Income Tax

There are really two flavors of income tax in America:

Ordinary income tax (money you make from your ordinary job, a.k.a. your salary).

Investment tax (money you've turned into cash after having successfully made money investing it).

In the U.S., we tax people at different rates on the money they actively earn. Like...from working at a job...versus money they passively earn (like from gains on investments...or inheritances from dead grandparents).

In the interest of not making you want to vomit or fall asleep, we have simplified a ton of things for the sake of clarity. The overarching theme of income taxes is that the government has taken the position that the wealthy or successful or high earners should be taxed at a higher rate than people who earn less money.

And since the actual numbers change with seemingly every presidential cycle, we’re going to just simplify them here. But if you earned 100 grand last year, you’d be taxed at different rates on the different levels of money you earned. Like, you’re going to be taxed a percentage on a certain amount of that 100 grand, and then you’ll be taxed different percentages on the rest of it. This system is called “progressive.”

On the first $10,000 of earnings, you might pay zero tax. From $10,001 to $25,000 dollars, you might pay 10%, so that’s 10% on that next 15 thousand bucks of earnings, or $1,500. Then from 25,001 to 60,000 dollars, you might pay 20%, so that’s a 20% rate on the 35 grand spread there. So 7 grand in taxes there. Then, on the 60,001 dollars to 100 thou, you might pay 30%, or 30% tax on that 40 grand, so you would have paid 12 grand on that last 40 grand in taxes. The total amount you would have paid then is, let’s see...1,500 plus 7 grand plus 12 grand...so a hair over 20 grand.

Your average tax on that ordinary income for your federal tax would be 20.5%. Things get way more complex from here.

Many states have a state tax in addition to the income tax. Wyoming, Florida, and Texas have no state tax. They pay their bills from sales taxes and mineral/oil/energy taxes on corporations that drill there. California has the highest taxes on ordinary income, topping out at 13.3% for the wealthiest earners there.

Yeah, it’s a mess. There’s a reason H&R Block is so profitable.

A lot of things beyond your paycheck get taxed at ordinary income rates, like rent you collect from renting out your guest house. And short-term investment gains. Like if you paid 10 bucks a share for a stock, held it less than a year and flipped it for 15 bucks in that year. Then you’d be taxed as if that 5 dollar a share gain was ordinary income.

Okay, so thus far we’ve been covering flavor number one: ordinary income tax. Time for the second flavor: investment gain taxes. When you invest in a stock or land or gold or rare coins or...art...and you hold it for a year or longer, you receive what is called long-term gain tax treatment.

Taxes on long-term gains have historically been roughly half of ordinary rates. The system is designed to reduce volatility in the markets in which assets are bought and sold. By giving a benefit to investors to hold things longer, they tend to marry them rather than have lots of one night stands. It’s better for everybody. Long-term rates have hovered around 20% and change. So if you invested a hundred grand in a stock and held it 5 years, and it turned into 250 grand and then you sold it, you’d show a gain of $150k.

That $150k is your realized gain. You realized it when you got the cash wired to you in your brokerage account. So you’d be taxed 20% on the gain of $150k. Well, $150k times 20% is $30k. So, from your original investment, which turned into $250k pre tax, you’d keep after-tax; that's $250k minus $30k, or $220k. And note that many states tax gains on income as well. The above is just an example based on federal rates.

The gist here is to be able to distinguish between ordinary income, from sources like your part-time job at the Wendy’s drive-thru window, or the money you make shoveling Old Man Mathers’ driveway, or that bi-weekly paycheck you get for selling your soul to Geico...and investment income, which gets long-term gains treatment... like flipping an IPO that gets ordinary income tax treatment because you owned the stock for only a day or so, or a great long-term investment over five years in a soft drink company that ends up being acquired for big bucks by Coca-Cola, or an angel funding of two kids in a garage who end up making a car that actually flies without killing people upon landing.

So yeah, two totally different flavors. And both can leave a bad taste in your mouth.