Investing - The Basics of US Income Taxes

Investing - The Basics of US Income Taxes

(2023-09-14 - I have made a few revisions to, hopefully, make things clearer.)

I have written several posts on investing, trying to illuminate the need for preparing for retirement and some of the different investment devices and how they work. And over many years of investing and a few in retirement, one thing that has become more and more clear to me is that how you handle income tax is very important (and not simple). You need to understand the different tax advantaged accounts (IRA, Roth IRA, etc.) and ordinary accounts and the taxes on different types of income (earned income, interest, dividend, capital gains).

I am writing this, in large part, for myself - to get a coherent, organized model of the US federal income tax code. This complex code has been transformed into a set of massively confusing and near infinite number of forms that obfuscate the rules. Maybe I can untangle it a bit.

I hope it's useful - maybe just as a sleep aid. After finishing this post, I am wondering if it's better to just find a good book on the subject.

Also see Investing, Investing - More Fun with Investing, Investing - How to Choose a Mutual Fund, Investing - Things I Have Learned in Retirement, and Investing - Retirement Money Tips .

There are many details to federal income tax law. Below is the foundation of the tax system as it relates to investing. This is only the foundation - there are many rules about special income sources farming, real estate, small businesses, much more that I know nothing about. The specific numbers are just an example (filing as a single person, 2021). You will have to look up numbers specific to you.

This post looks at these topics.

  • Income
  • Interest
  • Unqualified ordinary dividends
  • Qualified dividends
  • Short term capital gains
  • Long term capital gains
  • Capital losses
  • IRA, 401K, ... required minimum distributions (RMDs)

It does not look at these topics but they are worth digging into after getting past the basics.

  • Taxes on social security income
  • Foreign taxes
  • State taxes
  • Deductions (reduce your taxable income)
  • Standard deduction (lower limit of itemizing, eliminates itemizing for many people)
  • Credits (reduces the amount of tax that you owe)
  • Refundable credits (reduces the amount of tax that you owe and if greater than what you owe gives you a refund)
  • Exemptions (removes the tax obligation from some income)
  • Income based Medicare penalty
  • Alternative minimum tax
  • Money from pensions and annuities (generally treated like IRAs)

Why is this important? Tax details dramatically affect your effective income and there are secondary effects such as

  • Social Security payments are taxed based on income.
  • Medicare rates are based on income.
  • COVID relief payments are based on income.
  • Tax rates are based on income.
  • Student loan forgiveness will likely be based on income.

My Terminology -

  • Income - short for taxable income - any money that you get that is not tax exempt. I am not saying that exempt income is not good - it's great - but I don't want to prefix every use of the word income with taxable or exempt. If it's exempt, I will add that qualifier.
  • Exempt income - any money that would have been income except that it is exempt from income taxes
  • Earned income - money that is earned from a job or business
  • Total income - really total taxable income - the sum of earned income, interest, dividends, capital gains, and money from a pre-tax retirement account (IRA, pension, annuity), but not exempt income
  • Income (tax) rate - the rate of taxation based on the IRS income table
  • Income tax - tax on total income, calculated on the IRS Qualified Dividend and Capital Gains Tax Worksheet (which refers you to the Tax Table or Tax Computation Worksheet for the income rate side of the calculation)
  • Capital gains short and long
  • Short term capital gains
  • Long term capital gains
  • Long term capital gains (tax) rate - the rate of taxation based on the IRS long term capital gains table
  • Qualified dividends are actually qualified ordinary dividends. These are mostly dividends from US corporations.
  • Ordinary dividends include qualified and unqualified ordinary dividends.
  • Unqualified ordinary dividends ordinary dividends minus qualified dividends
  • Interest from a bond fund is labeled as dividends, actually unqualified ordinary dividends.
  • I use IRA to refer to IRAs, 401Ks, 403Bs, and any other pre-tax retirement accounts.
  • I often use Roth to refer to Roth IRAs, Roth 401Ks, Roth 403Bs, and any other after-tax retirement accounts.

