Understanding Taxes

  • January 15, 2023
  • malikshehu
  • 7 min read

We usually cringe when we hear the word “taxes”. Tax is what you and your business pay to the government as a compulsory contribution. 

The government uses taxes to keep street lights on and fix roads. It’s how citizens get free healthcare (in certain countries), how your country’s defense sector gets funded, how police officers are paid to protect the city, and how we take care of people living in extreme poverty. 

It’s up to the government to budget and plan for how to deploy tax funds effectively. 

You know why we pay taxes, but as a newbie investor let’s look at two taxes that may affect your investment returns. 

Income Tax

Income tax reduces your overall return on investments

This is a tax on income generated by individuals and companies and is the biggest source of income for the government. It. 

  • As a landlady, your rentals are subjected to income taxes.
  • As an employee, your salary is subjected to income taxes.
  • As an investor, your dividends are subjected to income taxes.
  • As an entrepreneur, your profits (revenue minus expenses) are subject to income taxes.

Income tax laws vary in different jurisdictions. These variations can be in:

  • Tax rates (eg 5%, 10%, 25%, etc of your total income).
  • Tax credits and tax deductions you are eligible for.
  • Tax brackets (eg income from $2000 to $5000 are taxed at 5%; $5001 – $8001 at 10%, etc).
  • Type of income to be taxed (e.g., dividends from shares can be taxed but income from municipal bonds is not taxed). 

There’s a difference between gross income and taxable income. Gross income is all the money you receive while taxable income is the portion of the gross income that is subject to taxation. 

So your gross income might be $10,000 but only $8,000 is what is taxed while the remaining $2,000 is tax-exempt. 

Let’s have an example of how income taxes work using the USA’s annual income tax rates. Note that there are different tax rates and brackets for single filers, married but filing separately, head of household, and married filing jointly. We’ll use the tax bracket for single filers to illustrate how it works. 

Say you earned $50,000 that year. Your marginal tax rate would be 22%.  

You can find out how much you owe in each bracket: 

  • Your first $10,275 would be taxed at 10% = $1,027.50.
  • Your next $31,500 (calculated by subtracting $10,275 from $41,775) is taxed at 12% = $3,780.
  • Finally, the remaining $8,225 ($50,000 – $41,775) is taxed at 22% = $1,809.50. 

Looking at the totals: 

Total taxable income is: 

$10,275 + $31,500 + $8,225 = $50,000, and 

The total tax due for the year is:

$1,027.50 + $3,780 + $1,809.50 = $6,617

The calculations above can be compressed by doing it as follows:  $4,807.50 + [22% x ($50,000 – $41,775) = $4,807.50 + $8,225 = $6,617

Sometimes, your entire gross income isn’t taxed. You may have earned $50,000 that year but only pay tax on $40,000, effectively reducing your annual tax due to $4,594.50.

A tax reduction could be due to tax deductions or tax credits.

Tax Deductions 

These are amounts that reduce your taxable income, effectively reducing the overall amount you have to pay in taxes. 

Examples of tax deductions are:

  • Healthcare costs
  • Mortgage Interest
  • Investment losses
  • Student loan interest
  • Charitable contributions
  • Retirement Contributions
  • Unusual business expenses 

If the deductions are large enough, you can move from a higher tax bracket to a lower tax bracket.

Tax Credits

Unlike tax deductions that reduce your taxable income, tax credits are reduced directly from the tax owed. 

For example, as we saw above, your tax on $50,000 is $6,617. If you were eligible for a $3,000 tax credit, your taxes would reduce to $3,317. 

In some cases, your tax credits can be more than the tax owed, making you eligible for a refund. 

Examples of tax credits are:

  • Adoption credit
  • Investment tax credit
  • Lifetime learning credit
  • Child and dependent care credit
  • Research and development tax credits

Knowing the basics of income taxes helps you file your taxes at the end of the tax year. 

Knowing beforehand how much you’d owe in income taxes at the end of the tax year also helps you budget for it. 

Income taxes reduce your disposable income, meaning you have less money to invest or do other things. Income taxes can also reduce your overall return on investments. 

For example, the dividend you get is taxed as ordinary income. You may have gotten $500 as dividends, but after taxes, you are left with $400, reducing your total rate of return.

While income tax taxes your income, capital gains tax taxes your realized profit on investments.

Capital Gains Tax (CGT)

Short-term CGT is higher than long-term CGT

Capital gains tax is a tax on the profit you make when you sell (or “realize”) a capital asset for more than you paid for it. Capital assets can include stocks, bonds, mutual funds, real estate, and other investment properties. 

Depending on the asset and how long you hold it, the gain may be subject to a short-term or long-term capital gains tax. 

Short-term is if you hold the capital asset for less than a year. Long-term is anything longer than a year. In most jurisdictions, short-term CGT is similar to your ordinary income tax rate. 

If you held it for more than one year, the gain would be considered a long-term gain and taxed at a lower rate.

The rate of tax depends on your income for that year. Still using the USA as an example, capital gains tax can be 0%, 15%, or 20% of the realized profit depending on your income.  

For example, say you bought a stock in January 2022 for $4,000. In June 2023, the stock is worth $10,000. Since you haven’t sold it, you have an unrealized gain of $6,000. No tax is levied upon you. 

If you sold it, however, you will have to pay tax on the profit of $6,000. If your taxable income for the year is $500,000 and you are a single filer, then you will pay a CGT of 20% = $1200. 

In some countries, there are different CGT rates depending on the assets like artwork and real estate. 

CGT also reduces your return on investments as it reduces the total amount of profits you get. 

You can offset your capital gains taxes by realizing capital losses. This is called “tax-loss harvesting”. 

For example, if you have a capital gain of $10,000 and a capital loss of $11,000, you can offset the gain with the loss and pay zero CGT. 

There are complexities involved in using losses to offset gains, but the notion is that it can be a good strategy to reduce the overall taxes you have to pay. 

You can also use tax-advantaged accounts, like retirement and education accounts, to reduce the total amount of tax you pay. 

Taxes and Investing

Paying taxes is encouraged and evading taxes is illegal. Avoiding taxes on the other hand is legal and is done to lessen one’s tax liability and maximize their after-tax income. 

A financial advisor or tax expert can help you structure your finances and investments in such a way that you don’t pay egregious taxes and are also abiding by the tax laws of your country. Speak to one today.