Nothing is more frustrating than dealing the income taxes. According to the 2013 CCH Standard Federal Tax Reporter, it would take nearly 74,000 pages (8 1/2 by 11-inch) to explain the federal tax code. It’s so complex that most people cannot get their arms around it. Here’s an example that can help you understand some income tax basics.
Different income, different taxes on income
Many people are confused by taxes, because they don’t understand that type of income that is being taxed. Speaking very broadly, here are the types of income that may be taxed:
- Ordinary income/ paycheck: Think of this as income you earn by getting a paycheck. When your firm runs payroll, they may withhold some level of federal and state income taxes, as well as Social Security and Medicare taxes. Currently, the employee portion of Social Security tax is 6.2%. Medicare taxes for an employee are 1.45%.
- Ordinary income/ self-employed: Many self-employed people pay tax through Schedule C on the individual 1040 tax return. This income is also taxed as ordinary income. There is a calculation connected to Schedule C for both Social Security and Medicare taxes for both the employee and the employer. Since a self-employed person is both employee and the employer, there’s a deduction for a portion of these taxes as a business expense.
- Tax on interest and dividend income: Investors earn interest income on bonds and dividend income on stock dividends. Over the years, the tax rate for interest and dividend income has been less than the ordinary income tax rate.
- Capital gains and losses: If you have a buy and a sell, you have realized capital gain or loss. Realized gains or losses have a tax impact. If you buy and investment and hold it, there is no gain or loss until a sale occurs. Over the years, the tax rate for capital gains and losses has been less than the ordinary income tax rate.
- Gift tax: We’re all allowed to gift a certain dollar amount to as many people as we want each year. It’s a way of reducing the size of our taxable estate before we pass away. If we gift more than the limit, we may be subject to gift tax.
- Estate tax: This tax is calculated based on the size of our estate, and the deductions we have from that tax.
Jeb Bush’s tax return
Jeb Bush earned a great deal of income since he returned to the private sector in January of 2007. Much of that income was from distributions from businesses. He could have set up business entities that would have taxed those distributions as dividend income and capital gains.
Bush chose to report his income as a self-employed person through Schedule C. That meant that the income was taxed as ordinary income. Given his total earnings, the income was taxed at the maximum ordinary income tax rates (currently 39.6%).
Click here for Live Webinar: Top 10 Personal Finance Mistakes (And the Tools To Avoid Them)
If Bush had chosen another business structure, he could have paid tax rates on dividend income and capital gains at much lower rates over that time span- as low as 15-20%. This decision caused Bush to pay $760,000 more in taxes over time.
How an example can help
Now, there’s a political reason for doing this- check out the article for more. The point here is that you need to first understand what type of income you’re earning. If you understand that, you can start to digest how your tax return is calculated. That knowledge should give you some peace of mind.
Do you have a good example that you use to explain a tax concept? I’d love to hear from you.
St. Louis Test Preparation
Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies
(amazon author page) amazon.com/author/kenboyd
(you tube channel) kenboydstl