Please note - when I talk about IRAs, HSAs (health savings accounts) and other tax advantaged accounts, I am not giving all of the rules of these accounts. They are limited by age, holding time, source and size of contribution, income, all of which may change at the whim of our government.

Some general rules (some of these rules are subject to a minimum asset holding time).

  • IRA, 401K, ... contributions from earned income are tax exempt, withdrawals are taxed at the income rate.
  • Roth IRA, 401K, ... contributions are only from after tax earned income, withdrawals are tax exempt.
  • Long term capital gains are taxed at the long term capital gains rate.
  • Qualified dividends are taxed as long term capital gains.
  • Earned income is taxed at the income rate.
  • Interest is taxed at the income rate.
  • Unqualified ordinary dividends are taxed at the income rate.
  • Short term capital gains are taxed at the income rate.
  • Capital losses can offset capital gains, including future capital gains if there is currently nothing to offset.
  • Required minimum distributions (RMDs) force you to take yearly IRA withdrawals (and pay income tax on them) starting at a certain age (72 right now). RMD withdrawals may not be transferred to Roth IRAs.
  • Tax exempt money is not taxed and is not included in deductions or income calculation.
  • Contributions to an IRA are tax exempt, but you must pay income taxes when you withdraw.
  • Contributions to health savings accounts are tax exempt and there are no taxes if you withdraw for medical expenses or Medicare premiums (not supplemental insurance premiums).
  • There are tax exempt bonds issued by local and state governments (municipal bonds).
  • Bonds may be tax exempt to different agencies - city, state, federal.
  • There are bond funds that invest in tax exempt bonds.


Tax Rates

Tax rate on earned income, IRA distributions, pension/annuity payment, interest, unqualified ordinary dividends, short term capital gains

t=total income less deductions, qualified dividends, long term cap gains

t less                    marginal  total tax        total rate
long term capital gains   rate                       range
and qualified dividends                               low   high

<9,950                    10%       t*10%            10.0   10.0
<40,525                   12%       t*12%-199        10.0   11.5
<86,375                   22%       t*22%-4251.5     11.5   17.1
<164,925                  24%       t*24%-5979       17.1   20.4
<209,425                  32%       t*32%-19173      20.4   22.8
<523,600                  35%       t*35%-25455.75   22.8   30.1
>=523,600                 37%       t*37%-35927.75   30.1   37

(These formulas are as used by the IRS. They seem backwards to me, subtracting off the offset from the lower brackets instead of adding on to the lower brackets, but it does simplify the formula.)

Note that I have subtracted out qualified dividends and long term capital gains from total income. This assumes that you are calculating tax on these separately, as noted below.

Tax rate on long term capital gains, qualified dividends

t=total income less deductions

t          tax rate
<40,000     0%
<446,000   15%
>=446,000  20%

Note that long term capital gains rates are a function of total income. They are not marginal rates - cross a line with your total income and all of your long term capital gains get a tax bump.

But you also calculate the tax on your total income via the income rate table. If that is lower than the tax calculated with the combination of income rate / long term capital gains rate, then that is the tax that you owe. It seems to me that is unlikely, but I haven't investigated.

Bond yield vs stock yield

Bond yield vs stock yield for a tax advantaged asset

There is no tax for a Roth withdrawal, and for a regular IRA all withdrawals pay the income rate, so there is no tax difference for bond interest and stock dividends

Bond yield vs stock yield for a tax unadvantaged asset

Looking at the income total rate ranges, you can see that long term capital gains rates are lower than income rates if your total income is below 40,000 or above about 100,000. But between 40,000 and 100,000, not much different. So stock qualified dividends are preferable to bond interest. For me stock dividends saved 20% in taxes vs what I would have owed with bond interest. And with stock dividends, you can use the income rate if it is lower than the long term capital gains rate.


Where are your assets?

