Executive Summary
- There are four taxes on income in the U.S., each with different rates and rules.
- By default, every dollar of income that you make is subject to one or more of these taxes.
- Tax efficient investing ultimately consists of: (1) strategically timing and classifying income so that it receives the most favorable tax treatment; (2) using tax incentives to delay or defer payment of applicable taxes; and (3) using tax incentives to eliminate taxes altogether.
The goal of tax efficient investing is to minimize your lifetime tax bill, thereby maximizing the value of your retirement portfolio and the estate that you’re able to leave.
In order to successfully evaluate and implement the various tax savings strategies available to you, it of course helps to understand a little about the taxes that you’re seeking to defer or eliminate.
This section provides an overview of the various income taxes that most Americans are subject to, providing a critical framework for the rest of this guide.
Download This Guide As a PDF
Get the full PDF version of this Ultimate Guide To Tax Free Investing.
Your free instant download includes special bonus content.
The Four Taxes On Income
In general, there are four types of taxes that can be applied to the income you earn. Which taxes apply depend on the source of the income.
These four taxes are:
- Medicare Tax;
- Social Security Tax;
- Ordinary Income Tax;
- Dividend & Long-Term Capital Gains Tax.
Depending on the source of your income, it may be subject to zero, one, two, or three of these taxes (more on that below).
A Quick Note...
Unfortunately for investors, there are dozens of different taxes that are levied. There is a sales tax, gas tax, property tax, hotel taxes, airline taxes — some cities even charge an “entertainment tax.” This chapter will focus on income taxes: the taxes that must be paid as a result of earning money.
This chapter is generally going to focus on federal taxes and steer clear of state taxes. While the impact of state taxes definitely should not be ignored, the sheer volume of different regulations makes it difficult to address thoroughly.
Tax #1: Medicare Tax
As part of the Federal Insurance Contributions Act (FICA), the federal government collects a tax to fund Medicare.
Taxed Amount
The FICA Medicare Tax is applied to your salary, wages, or other earnings from your job.
Tax Rate
Standard Rate: 1.45% of your gross wages.
Additional Rate: An additional tax of 0.9% applies to earnings in excess of:
- $200,000 for single filers
- $250,000 for married couples filing jointly
- $125,000 for married individuals filing separately
The Additional Rate of 0.9% applies only to amounts over the applicable threshold.
Additional Notes
The 1.45% contribution made by employees is matched by employers. Any applicable Additional Rate of 0.9% is not matched by employers.
Self-employed individuals must pay both the employee and employer contributions, resulting in an effective rate of 2.9%.
There is no income cap for Medicare tax, meaning all earnings are subject to Medicare tax. Similarly, there is no “income floor” for this tax; it applies to all earnings.
Medicare taxes are commonly withheld from your paycheck, and often labeled as “FICA”
Examples
Example #1: Single taxpayer with gross wages of $150,000
Calculation: $150,000 x 1.45% = $2,175
Example #2: Married filing jointly taxpayer with gross wages of $300,000
Calculation: [$300,000 x 1.45%] + [$50,000 x 0.9%] = $4,800
Tax #2: Social Security Tax
As part of the Federal Insurance Contributions Act (FICA), the federal government collects a tax to fund Social Security payouts to retired and disabled Americans.
Taxed Amount
The FICA Social Security Tax is applied to your salary, wages, or other earnings from your job.
Tax Rate
6.2% of your gross wages.
There is an income cap (also known as the Social Security wage base limit) on the Social Security tax; in 2024, only the first $168,600 (regardless of filing status) is subject to this tax (note that this amount is adjusted annually).
Additional Notes
The 6.2% contribution made by employees is matched by employers.
Self-employed individuals must pay both the employee and employer contributions, resulting in an effective rate of 12.4%.
There is no “income floor” for this tax; it applies to all earnings.
Examples
Example #1: Taxpayer with gross wages of $150,000
Calculation: $150,000 x 6.2% = $9,300
Example #2: Taxpayer with gross wages of $300,000
Calculation: $168,600 x 6.2% = $10,453
Example #3: Self-employed taxpayer with gross wages of $300,000
Calculation: $168,600 x 12.4% = $20,906
Tax #3: Ordinary Income Tax
You’re not done with taxes after you’ve deducted the Medicare and Social Security taxes from your paycheck… not even close. Next comes the federal tax on your “Ordinary Income.” This is also referred to simply as “income tax.”
Taxed Amount
Ordinary Income tax rates are applied to Adjusted Gross Income less any applicable deductions.
Tax Rate
The Ordinary Income tax system is progressive, meaning that the rate applied to income increases along with income. These rates range from 10% to 37%, as detailed below.
