Most married couples I know choose to burden only one member of the couple with tax return preparation — delegation and work splitting are keys to a happy home life, after all.
So, if you are divorcing after a long marriage, you may be doing your own taxes for the first time (or the first in a long time).
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 it's hard to be tax-aware when you don't even know the basic mechanics of the tax system.
Here, I've put together a primer to get you started on your journey to understanding taxes a little better.
Types of Taxes
Individuals and families are subject to a variety of taxes at the federal level.[1] The most common of these 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. For now, think of this as the tax levied on your earnings from labor or business activities.
Capital Gains Tax
If you own investments like real estate, stocks, bonds, mutual funds, or exchange-traded funds, you may be subject to capital gains taxes.
A capital gain is an increase in value of a capital asset. Capital assets for most individuals would include 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.
Long-term vs. Short-term Capital Gains
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 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 at ordinary income rates.[2]
Employment Taxes
Employment (or payroll) taxes are due on income earned through employment – we call this earned income. 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 $142,800[3] of earned income for Social Security. You also pay 1.45% on all of your earned income for Medicare. Your employer pays the same. If you are self-employed, you must pay both the employer and employee portion of these taxes.
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, or rather a chain of additions and subtractions, that can help you understand income tax a bit better:
Income Broadly Defined - Exclusions = Gross Income
Gross Income - Deductions for Adjusted Gross Income = Adjusted Gross Income (AGI)
Adjusted Gross Income - The greater of Itemized Deduction or Standard Deduction = Taxable Income [4]
Apply the Tax Table for Your Filing Status to Taxable Income = Tax on Taxable Income
Tax on Taxable Income – [Taxes Already Paid + Credits] = Taxes (or Refund) 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.[5] 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).[6]
Once you've arrived at your Adjusted Gross Income, you can either take the Standard Deduction or Itemized Deductions (a deep dive on Standard vs. Itemized Deductions, as well as Qualified Business Income (QBI) Deduction are beyond the scope of this article).
After backing out your Standard (or Itemized) Deduction from Adjusted Gross Income (and any applicable QBI Deduction), 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.[7] That gives you Tax on Taxable Income. From this you back out any income tax you've already paid through withholding or quarterly payments as well as any Tax Credits[8] you qualify for.
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.
What Now?
I do not expect you to go out and start doing your own taxes. The point here is to arm you with a basic understanding of what taxes you might have to pay and what drives those taxes so you can make tax-aware decisions.
If you are a wage earner who gets a W2 every year and you have few investments, your annual tax preparation could be relatively simple. You may be able to use software from a provider like H&R Block or TurboTax.
If you are retired and/or living off investments, things will likely be more complex, and you may benefit from working with a qualified tax preparer or CPA.
Your Financial Advisor will play a key role in these circumstances to help you make tax-aware choices and advise you of any tax consequences that may arise from investing activities.
In my practice, I specialize in working with women in transition, especially post-divorce.
If you find yourself administering meaningful investments for the first time and are feeling a bit lost, click the button below to get in touch. I'd love to help.
[1] This article will only address taxes levied at the federal level. A discussion of state and local taxes (SALT) is beyond the scope of this article.
[2] 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:
- Have been paid by a U.S. company or a qualifying foreign company.
- Not be listed with the IRS as a company that does not qualify.
- 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.
[3] As of tax year 2021
[4] You may also make a Qualified Business Income (QBI) Deduction when computing Taxable Income
[5] Transfers of property (such as a home, investments, vehicles, etc.) are not included in this definition and are not considered in preparing a tax return in the year of divorce.
[6] 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
[7] The tables referenced here are for Ordinary Income only. There are separate tables for long-term capital gains and qualified dividends. The last dollar of your Ordinary Income determines the rate at which your first dollars of long-term capital gains and qualified dividends are taxed. A detailed discussion is beyond the scope of this article.
[8] 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. These credits might include:
- Child Tax Credit
- Child and Dependent Care Credit
- Retirement Contribution Savings Credit (Saver's Credit)
- American Opportunity Tax Credit (AOTC)
- Lifetime Learning Credit (LLC)