Where are your assets? This affects taxes on withdrawals. But you can't move assets between accounts pain free. And the pain may be worse than the advantage. Plan ahead.

In a tax unadvantaged account

  • A fund that trades growth stocks distributes big capital gains from trades, small dividends from profits.
  • A fund that trades dividend or value stocks distributes capital gains from trades, dividends from profits.
  • A fund that holds growth stocks (index fund) distributes small capital gains and small dividends, so value goes up and unrealized capital gains go up.
  • A fund that holds dividend or value stocks (index fund) distributes small capital gains and big dividends.
  • A fund that trades bonds distributes capital gains and unqualified ordinary dividends.
  • Bonds or funds that holds bonds (index fund) distributes unqualified ordinary dividends.

In an IRA

  • All distributions come to you as unqualified ordinary dividends.
  • Distributions can be moved to a Roth.

In a Roth

  • Distributions are not taxed.
  • Deposits can only come from earned income (you must have a job) or an IRA conversion.

Note that the dividends noted above, unless specified, may be qualified, if the asset is US and is held long enough, or unqualified. And capital gains may be short or long, depending on how long the asset has been held.

Same subject, a few details -

Mutual funds distribute capital gains on sold stocks every year (or quarter or month). And for tax unadvantaged accounts, you must pay taxes on this. Index funds and other funds with low turnover have low capital gains distributions, so low capital gains taxes while you are holding the funds. But the stock values keep going up (historically anyway) while the cost basis stay the same, so unrealized capital gain keeps going up. When it's time to sell the fund, big capital gains taxes.

You can transfer assets from an IRA to a Roth IRA. This requires that you pay income rate taxes on the IRA withdrawal. Then the asset is in a Roth IRA and no more tax is due on the asset or distributions from the asset. Best to pay income taxes when your income is low, or the tax rates are low, or when the asset value is low (during a stock market low).

States have different policies on state taxation of IRA withdrawals. In Kentucky, the first $31000 (not sure of the exact number) of an IRA withdrawal is exempt from state income tax. If you don't need this as income, it is handy to use it for a Roth transfer.

I prefer to maximize my Roth account in preference to my IRA because it can hold any asset without tax consequences. But you might have a special fund in a 401K that you don't want to drain, for example you might be counting on a stable value fund for the long term. 

Where to withdraw when you need money

If you have an IRA required minimum distribution, take that first. There is a big tax consequence if you don't take the RMDs and you can't get around it.

Take cash from a distribution in a tax unadvantaged account. The tax consequences were set when the distribution was done, so no more tax on the cash.

Withdraw assets from a tax unadvantaged account. The taxes will be on capital gains (the asset value minus the cost basis). That is likely much less than withdrawing from an IRA.

As noted above, states have different policies on state taxation of IRA withdrawals. In Kentucky, the first $31000 (still not sure of the exact number) of an IRA withdrawal is exempt from state income tax, so a significantly reduced tax rate for this money.

Where to put different types of assets

I would be happy to have everything in my Roth, but it hurts too much to quickly transfer from my IRA. And there is no way to move my tax unadvantaged assets in the the Roth because I have no earned income (job or business).

So, in a Roth, I put my investments with the best chance of big rewards. If I get lucky with an investment, being tax free is a nice bonus.

In my tax unadvantaged account, I like dividend index stock funds that produce qualified dividends. I will have to pay mostly long term capital gains tax on this income. Hopefully, the dividends will support the stock price. And there should never be a management issue that would push me into selling.

That leaves the safest investments in my IRA, CDs, bonds, 40/60 fund. Assuming these a necessary parts of your portfolio, the slow growth will cause less RMD problems than fast growth assets.

And I can move IRA assets to my Roth slowly, keeping my total income low. Until the RMDs start. It might be better to take some of the pain now.


Enough (This has taken over a week.)

Do you have any thoughts, especially on where to put your assets, where to withdraw money, and what type of assets are useful in retirement? I would love to hear them.

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