It’s that time of the year, so let’s talk about taxes. I certainly understand that this can be a boring and tedious topic… but in many cases is THE MOST IMPACTFUL piece of your financial plan. So, whether you are managing your finances by yourself, or working with an advisor, it is incredibly important to think about the tax implications of every financial decision made.
I will be covering this topic over the next few weeks, so buckle down. This week will be a high-level overview of the workings of income tax brackets and qualified (retirement) assets.
Income Tax
The first thing I want to cover is the concept of how income taxes work (see the chart below for 2023 income tax brackets). Think of income tax like a layered cake… if you’re single, you pay 10% tax on the first $9,950 earned, then 12% everything earned over $9,950 up to $40,525, then 22% on everything earned over $40,526 up to $86,375, etc. A common misconception I see is that some think when we earn more and get pushed into a higher tax bracket, then all of the money we have earned is taxed at a higher rate. That’s not true… only the money we earn that is more than the specifc tax rate is taxed at that higher rate. So, your overall tax % paid will be effectively lower than the tax bracket you fall in. This is where we get the difference between marginal and effective tax rates.
It is important to track and manage your tax bracket for other tax implications that might exist like capital gains, dividends, and Roth conversions. If you are not monitoring the tax bracket you fall in each year and how far away you are from the next bracket, then I would recommend tracking that as a first step.
Qualified Assets
Next, it’s important we distinguish the difference between retirement assets and non-retirement assets as each of these buckets are taxed differently. Retirement assets are also called qualified assets and have specific tax advantages associated with them. Non-retirement assets are also known as non-qualified assets.
Let’s start with Qualified accounts. Think…
– Any Employer retirement plan (401k, 403b, 401a, SEP IRA, SIMPLE)
– IRA or Roth IRA
Qualified assets “qualify” you for certain tax advantages that aren’t available elsewhere. But, like most things in life, you have to give something up to receive something in return. For most qualified assets, generally, you are not allowed to withdraw from them until you are 59 1/2 without penalty. So, in this case, you are giving up liquidity to gain a tax advantage.
There are two tax advantages available in qualified assets…
1. Saving into a pre-tax account (401k, 403b, IRA, SEP, SIMPLE). Here, your contributions will count as a deduction towards your income because you’ve saved the money before paying taxes (hence the term pre-tax). For example, if you made 100k in income and contributed 10k to your pre-tax 401k, then you can deduct 10k from your income, making it 90k. The taxes owed on 90k of income is going to be less than taxes owed on 100k of income, where the tax advantage comes into play. However, when you withdraw money from this account in retirement, you will be required to pay income tax on the entire withdrawal.
2. Saving into a tax-free account (Roth IRA, Roth 401k, Roth 403b). These types of accounts work just the opposite of a pre-tax account. Here, you save the money after you’ve paid taxes, so there is no deduction or tax advantage felt today. Instead, when you retire and withdraw funds out of the account, you will owe zero taxes on withdrawal including any investment growth. This can be incredibly beneficial for a young investor who has a lot of time to let their investments grow and not have to pay any tax on this account when taking withdrawals in retirement.
Thanks for reading… stay tuned for more tax fun next week!
