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My Financial Independence Journey » Investing, Reflections » A Primer on Federal Income and Investment Taxes

A Primer on Federal Income and Investment Taxes

228303_hands_7_money_burnedTax season is upon us yet again.  We all pay an exorbitant amount of money in taxes.  Seriously, go look at your pay statement and see how much money was ripped out of it by the government.  It’s okay if you feel the need to sob uncontrollably while drowning your sorrows in a bottle of vodka after that.  I’ll wait.  I think most of us are intimidated by taxes, but because we pay so much of our gross income in taxes we owe it to ourselves to better understand how the tax system works and how it affects our income and investments.

Every arm of government, Federal, State, and Local, has its hand in your wallet at all points in your life.  Income taxes, property taxes, sales taxes, payroll taxes, and estate taxes.  And let’s not forget the slew of fees that you may be expected to pay for everything from getting a driver’s license, to doing some yard remodeling, to obtaining a professional license.  That is an immense and almost insurmountable list, so we’re going to narrow things down to just Federal taxes on income and investments.  So what taxes are we responsible for paying to the federal government?

  • Social Security Taxes - Social security taxes are taxes on wages that are used to fund the various programs administered under the Social Security Act, the most well known of which is payments to retirees.
  • Medicare Taxes - Medicare taxes are taxes on wages, (usually) not investment income, which are used to provide health insurance to Americans 65 and older.
  • Income Taxes - Income taxes apply to all income received, whether from your day job or your investments.  However, as we shall see, all income is not created equal.  These taxes help fund the regular operations of the Federal government.

Social security and medicare taxes are collectively referred to as payroll taxes or FICA (Federal Insurance Contributions Act) taxes.

Types of Taxation

All taxes can be considered either regressive, flat, or progressive depending on how the tax rate changes with the size of your income.

  • Regressive - The tax rate decreases as your income increases.
  • Flat - The tax rate stays the same regardless of how high or low your income goes.
  • Progressive - The tax rate increases as your income increases.

FICA Taxes are FLAT-ish

Social Security and Medicare taxes are essentially flat taxes applied at the same percentage across all of your wage income, what most of us earn at our day job.  Currently, we must pay 6.2% of our wage income to fund Social Security, and another 1.45% of our income to fund Medicare.  Your employer contributes an equal amount of money to both Social Security and Medicare.

But this being the Federal government, things are not that simple.

Remember how I said that employers contribute an equal amount of money to FICA?  You may have been asking yourself “But what about the self-employed?”  Our government has an answer for that too.  They pay double.  Instead of paying 7.65% in FICA taxes, they pay 15.3%.

Remember how I said that Social Security and Medicare taxes were flat?  That’s not entirely true either.  Currently, social security income only applies to the first $113,700 (*) of your income per year.  After that, the tax disappears.  So Social Security is kind of regressive.

Medicare, on the other hand, becomes progressive at higher income levels.  If an individual earns investment or passive more than $200,000 ($250,000 for couples) the medicare tax increases by another 0.45% to be 1.9% on the excess income.  This system is needlessly confusing, but that’s our government.

Income Taxes are PROGRESSIVE

Taxes in the US are progressive, meaning that as you make more money you will pay a larger share.  This means that we need to introduce a VERY important concept called marginal tax rates.  Your income is first divided into brackets.  Then each bracket of your income is taxed at a different percentage, with that percentage increasing as your income rises to the next bracket.

When people quote their tax bracket, they only state their top marginal bracket.  So I if I say that I make $100,000 and that I am in the 28% tax bracket, that does NOT mean that I pay 28% taxes across all my income.  It only means that my top tax bracket is 28%.  My actual income is taxed in brackets of 10%, 15%, 25%, and 28%.

An example would be beneficial.


Note that the effective income tax rate in the above example is 21.29%, not 28%.  You can calculate the effective tax rate simply by adding up all the taxes paid and dividing by income.

What about your effective total federal tax burden?  Remember those FICA taxes we talked about above?  Those apply to all of your income.  So our example person earning $100,000 per year, owes an additional $7,650 (7.65% of 100K) to the federal government.  This brings the total federal tax burden to $28,943.25 (28.94%) of his income.

Once you start piling on state and local taxes, you can easily kiss 35% to 40% of your income goodbye.  I’ll wait while you move on to tequila.

2013 Tax Brackets

Here’s the tax brackets for 2013.


Not all Income is Created Equal

To further complicate things we need to become familiar with two different kinds of income, ordinary and qualified.

Ordinary income - Employers have not been taxed on this money, so the tax brackets used are much higher.

What constitutes ordinary income?

  • Wages.  Just so you don’t forget, these are also subject to FICA taxes.
  • Distributions from master limited partnerships (MLPs), real estate investment trusts (REITs) and business development companies (BDCs).  These are pass through organizations, so they don’t pay corporate tax on their income, instead they distribute 90+% of their income to shareholders.
  • Short-term capital gains.  If you’ve held it for less than a year, it’s considered ordinary income.
  • Interest.  If you earned interest from your checking or savings account, that’s considered ordinary income.

