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How Do Taxes Work?

May 17, 2022
Originally published September 2020
Updated May 2022

The U.S. tax code is a mystery to the typical individual.

But federal taxes (not to mention state and local taxes) are a big expense for most of us - and most of us are interested in paying less in taxes.

But you can't mitigate what you don't understand.

In this installment of Wealth Management 101, I'm going to lay out the most common types of federal taxes we all pay, give you some insight into how each works, and outline ways to potentially lower your tax bill.

If you are short of time, you can watch this quick two minute video. For all the details, read on.

Types of Taxes

Individuals and families are subject to a variety of taxes at the federal level.

The most common include ordinary income tax, capital gains tax, tax on dividends, and employment taxes. Each works in its own unique way.

Ordinary Income Tax

Nearly every taxpayer is subject to ordinary income tax, and it is likely the biggest part of your tax bill each year.

The textbook definition of ordinary income is any income earned by an individual that is taxable at ordinary rates.

So what does this include?

For most individuals this includes wages, salary, tips, bonuses, rental income, royalties, interest income from bonds, and commissions.

We'll get into the nitty-gritty of how these taxes are calculated later.

Capital Gains Tax

If you own investments or a home that has appreciated in value, you may be subject to capital gains taxes.

A capital gain is the increase in value of a capital asset.

A capital asset for most individuals would be things like real property, stocks, bonds, mutual funds, and exchange-traded funds.

Capital gains taxes can be long-term or short-term and are only incurred when an asset is sold.

Capital gains taxes...are only incurred when an asset is sold.

For example, if you bought a stock for $50 a share on January 1, 2019, and sold that same stock for $55 a share 366 days later (on January 2, 2020), you would have a long-term capital gain of $5 a share that would then be taxable for 2020.

If you sold the shares 364 days later (December 30, 2019), you would have a short-term capital gain of $5 a share that would then be taxable for 2019.

If you continued to hold the stock, no capital gains taxes would be due.

Short-term capital gains are taxed at your top marginal ordinary income tax rate.

Long-term capital gains are taxed at a more favorable rate that can range from 0% to 20% depending on your top marginal ordinary income tax rate.

Tax on Dividends

Some stocks pay dividends. Those dividends are taxed in a similar fashion to capital gains in that they are taxed at either your highest marginal ordinary income tax rate or at your long-term capital gains tax rate.

In general, most dividends are taxed as ordinary income.

There is a three-part test to determine if a dividend is qualified to be taxed at your long-term capital gains rate.

To be a qualified dividend, it must:

  1. Have been paid by a U.S. company or a qualifying foreign company.
  2. Not be listed with the IRS as a company that does not qualify.
  3. Meet the required holding period. In general, this means holding the dividend-paying stock for between 60 and 90 days before dividends are considered qualified.

Employment Taxes

Employment (or payroll) taxes are due on income earned through employment.

If you are a W2 employee, you pay half of this tax burden while your employer pays the other half.

This set of taxes is known as FICA and comprises Social Security and Medicare taxes.

As an employee, you pay 6.2% tax on the first $147,000 of gross income for Social Security. You also pay 1.45% of your gross income for Medicare.1

Your employer pays the same.

If you are self-employed, you must pay both the employer and employee portion of these taxes.

Read: 3 Reasons You Might Need a Financial Advisor

The Income Tax Formula

By far, the most complex computations are done when figuring income tax, which encompasses ordinary income, capital gains, and tax on dividends.

There is a formula you can keep in mind to help you understand income tax a bit better:

Income Broadly Defined

- Exclusions
= Gross Income

- Deductions for Adjusted Gross Income (AGI)
= Adjusted Gross Income (AGI)

- The greater of Itemized Deduction or Standard Deduction
= Taxable Income

(applied to) Tax Table for Your Filing Status
= Tax on Taxable Income

- Taxes Already Paid
+ Credits
= Taxes Due

Let's look at this more closely.

Income Broadly Defined is any money or item of value that came into your hands during the year - be it income from your job, a gift from mom and dad, or a loan to buy a car.

From that you back out things that are excludable like your 401(k) contributions, most gifts, and loan proceeds.

Now you have Gross Income, and from that you take certain deductions to arrive at Adjusted Gross Income (AGI).

Those deductions include:

  • Certain retirement plan contributions to plans like individual retirement accounts (IRAs), SIMPLE IRAs, or SEP-IRAs
  • Contributions to your healthcare savings account (HSA)
  • Student loan interest (exceptions and limits apply)
  • Certain capital losses
  • 50% of self-employment tax

Once you've arrived at your Adjusted Gross Income, you can either take the Standard Deduction or Itemized Deductions (more on this topic later in the article).

