Essential for physicians is a basic understanding of the US tax system. After all, it’s not how much you make but how much you keep. Today, let’s learn the fundamentals of income tax and capital gains tax in the United States, shedding light on each and providing valuable insights.
Understanding Tax Brackets
The US income tax system employs a progressive structure. Think of taxable income as a pitcher of water being poured into a series of cups. When the first cup is full, it spills into the second cup, then the third, and so on. The water in each cup is taxed at its own tax rate. Therefore, the last few drops in the final cup are the only income taxed at the highest rate. Ordinary income fills the initial cups and capital gains the latter cups.
Income can be categorized into several types:
- Earned Income: This includes salaries, wages, tips, and self-employment income—essentially, money earned through active work. Contrast this with passive income below.
- Portfolio Income: This refers to income generated from investments, such as interest and nonqualified dividends.
- Passive Income: Passive income encompasses royalties, real estate investments, and limited partnerships.
The ordinary income tax rates range from 10%-37%.
Capital gains tax is related to the profits earned from the sale of assets and earning qualified dividends. Consider the following key points:
- Holding Period: The duration of asset ownership before sale determines the tax rate. Assets held for more than one year are subject to long-term capital gains tax rates, while short-term rates use ordinary income tax brackets.
- Calculation: Capital gains tax is calculated by subtracting the original cost basis (purchase price) of the asset from the selling price. Adjustments are made for depreciation of the asset and reinvestment of distributions. The resulting gain is then subject to the applicable tax rates.
- Exceptions and Exclusions: Certain assets may qualify for special rules, exemptions, or exclusions from capital gains tax. For instance, selling a primary residence may allow for a tax exclusion if specific criteria are met.
The capital gain rates range from 0%-20%
Note – portfolio income or capital gains generated in a tax deferred retirement account are…deferred. Therefore, you don’t pay tax on the annual income or appreciation when generated. Instead, tax is paid on the amount distributed from the account, unless of course the retirement account is a Roth which may be tax free.
Deductions and Credits
Deductions and credits play a crucial role in reducing adjusted gross income (AGI) and the overall tax liability. Key aspects include:
- Deductions such as student loan interest, mortgage interest, charitable gifts, and certain business expenses lower taxable income. By subtracting deductions from AGI, one arrives at the taxable income used to determine the final tax liability.
- Credits: Tax credits provide a dollar-for-dollar reduction in the amount of tax owed. Examples include the Child Tax Credit, Earned Income Tax Credit, and Education Tax Credits.
Net worth can be enhanced by investing according to the tax code. Some examples:
- Defer income into pretax 401(k) or 403(b) accounts during high tax years.
- Realize income in low tax years with Roth conversions or Roth contributions.
- Maximize itemized charitable deductions in high tax years using donor advised funds (charitable account).
- Hold assets that generate portfolio income in tax deferred accounts and assets that generate capital gains in taxable accounts.
Navigating the US income tax system can be complex, but it’s a critical piece of a financial plan for a physician. Remember to consult a tax professional for your specific situation.
For personalized help eliminating debt, investing smart and securing retirement, please contact Mark Ziety, CFP®, AIF® 608.442.3750.
Mark Ziety, CFP®, AIF®
WisMed Financial, Inc. part of the Wisconsin Medical Society.
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