I’ll never forget the guy who told me he paid all of his earned income to the IRS in taxes. At first, I laughed it off internally, assuming he was mistaken or exaggerating, but he wasn’t.;
I found out his tax bill was literally the same number as his entire earned income! How could that be? What I discovered was that he was a victim of his own success.
The first thing to understand is that all of us are taxed by the federal, state and local governments in several different ways.
First, most wage earners pay a payroll tax. That’s the line item on your paycheck stub labeled “FICA (for Federal Insurance Contributions Act).” FICA is the federal law that requires your employer to withhold three separate taxes from your wages.
Second, and separate from the FICA (or payroll) tax, you pay a tax based on how much income you earn. As you earn more money and reach higher levels of income, you pay a larger percentage of that income in federal income taxes.
Third, you pay a tax on the income you receive, though you did not earn it in a traditional wage-earning job. This is known as unearned income. This category covers everything from interest earned on a bank account, to rent payments you receive, to interest, dividends and capital gains earned on a portfolio of investments.
In the case of the man who paid 100% of his earned income in taxes, it was the unearned income category that was the source of his tax problem.
When you first start out as an investor, you put a few bucks into a mutual fund, hopefully it grows a little and (unless it is in a tax advantaged account like an IRA) you and the IRS get a note from the mutual fund telling everyone how much you made that year.
If you invested $10,000 and earned 10%, your account would have grown by $1,000. That $1,000 is added to your total income taxes for that year.
Fast forward thirty years and let’s assume your account is worth $1,000,000 (sweet!). If it had a really spectacular year and earned 15%, your account would have earned $150,000 for the year on top of the million already there. Now let’s say you are earning $100,000 per year in your job.
When it comes time to do your taxes, you’ll have to report $250,000 of taxable income to the IRS: $100,000 of it earned from working and $150,000 of it earned from investing. Your total tax bill would be about $58,000 – more than half the income you earned.
There are a variety of tax reduction techniques you may consider to reduce an income tax bill made higher from investments. Some make more sense than others and all should be judged in the context of your specific circumstances. Consult qualified tax and investment advisors when considering any of these.
Just keep in mind that paying taxes because your investments are doing so well is the kind of problem everyone wished they had.