4 Tax Concepts That Are Often Misunderstood

I decided to get a head start on my personal taxes this year.

Tax laws change constantly, which makes tax preparation a challenge each year. However, there are some tax concepts that don’t change a great deal from one year to the next. My CPA told me that learning these concepts will help me understand the information on my tax return. 

The first concept explains investment gains and losses.

1. Realized Gains and Recognized Gains

When you buy an investment (stocks, bonds, property, etc.) and sell it for more than you paid for it, you have a realized gain. If a gain is taxed, it’s a recognized gain. However, not all realized gains are recognized gains. 

Confused? I’ll provide two examples.

Assume that I bought 100 shares of IBM common stock at $20 per share, and my total cost is $2,000. Five years later, I sold the 100 shares for $50 per share, totaling $5,000. My realized gain is ($5,000 – $2,000), or $3,000. Assuming that the stock shares are not held in a retirement account or some other tax-deferred account, the entire $3,000 is also a recognized gain. I pay tax on $3,000.

Fortunately, you may be able to offset realized gains with realized losses, so that the tax on your gains is reduced. 

What about a gain on the sale of your home?

In this example, assume that I bought my home for $200,000 and 25 years later I sell it for $350,000. I have a $150,000 realized gain — but how much is taxed as a recognized gain?

Like many tax issues, it depends.

This IRS Publication explains that: “Taxpayers who are selling their home may qualify to exclude all or part of any gain from their income when filing their tax return.” If the home was your primary residence and you meet other requirements, you may be able to exclude up to $250,000 of the gain from your income.

In my example, the $150,000 realized gain may not be recognized at all, meaning that none of the gain is taxed. This tax law is in place so that taxpayers who sell their primary residence can keep more of the gain, possibly to fund retirement.

2. Understanding the Self-Employment Tax

If you’re self-employed, or own certain types of businesses, you must pay the self-employment tax. The tax is confusing, and many people don’t calculate the tax correctly, or don’t deduct the correct amount on the tax return.

Here’s a good way to understand the concept: All taxpayers, including employees and people who are self-employed, have to pay Social Security and Medicare taxes. This happens in one of two ways:

• Employee payments: FICA taxes, which fund Social Security and Medicare, are withheld from payroll and reported to the employee on Form W-2. The employer and the employee each pay a portion of the tax. This publication explains that “the current tax rate for social security is 6.2% for the employer and 6.2% for the employee, or 12.4% total.”

• Self-employment tax: If you’re self-employed, you pay both the employer and employee portion (12.4%), and deduct the employer portion (6.2%) as a business expense.

In both cases, the employee pays 6.2%, and that’s the key to understanding this tax concept.

3. Working with the Marginal Tax Rate

You’ll hear the marginal tax rate discussed in the financial media, and the marginal tax rate is not the tax you pay on all of your income. The tax rates are different.

The reason for the difference? Most taxpayers pay more than one tax rate on their income. Here are some of the 2022 Tax Brackets, reported by Kiplinger, for a single tax filer:

• 12% Taxable income $10,276 to $41,775
• 22% Taxable income $41,776 to $89,075
• 24% Taxable income $89,076 to $170,050

There are seven tax rates for 2022, but I’ll show a portion of the rates to make the point. The dollars you earn between $10,276 to $41,775 are taxed at 12%. If your total earnings are $70,000, the dollars you earn between $41,776 to $70,000 are taxed at 22%.

You get the idea.

The point is that the total tax you pay is based on multiple tax rates. Your marginal tax rate is the rate you pay on the next dollar of income. If your total income is $70,000, your marginal tax rate is 22%.

Wanna know the percentage of your income you paid as federal income tax? Divide your total tax liability by your taxable income. You’ll find that the percentage is less than the marginal tax rate.

4. How Are Federal Taxes Paid? Two Ways

If you’re a business owner who generates taxable income from a business and earns other sources of income (i.e., investment income, rental income from property), tax payments can be confusing. Remember that the IRS goal is to collect a large percentage of each individual’s tax liability before the end of the year. 

Here are two ways that taxes are collected during the year.

Employees pay federal income tax through tax withholdings on wages. The employer is required to send the worker a W-2 Form, which reports the amounts withheld. If your tax liability is more than the taxes withheld, you send the additional dollars owed with the tax return.

Pretty basic — something most people have worked with.

It’s different for business owners.

In most cases, the owner isn’t paid wages, so no taxes are withheld from wages. Instead, the owner pays estimated tax payments each quarter. Determining how much to pay can be difficult, since the taxpayer won’t know the total taxable income until the end of the year.

If this discussion makes you anxious, I don’t blame you. Calculating your tax liability can be more painful than a trip to the dentist, which is why you need help from a professional.

Work With a Tax Expert

The tax laws change from year to year, and so can your taxable income. For these reasons, get help from a CPA or an enrolled agent who prepares taxes. CPAs and enrolled agents are required to take continuing education courses to stay on top of the IRS rules, which benefits their clients.

At Stampli, we believe that succeeding in any business requires careful planning and a high level of professionalism.

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