Posted By: CFP&WM On: Aug 8th, 2011 In: Money Matters

A Basic Guide to Americas Most Common Income Taxes

As a teenager I worked in an ice cream store. There were 31 flavors, so I think you know which store in which I worked. My problem with ice cream is I like all the flavors. That is not the case with the different flavors of income tax.

The most common flavor of income tax is Fully Taxable. The sources of income subject to full tax are wages, bonus, business income, partnership income, bank account interest, alimony, pensions and rent that you might receive. The tax rates are 10%, 15%, 25%, 28%, 33% and 35% depending on your total income. With the current financial status of this country, it’s pretty clear that these income tax rates will be going up at some point in the future.

The second flavor of income tax that’s better than the full tax flavor is deferred tax. This includes traditional IRA’s, 401K, 403B 457 and a few others. It depends on the type of employer as to which type plan is offered but regardless to the plan they all provide the same feature. They allow employees to defer income until the retirement years when you might be in a lower bracket. With this flavor of tax you don’t pay now you pay later when you take the money out.

The third tax flavor is preferred tax status. Many of you who are retired do have this preferred tax on your Social Security benefits. If you’re in a low income tax bracket you pay no tax on your Social Security benefits. If you have some additional income you could tax on up to 85% of your benefits. Some of you might be old enough to remember the government’s previous promise never to tax Social Security benefits.

Another type of preferred flavor is that of long-term capital gains. If you invest in stocks or other types of investments and hold it for longer than one year, sell the item and reap a profit, you pay less than ordinary income. If you are in a low tax bracket would pay zero tax and in higher brackets long-term tax rates are 15% which is honestly preferred to the higher rate of fully taxable.

A perpetual tax flavor favorite is tax-free. The income from municipal bonds is what most people think of when they think of tax-free income. There are however many other sources of tax-free money. When someone gives you a gift, there is no tax due. If you receive an inheritance, there is no tax due. Life insurance payouts are income tax-free. When a couple sells their home, there is no income tax up to $500,000. Child support is tax free to the recipient. Roth IRA withdrawals are tax-free. Health Savings Account withdrawals are income tax free as long as you use it for a qualified expense. 529 plan with drawls for college education are tax-free when the proceeds are spent on qualified expenses.

The fifth flavor is not bad but is not great. It is when there is no tax due because the income is below the taxable threshold. On one hand its good because no tax is due. Yet it is not so desirable in that there may not be adequate resource to fund current needs and save for the future.

The last flavor of tax is the Alternative Minimum Tax. The Federal government invented this particular flavor years ago for the purpose of making sure the “wealthy” pay their “fair share”. When the legislature wrote this rule they did not index the law for inflation. As a result, years later, it is impacting many middle-income taxpayers. Unfortunately, our lawmakers don’t have the time to eliminate this flavor from our ice cream shop oh I mean tax code.

As a financial planner as well as a taxpayer, my favorite flavor is tax-free, followed by tax preferred then tax-deferred. I have to put up with fully taxable but I personally have never had to taste Alternative Minimum tax. What are your favorites, if any?

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