The Investor’s Guide to Income Taxes

Mar 26, 2015 • Written by Paul Staib | Certified Financial Planner (CFP®), MBA, RICP®

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Tax Planning

Key PointsTax Planning

  • Understanding what constitutes income can help you pay less in taxes
  • The amount of income you’re required to recognize for tax purposes depends on the extent to which the Internal Revenue Code allows special exclusions, adjustments, deductions and credits


Your  investment decisions always come first, but paying attention to taxes along the way can help you keep more of your hard-earned returns.  Understanding what constitutes income and how different types of income are treated under the federal income tax rules is the first step in a sophisticated tax planning strategy.  While the rules change periodically, there are some important fundamentals that can help you better position your finances.


Everything is Income

Income extends beyond wages, interest, dividends, annuities, royalties and alimony – it’s any form of realized income, and includes property or services you receive, or are entitled to receive.  Debt that is cancelled or forgiven (from a mortgage or student loan) is also considered income for tax reporting purposes.


That said, your gross income isn’t fully taxable either. Internal Revenue Code (IRC) rules allow the following adjustments:

  • Special exclusions: such as tax-free municipal bond income, gifts, inheritances and life insurance proceeds.
  • Adjustments: such as above-the-line adjustments for retirement plan contributions, alimony and self-employed health insurance.
  • Deductions: such as the standard deduction or itemized deductions for such things as qualified mortgage interest, state and local taxes, and charitable gifts.
  • Personal and dependent exemptions
  • Credits: such as foreign tax credit.

Gross Income

–  above-the-line deductions

= Adjusted Gross Income (AGI)

– Standard or Itemized Deductions

– Exemptions

= Taxable Income

x  Tax Rate (ordinary, capital gain, AMT)

= Gross Tax

–  Tax Credits

– withholding and/or quarterly estimated payments_

= Tax Owed (or refund due)

For more information and details on these categories, see IRS Publication 17, Your Federal Income Tax For Individuals. Publication 17 also provides a list of more specific resources, including one that investors will find particularly useful: IRS Publication 550, Investment Income and Expenses.


Types of Income

For tax purposes, there are three main types of income:


  • Ordinary: Income from wages, self-employment income, interest, dividends, etc.
  • Capital: Income from the sale of property.
  • Passive: Income from investments in real estate, limited partnerships or business activities where participation is immaterial.


There are further classifications within some of these categories.  For example, some interest income is considered tax-exempt (for example, interest from state and local municipal bonds) and some dividends are deemed “qualified” and receive special long-term capital gain tax treatment.


Also, while capital gains can be either short-term or long-term, there are further categories for such things as collectibles or recaptured depreciation (see IRS Publication 550).


Finally, special rules apply to the interaction between these categories. For example, passive losses can usually only offset other passive income, but generally not ordinary income.


The Difference Between Effective and Marginal Tax Rates

Our income tax system applies higher tax rates to higher levels of income and lower tax rates to lower levels of income.  Currently, the rates range from 10% at the low end to 39.6% at the high end.  The cutoff between the graduated tax rates is known as a tax bracket.


Your marginal tax rate is the tax you pay on your last dollar of income.  If you’re single and you make over $406,750 a year, you’ll fall into the 39.6% tax bracket this year—and will pay $39.60 for every $100 you make over $406,750 in taxable income.  But for every dollar prior to that $406,750 threshold, you’ll have paid less.


Your effective tax rate is the total amount of tax you pay divided by your taxable income (or AGI, depending on the approach you use).  This average is the actual overall rate you pay in taxes.  For tax planning purposes, however, the marginal rate is more important because it tells you how much you will pay on the next dollar of income or how much benefit you will get for the next dollar of deductible expense.


Knowing your marginal tax bracket can help you with all kinds of decisions, such as whether municipal or taxable bonds make sense in taxable accounts, which assets go best in taxable vs. tax-advantaged accounts, or how much bang for the buck you might receive from harvesting capital losses.


Payroll and Medicare Taxes

Under the Federal Insurance Contributions Act (FICA), the wage base limit for Social Security is now $118,500 (2015) with a tax rate of 6.2%.  That means a maximum of $7,347 ($118,500 × .062) can be withheld from your annual salary for Social Security.