Qualified income - Employers have already been taxed on this money, so the tax brackets used are lower. This avoids problems of double taxation.

What constitutes qualified income?

  • Dividends. Dividends from most common stocks enjoy lower tax rates.
  • Long-term capital gains.  If you’ve held it for more than one year, you get the benefit of reduced taxes.

Most of the time, your dividends and distributions are reported on Form 1099, which is sent to you by your banks and brokerage houses.  MLPs are a notable exception, since they send a separate Form K-1 to you, which is a bit more complex.

Capital Gains and Losses

When you sell a security (e.g. stock, bond, option, etc.), you are required to report your capital gains or losses.  You can determine your gain or loss by simply subtracting your sale price from your cost basis (what you paid for it).  Note the use of the term cost basis.  This should clue you in to the fact that this isn’t quite as simple as how much you bought it for.  Indeed, the purchase price of the stock can be adjusted up or down by commission fees paid to purchase the stock or options premiums received against the stock.  Most brokerage houses will track this information for you.

A capital gain occurs when you’ve sold the security for more than your cost basis, while a capital loss occurs when you’ve sold the security for less than your cost basis.  We’ve already discussed that capital gains can be taxed as either ordinary or qualified income depending on how long you held the security before selling it.

But what about capital losses?  Losses are categorized as short-term and long-term, just like gains.  Capital losses are first used to offset capital gains.  Short-term losses first offset short-term gains, while long-term losses first offset long-term gains.  Then then short- and long-term results are combined.  If there are still losses, you may deduct up to $3,000 worth of capital losses per year from your taxes.  If you have more than $3,000 worth of capital losses, then you can roll the remainder over to the next year, when the whole game repeats itself.  If you have particularly large losses, those can even get carried over for multiple years.


This is by no means an all encompassing description of taxes.  But hopefully, this primer has increased your understanding of taxes and will make you a little less intimidated the next time you file taxes.

Obligatory Disclaimer:  I’m not a tax professional.  I didn’t go to school for this.  Nor am I employed in any capacity to perform tax related functions.  I’m not certified in tax preparation or anything like that.  I’ve tried to be as informative and accurate as an amateur can be, but if you have tax questions, I highly recommend that you find yourself an actual tax professional.

(*) This number changes often.  It is accurate as of 2013 when i wrote this article.

Readers:  The big question is what strategies do you use you use to shift your income away from wages and ordinary income, which have much greater tax burdens associated with them and towards qualified income, which has far less associated taxes.

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17 Responses to "A Primer on Federal Income and Investment Taxes"

  1. I thought that Social Security was regressive as well.

  2. I don’t mind paying taxes. I just hate when tax money is wasted! =)

    But I do think it’s unfortunate that wages are taxed so heavily in comparison to long term gain income. However, I suppose it is just an incentive for people to invest. The most important thing is to make the system work for you and pay as little taxes as possible.

    1. The reason why wages are taxed more than gains has to do with the fact that companies earnings are only computed after wages (and associated taxes) are paid. So it avoids double taxation.

  3. The vast majority of my income is still taxed as ordinary income, but I do try to lower my taxable income as much as possible by taking advantage of my tax advantaged retirement accounts.

    1. The problem with tax advantaged retirement accounts is that my money is locked away until an age far later than I want to achieve FI. After I hit FI, I may reevaluate how I save and start moving some money into more tax advantaged accounts.

  4. Great overview of our ridiculously complicated tax system. I wish it would be simpler, but every election cycle there’s campaign promises to simplify the tax code but it seems more and more pages end up getting added to it.

    Almost all my income is taxed as ordinary, but I’m working on getting as much as possible converted to qualified income. Unfortunately I can’t just snap my fingers and make that happen.

    1. At some point, every investor needs to have a rudimentary understanding of taxes.

      I’m also working on shifting my income to qualified over ordinary. One of the interesting things about this shift is that $40,000 worth of dividends is way more than $40,000 worth of wages. So I could live on less dividend income than wage income. FI just got that much easier.

      And now that you’ve got me thinking about it, I forgot to really illustrate the concept of marginal and effective tax rates. Which almost no one understands.

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  6. I’d by lying if I said my eyes didn’t go crossed a little bit when reading that. I think I have a automatic aversion to taxes and want to tune them out. I will say that by owning an incorporated business, I have been able to take a lower, but fair, salary and take the majority of my income in dividends, which, as you pointed out, helps tremendously with tax burden.

    1. As someone who has always been an employee, I’m very curious as to how being an incorporated business affects taxes, and thus take home pay.

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  12. Wanda says:

    I was hit with Alternative Minimum Taxes this year. Could you explain AMT? I took a voluntary buyout in 2012 due to my job moving to another city due to a merger, which increased my income substantially. I assume that is why AMT was triggered, but I don’t understand it.

    1. MFIJ says:

      I need to read up a lot more on the AMT. But it’s possible that it was triggered when your income jumped up. The needless complexity of our tax system never ceases to amaze me.


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