After backing out your Standard (or Itemized) Deduction from Adjusted Gross Income, you're left with your Taxable Income. This is the portion of your income that you'll actually pay taxes on.

To this number you apply the relevant tax table for your filing status.

That gives you Tax on Taxable Income.

From this you back out any income tax you've already paid through withholding or quarterly payments and add in any Tax Credits2 you qualify for. These credits might include:

  • Child Tax Credit
  • Child and Dependent Care Credit
  • The Retirement Contribution Savings Credit (Saver's Credit)
  • American Opportunity Tax Credit (AOTC)
  • Lifetime Learning Credit (LLC)

The final computation will get you to the bottom line and tell you if you owe tax or if you'll be getting a refund.

Read: What to Be Wealthy? Then Plan on It

Deductions for and from AGI

There are two points in the tax formula where deductions happen: before you calculate Adjusted Gross Income (AGI) and after you calculate AGI.

Your AGI drives much of what you can and can't deduct as well as your eligibility for some tax credits. Also, any dollars backed out before you arrive at AGI can be thought of as "tax free."

Getting to the lowest possible AGI is key to lowering your tax bill.

In fact, anytime you can find exclusions or deductions for AGI, you should maximize them where possible and practical.

Your 401(k) contributions are always excluded, and some IRA contributions may be deductible for AGI.

Once you've arrived at your AGI, you'll need to determine if you'll take a Standard Deduction from AGI or Itemized Deductions from AGI.

The tax law changes passed in 2017 and effective for 2018 made the Standard Deduction much higher and thus more appealing to most taxpayers.

Popular itemized deductions include:

  • Unreimbursed medical and dental expenses
  • Mortgage interest expenses
  • Personal property taxes paid
  • Charitable donations
  • Casualty and theft losses

Itemized Deductions are also subject to a good deal of rules and exceptions, so be wary when pursuing them.

Tax Minimization 101

I'll start this section by reminding you that having a tax bill is a good thing; it means you earned money during the year.

However, no one wants to pay more than they must, and there are some common-sense things you can do to lower your tax bill.

  1. Maximize your 401(k) contributions, because they are fully excludable from your income for income tax purposes.3
  2. Maximize deductions for AGI, such as certain IRA and HSA contributions.4
  3. Plan to hold most investments for a year or more where it is practical to do so. This will qualify you to pay long-term capital gains rates when you do sell and may help you earn qualified dividends (which are taxed more favorably).5
  4. Limit trading in your non-retirement accounts where it is practical to do so. Again, if you do not sell an asset, you do not trigger a capital gains tax burden.
  5. Make tax-loss harvesting an annual practice. A taxpayer is eligible to deduct up to $3,000 in capital losses against ordinary income each year. This is one of those deductions for AGI that is so valuable. You can also use realized Capital Losses to offset realized Capital Gains for the year.

Just a little bit of planning and forethought, along with the implementation of certain principals, can help you pay just a little less in taxes and keep more of your hard-earned dollars in your pocket and working for you.

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Fact checking for this article kindly provided by Douglas Hord of My Tax Guy in Houston.
Robert W. Baird & Co. Inc. is not affiliated with My Tax Guy in Houston.
Robert W. Baird & Co. Inc. does not give tax or legal advice.

1 Plus 2.35% on all wages in excess of $200,000.
2 Tax credits are very valuable because they reduce your tax liability dollar-for-dollar instead of just lowering your taxable income. However, they are subject to many rules and restrictions that mean higher earners are often ineligible to claim these credits.
3 Up to the IRS's specified limit, which is $20,500 for 2022.
4 Income limits apply, so work with your tax advisor to determine your eligibility.
5 In a case where you are selling only a portion of the shares you own in a given holding, consider selling the shares you've owned the longest if there is a gain or the shares you've owned for the shortest period if there is a loss. In so doing you can qualify for either long-term capital gain treatment or retain qualified dividend status.

The information herein is from sources regarded as credible, but Baird has not verified the accuracy or completeness of this material and as such, this should be regarded as for educational purposes only and is subject to change and potentially subject to ongoing interpretation. It is strongly encouraged that clients speak with their tax or legal professional prior to acting on this information. The opinions expressed are those of the author and not necessarily those of Baird. This list should not be considered an endorsement of the services offered by these individuals or their firms.