In this episode: If business taxes are as clear as mud, personal taxes are quicksand. Jon Peyton explains the difference between your marginal tax bracket and your effective tax rate, the other taxes high earners can face, and how capital gains and losses work. He also shows why understanding these basics helps you plan how you’re paid.
Key insights
- The U.S. tax system is progressive. Your top bracket isn’t the rate you pay on all your income.
- Your effective tax rate (total tax divided by income) is usually well below your top marginal bracket.
- State taxes vary widely. States without an income tax may collect more through property or other taxes.
- High earners can owe additional taxes, such as the net investment income tax and the additional Medicare tax.
- Long-term capital gains generally get lower rates than short-term gains, and capital losses can offset gains.
Episode timeline
- 0:00 Personal taxes: into the quicksand
- 2:04 Marginal brackets versus effective tax rate
- 5:24 Brackets change with the law
- 5:28 A single-filer example
- 7:33 Finding your effective rate
- 8:53 State income and property taxes
- 11:59 How the way you’re paid affects your taxes
- 16:29 The net investment income tax
- 17:25 The additional Medicare tax
- 17:57 Short-term and long-term capital gains
- 19:45 Using capital losses
- 20:22 Provisions set to expire
The episode in brief
Marginal versus effective. Many people say “I’m in the 32% bracket” as if they pay 32% on everything. The U.S. system is progressive: each slice of income is taxed at its own bracket’s rate. Jon walks through a single filer using the brackets he cites: income of $164,925, the top of the 24% bracket, owes $33,603 before any deductions or credits. That’s an effective rate of about 20.4%, well below 24%. Brackets are adjusted for inflation most years, so the dollar thresholds change, but the math works the same way. Deductions such as retirement contributions, HSA contributions and certain itemized deductions lower taxable income and, with it, your effective rate.
State taxes. Most states add their own income tax, sometimes up to around 10%. Some states have none, but may collect more through property or other taxes. Jon notes that family in Texas pay no state income tax but face higher property taxes, which can offset much of the savings. If you’re weighing a move, compare the total tax picture, not just the income tax rate.
How you’re paid matters. Building on the last episode, Jon shows how splitting an owner’s income between a reasonable salary and distributions, rather than taking everything as salary or bonus, can change the overall tax bill. The specifics depend on your entity, income and state, so model it with your CPA before you change anything.
Other taxes high earners face. Above certain income thresholds (at the time of recording, $200,000 for single filers and $250,000 for married couples filing jointly), the 3.8% net investment income tax can apply to investment income, and a 0.9% additional Medicare tax can apply to wages and self-employment income. These add to federal and state income taxes.
Capital gains and losses. Gains on investments held a year or less are taxed at ordinary income rates. Long-term gains generally get lower rates. Capital losses can offset gains, up to $3,000 of excess losses can offset ordinary income each year, and unused losses carry forward.
The law keeps changing. At the time of recording, many provisions of the 2017 tax law, including brackets, estate tax limits and the QBI deduction many owners use, were scheduled to expire after 2025. Tax planning is never one-and-done.
Key action items
- Calculate your effective tax rate. Divide last year’s total federal tax by your total income to see what you actually pay.
- Ask your CPA about thresholds. Find out whether the net investment income tax or the additional Medicare tax applies to you.
- Review how you’re paid. Model your salary and distribution mix with your CPA before year-end.
- Harvest losses deliberately. Talk with your adviser about using capital losses to offset gains, rather than letting them sit.
Listen next: Episode 33: The Four Ways Entrepreneurs Protect Their Business’s Legacy
Value Creation Consultancy™ has since merged into Founder’s Accounting™.
Tax rules, rates and limits mentioned reflect the law at the time of recording in 2022 and may have changed since.
This episode is educational and isn’t legal, tax or financial advice. Speak with your own attorney and advisers about your situation.