Taxes – ugh – we all hate em. I was never taught anything about filing taxes in school and I studied Economics! It has always been this alien concept to me and over the years I have slowly started to pay attention to the cause and effect relationship my financial decisions can have on how much I might owe Uncle Sam at the end of a year. I am not a certified tax professional nor an advisor and have had to rely on such professionals to guide me through various tax laws along the years. This article is purely for educational purposes and covers things that I have experienced. Your tax situation could be completely different than mine – so please consult a certified tax professional when in doubt.
Income Levels and Tax Rates
Since I am at the time of writing this article a Single Tax filer for all intents and purposes, I start by understanding how I might be taxed based on earned income.
One thing to understand is that the US has a marginal tax system as indicated by the table below for tax year 2023:
Based on this, for a person earning $100,000 from their full-time employment (W-2) they will be taxed 10% on the first $11,000 i.e $1,100, 12% on the $11,001 to $44,725 i.e. $5,147 (including the $1,100) and so on for a total federal tax liability of ~$17,400. Note state taxes can vary but I choose to live in a no-income tax state so I only factor in federal taxes.
Standard Deductions
IRS lets you subtract certain deductions from your adjusted gross income to lower the amount of income you get taxed on. You can either take the standard deduction or itemize on your tax return. The standard deduction is a blanket amount you can subtract from your AGI without having to prove anything to the IRS – this is the easier option for most especially in your younger years as your tax situation isn’t as complicated yet. Alternatively, itemized deductions also reduce your taxable income — but they are more complicated and need detailed records.
Being a single filer after reading through the IRS’s list of eligible deductions, I realized taking the standard deduction is the better route.
Capital Gains and Losses
These refer to gains and losses incurred by trading stocks, bonds, ETFs and Mutual Funds in your non-tax advantaged brokerage accounts. Markets can be volatile in both directions and I have kept a strong investing philosophy tracking major P&L bookings I realized.
Tax-Loss Harvesting
One habit that has helped me a lot is leveraging Tax-Loss Harvesting to build up a realized loss even though I stay in my original position on paper. Here is a breakdown example:
Say I had $10,000 worth of SPY (that tracks the S&P500) and half-way through the year, it dropped to $7000 – a $3000 paper loss. I realize that loss by selling SPY and I immediately buy VTI (total US market ETF) for $7000 keeping in mind wash-sale rules. Now say, in the next few months, VTI goes down and my $7000 position is now worth $6000. Since it has been over 30 days since I last sold SPY, I can now sell VTI and repurchase SPY or any equivalent S&P500 tracking ETF/Mutual fund so as to realize another loss of $1000 for a total loss of $4000 realized while being back in my original SPY position only now it is worth $6000.
Why is this important? Well, for me, SPY is a key holding that I plan on holding forever and the opportunities to book such losses while still staying in the same equity are rare. The S&P500 has longer bull runs while having shorter bear dips and being able to build up a stash of these realized losses which over the years will scale up – helps me immensely as I can carry these losses indefinitely.
This allows me to offset future years short and long term capital gains as well as a $3000 offset against ordinary income each year I have these losses. This is especially great for people who have ESPP through their employers with the ability to sell their shares immediately at the end of the quarter at anywhere from 5-15% discount anyways as well as day-traders which realizes short-term tax liability at ordinary income tax rates.
Tax Loss Harvesting is a bit of extra work but can be very rewarding in the long run. Your future self will seriously thank you for accumulating those losses for when it is time to start booking profit or taking distributions of those 6 or 7 digit portfolios and not have to pay as much in taxes for N years to come.
Long Term Tax Rate
Another important factor a lot of people do not realize is that their tax rate on gains could vary drastically if they sold a stock or ETF in under 365 days vs 366 or more days. In 2023, the long term tax rates – based on one’s ordinary income and securities sold 1 year + 1 day are:
This can be crucial as based on your income, the higher bracket you fall in, you might pay higher short-term taxes. Note, if you have open losses being carried forward, you won’t pay any taxes on even long-term gains as long as they cancel each other out in the current year.
Retirement (401k, IRA) and HSA Plans
Many employers offer sponsored 401K plans and HSAs. These are different than an IRA account which is self managed/directed. For the purposes of this article, I will cover the traditional 401K, HSA and traditional IRA.
Contributions made to traditional retirement accounts are considered pre-tax and one may deduct their ordinary income by their contribution amount to potentially lower their tax bill. However, IRAs are income restricted as well as based on whether you have a retirement plan at work and it is important to note if you will qualify for those deductions or not. NOTE I am not covering Roth IRAs in this sections, if you’d like to learn more click here.
HSAs are triple tax advantaged accounts as the amount you contribute is pre-tax (hence allowing a deduction from your ordinary income), it grows tax-free when invested (which is highly recommended) and withdrawals for qualified medical expenses are tax and penalty free. NOTE: Any funds in your HSA after you turn 65, can be spent for anything (non-qualified medical expenses) — but it will be taxed as income at your then current tax rate. Qualified medical expenses will still carry the no tax benefit on withdrawal. HSAs are very powerful investment vehicles when the money is invested – be sure to fully leverage this.
Conclusion
While not a comprehensive list, these are some of the basic tax advantaged breaks one can be aware of and take accordingly to lower their end of year potential tax liability. In some cases a Roth IRA or Roth 401K might make more sense and in others a traditional – it all comes down to your specific tax situation which a certified advisor can help you better understand.
I personally follow some of these legal loopholes and avoid others based on my tax situation – which constantly evolves as I work more years and gain more insight into the changing tax code.
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