The wage base for Medicare withholding remains unlimited with an employee tax rate of 1.45%. An additional 0.9% Medicare tax will be levied on earned income over $200,000 for single filers and over $250,000 for married couples filing jointly.  That means a new marginal Medicare tax of 2.35% on earned income for high earners (the employee rate of 1.45%, plus 0.9% for amounts over the threshold).  An additional 3.8% surtax applies to net investment income for taxpayers with AGI over $200,000 for single filers or $250,000 for married filing jointly.


If you’re married filing jointly and pay excess Medicare taxes, you’ll be eligible for a credit when you file your tax return.  For example, let’s say you’re the only earner in a married couple.  You make $225,000 in the course of the year, and your employer automatically withholds the additional 0.9% tax on your wages between $200,000 and $225,000.  You’ll be eligible for a credit when you file because your total income falls below the $250,000 threshold for married joint filers.


For more information on these and other changes, please see the article on inflation adjustments on the IRS website or read about Social Security cost-of-living adjustments at


Capital Gains Taxes

A top rate of 15% applies to qualified dividends and the sale of most appreciated assets held over one year (28% for collectibles and 25% for depreciation recapture) for single filers with taxable income up to $406,750 ($457,600  for married filing jointly).  Long-term capital gains or qualified dividend income over that threshold are now taxed at a rate of 20%.


For example, if a married couple earns $457,600 in ordinary income and an additional $100,000 in long-term capital gains and qualified dividends, the full $100,000 would be subject to the 20% rate.  If, however, they earn $400,000 in ordinary income, and $100,000 in long-term capital gains and qualified dividends, then $57,600 would be taxed at 15% and the additional $42,400 would be taxed at 20%.


Note that while capital losses can offset capital gains without limit, only $3,000 of capital losses per year can be used to offset ordinary income ($1,500 for married filing separate).  For both passive and capital losses, carryover rules allow unused losses to be saved for use in future years.


Tax-Efficient Investing

Knowing how your income is taxed helps you to increase your after-tax return by prudent account placement. Broadly speaking, investments that tend to lose less of their return to income taxes are good candidates for taxable accounts.  Likewise, investments that lose more of their return to taxes could go in tax-deferred accounts.


Where Tax-Smart Investors typically place their Investments


  • Taxable accounts: ideal for: (a) individual stocks you plan to hold more than one year, (b) tax-managed stock funds, index funds, exchange-traded funds (ETFs), low-turnover stock funds, (c) stocks or mutual funds that pay qualified dividends, and (d) municipal bonds, I Bonds (savings bonds).


  • Tax- advantaged accounts such as Roth IRAs and tax-deferred accounts including traditional IRAs, 401(k)s: ideal for: (a) individual stocks you plan to hold one year or less, (b) actively managed funds that may generate significant short-term capital gains, (c) taxable bond funds, inflation-protected bonds or high-yield bond funds, (d) real estate investment trusts (REITs).


Bottom Line

You don’t want taxes to dictate your investment strategy, but you should consider the tax consequences of your financial actions, especially prior to entering into any significant transaction.


Remember, virtually all the goods and services you purchase are bought with after-tax dollars.  Keeping more of what you make is paramount when finances are tight and investment returns are low.  Knowledge is power, and understanding the basics of our tax system is just a first step.

Paul Staib | Certified Financial Planner (CFP®), MBA, RICP®

Paul Staib, Certified Financial Planner (CFP®), RICP®, is an independent Fee-Only financial planner. Staib Financial Planning, LLC provides comprehensive financial planning, retirement planning, and investment management services to help clients in all financial situations achieve their personal financial goals. Staib Financial Planning, LLC serves clients as a fiduciary and never earns a commission of any kind. Our offices are located in the south Denver metro area, enabling us to conveniently serve clients in Highlands Ranch, Littleton, Lone Tree, Aurora, Parker, Denver Tech Center, Centennial, Castle Pines and surrounding communities. We also offer our services virtually.

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