Additional Notes
There is effectively a 0% tax bracket as well. Because gross income is reduced by either a Standard or Itemized Deduction, taxpayers making under a certain amount will owe no income taxes.
Examples
Example #1: Single taxpayer with taxable income of $150,000
Taxes Due: $29,034 (see below for details)
Example #2: Married couple filing jointly with taxable income of $500,000
Taxes Due: $115,373 (see below for details)
Ordinary Income Tax Brackets
The tables below present the ordinary income tax brackets for 2024, for single taxpayers and married couples filing jointly.
| Tax Rate | Single Income Range | Single Taxes Owed | Married Filing Jointly (MFJ) Income Range | MFJ Taxes Owed |
|---|---|---|---|---|
| 10% | $0 to $11,600 | 10% of taxable income | $0 to $23,200 | 10% of taxable income |
| 12% | $11,601 to $47,150 | $1,160 + 12% over $11,600 | $23,201 to $94,300 | $2,320 + 12% over $23,200 |
| 22% | $47,151 to $100,525 | $5,426 + 22% over $47,150 | $94,301 to $201,050 | $10,852 + 22% over $94,300 |
| 24% | $100,526 to $191,950 | $17,160 + 24% over $100,525 | $201,051 to $383,900 | $34,337 + 24% over $201,050 |
| 32% | $191,951 to $243,725 | $39,111 + 32% over $191,950 | $383,901 to $487,450 | $78,221 + 32% over $383,900 |
| 35% | $243,726 to $609,350 | $55,679 + 35% over $243,725 | $487,451 to $731,200 | $111,357 + 35% over $487,450 |
| 37% | $609,351 or more | $183,647 + 37% over $609,350 | $731,201 or more | $196,670 + 37% over $731,200 |
Example: a single taxpayer with taxable income of $150,000 would owe taxes as follows:
- The first $11,600 is taxed at 10% (10% x $11,600 = $1,160);
- Income up to $47,150 is taxed at 12% (12% x $35,550 = $4,266);
- Income up to $100,525 is taxed at 22% ($53,375 x 22% = $11,743);
- Income up to $150,000 is taxed at 24% ($49,475 x 24% = $11,874)
Example: a married couple filing jointly with taxable income of $500,000 would owe taxes as follows:
- The first $23,200 is taxed at 10% (10% x $23,200 = $2,320);
- Income up to $94,300 is taxed at 12% (12% x $71,100 = $8,532);
- Income up to $201,050 is taxed at 22% ($106,350 x 22% = $23,485);
- Income up to $383,900 is taxed at 24% ($182,850 x 24% = $43,884);
- Income up to $487,450 is taxed at 32% ($103,550 x 32% = $33,136);
- Income up to $500,000 is taxed at 35% ($12,550 x 35% = $4,393).
Tax #4: Dividend & Long Term Capital Gains Tax
While interest income from bonds and any short-term capital gains are taxed as Ordinary Income, investors are able to get more favorable tax treatment for certain investments. Specifically, qualified dividends (which are most dividends paid by public companies) and capital gains on investments held for more than one year are taxed at a different rate.
Taxed Amount
This tax applies to all qualified dividends and long-term capital gains (generally, gains realized on a position held for one year or longer).
Tax Rate
This tax system is progressive, meaning that the rate applied to income increases along with income. These rates range from 0% to 20%, as detailed below.
Additional Notes
The top rate is effectively 23.8%, as there is a 3.8% Medicare surcharge applied to amounts subject to the 20% tax.
Examples
See below for examples — the rules are a bit complicated.
Dividend & Long Term Capital Gains Tax Brackets
Similar to Ordinary Income, the taxes that apply to long-term capital gains and qualified dividends are progressive in nature.
| Filing Status | 0% | 15% | 20% |
|---|---|---|---|
| Single | $0 to $47,025 | $47,026 to $518,900 | $518,901 or more |
| Married Filing Jointly | $0 to $94,050 | $94,051 to $583,750 | $583,751 or more |
The math to figure out which bracket applies to your dividends is a bit tricky. You need to consider your total taxable income, which includes Ordinary Income, as well as dividends and capital gains.
Example: married couple filing jointly, with $10,000 in dividend income and $118,250 in salaries.
Subtracting the standard deduction of $29,200 from the salary gets us $89,050 that is subject to Ordinary Income taxes.
From here, we “fill up” that dividend tax brackets. We do this by adding the dividends to the Ordinary Income. The first $5,000 in dividends is taxed at 0% (since that takes us up to $94,050). The next $5,000 in dividends is taxed at 15%, resulting in a total tax of $750.
