you have the potential to be taxed on.
Tax Terminology: Dividends
Dividends are the awards you get from investing in a company when the company earns money. We all want dividends on our investments. If you’re saving for retirement (or just investing for a rainy day), it’s important to familiarize yourself with the tax terminology surrounding dividends.
Dividends are usually in the form of the following:
Cash Dividends: These are taxed in the year they are received. Cash dividends are the only type that is taxed in this way.
Stock Dividends: These dividends will not change the overall value of the investment, though they do lower the cost-basis per share.
Dividends from Mutual Funds: These are dividends and interest from securities that are held in a mutual fund portfolio. The type of securities, as well as the time you’ve held the securities, is how you will be taxed.
As you can see, it’s crucial to understand the concept of dividends if you’re preparing for retirement. You can vary your investments to ensure you have a steady payout (that can offset your taxes).
Tax Terminology: Capital Gains
Capital gains are the profits you earn after selling a security. One of the biggest questions after selling is, “did I really earn anything?” To know for sure if you have incurred a gain, start with your cost basis: what you paid for the security, plus any commission.
If you sold your security at a higher price than what you paid for it, you have incurred a “capital gain.” (Now you know what the heck they’re talking about when they discuss the capital gains tax).
Another little tidbit to keep in mind with capital gains is that a capital gain won’t be realized until your security is sold. After the sale, it’s fully taxed at the federal, state, and local levels.
So then, you may need to know the answer to the big question: Is your capital gain considered a short-term capital gain, or a long-term capital gain?
- Short-Term Capital Gain: when you’ve held your security for one year or less.
- Long-Term Capital Gain: when you’ve held your security for more than one year.
Understanding capital gains can help you find ways to reduce your tax strain, come retirement. For example, if your company offers stock to hold within your 401(k), you may be eligible to have the growth treated as capital gains (lower rates) instead of income.
Capital gains are often lower than income tax (depending on your tax bracket), so this should be factored into your retirement planning and investment strategy. As I tell everyone, it’s so important to work with a financial advisor you can trust to steer you in the right direction.
And VOILA! You’re now an expert on understanding tax terminology!
Whew! I have to admit, that was a lot of consolidated information, especially on a topic that’s less than riveting.
Now that you’ve got a grip on putting your taxes in their place, you’re well-prepared when Uncle Sam comes calling for you!
Disclaimer: I am not a CPA or tax advisor and do not give tax advice, so please be sure to consult with your tax advisor regarding your particular situation.
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