Summary: The Four Income Taxes
Below is a summary of the four types of income taxes. Next, we’ll discuss which taxes apply to which types of income, laying the groundwork for understanding how to minimize (or even eliminate) these taxes.
| Tax | Rate Type & Amount | Applies To |
|---|---|---|
| FICA - Medicare | Progressive 1.45% to 2.35% | All Wages |
| FICA - Social Security | Flat 6.2% | All Wages up to $168,600 (2024) |
| Ordinary Income Tax | Progressive 10% to 37% | All Taxable Income |
| Long Term Capital Gains & Dividend Tax | Progressive 0% to 23.8% | All LT Capital Gains & Dividends |
Tax Treatment of Income
We’ve now covered the four types of income that can apply to the income you earn.
Now we can turn our attention to the different types of income, and understand which taxes apply to which income types.
From a tax perspective, not all income is created equal. For example:
- Income that you receive as wages or salary is subject to relatively unfavorable tax treatment; you’ll have to pay Medicare, Social Security, and Ordinary Income taxes.
- Interest income received from debt that you hold is not subject to Medicare and Social Security — but is subject to Ordinary Income taxes.
- Qualified dividends are subject to the dividend & long-term capital gains tax rates — which are generally more favorable than Ordinary Income rates.
The table below provides a summary of how several different types of income are taxed.
| Income | FICA Taxes | Ordinary Income Tax | Dividend / LT Cap Gains Tax |
|---|---|---|---|
| Wages / Salary | ❌ | ❌ | |
| Self-Employment Income | ❌ | ❌ | |
| Interest Income | ❌ | ||
| Interest Income in a Tax-Advantaged Account (IRA, 529, 401(k)) | |||
| Qualified Dividends | ❌ | ||
| Non-Qualified Dividends | ❌ | ||
| Dividends in a Tax-Advantaged Account (IRA, 529, 401(k)) | |||
| Short Term Capital Gains | ❌ | ||
| Long Term Capital Gains | ❌ | ||
| Capital Gains in a Tax-Advantaged Account (IRA, 529, 401(k)) | |||
| Royalties | ❌ | ||
| Rent | ❌ | ||
| Passive Business Income | ❌ | ||
| Social Security | ❌ [a] | ||
| Pensions | ❌ [b] | ||
| Roth IRA Conversions | ❌ | ||
| Roth IRA Withdrawals | |||
| Traditional IRA Withdrawals | ❌ | ||
| 401(k) Withdrawals | ❌ |
Key Takeaways
This chapter has contained a lot of numbers and information. Let’s simplify it to a few key takeaways…
Ultimately, tax efficient investing consists of doing three things: (1) getting a more favorable tax treatment for your income; (2) deferring the taxes due on your income, so that you can pay them later and not today; and (3) eliminating taxes on your income altogether.
Upcoming chapters will cover exactly how to do this.
Takeaway #1: The Best Times To Pay Taxes
Most tax strategies involve either deferring or eliminating one of the four taxes shown here. In other words, the two best times to pay taxes are “later” and “never.”
Takeaway #2: Favorable "Buckets"
Some income tax treatments are more favorable than others. For example, Ordinary Income rates are higher than taxes on Long Term Capital Gains. Thus, categorizing income more favorably can lead to tax savings.
Takeaway #3: Tax Arbitrage
Even within these tax “buckets,” not all dollars are taxed equally (due to the “progressive” nature of some rates). For example, your first dollar of Ordinary Income and your millionth dollar of Ordinary Income are taxed very differently.
Download This Guide As a PDF
Get the full PDF version of this Ultimate Guide To Tax Free Investing.
Your free instant download includes special bonus content.
Table of Contents
This page is part of our Ultimate Guide To Tax Efficient Investing. Follow the links below to read through the entire guide. Or, click here to download the full PDF version.
- Chapter 1: Why Taxes Matter (The One Big Myth) — The impact of taxes on your portfolio.
- Chapter 2: The Four (Yes, Four) Types Of Income Taxes — Understanding the “default” tax treatment your income receives.
- Chapter 3: Guiding Principles (And An “Aha Moment”) — Six rules of thumb that will make your life easier.
- Chapter 4: The 401(k) (Your Tax Free “Workhorse”) — My the 401(k) is the most powerful wealth creation account for most investors.
- Chapter 5: IRA Strategy (And the Value of Flexibility) — How to use IRAs optimally to minimize your lifetime tax liability.
- Chapter 6: Asset Location (And the Greatest Investment Ever Made) — Why it matters where you hold your bonds.