Now that I’ve laid the foundation, let’s take some time to discuss taxes and how they affect the four different types of income. Then I’ll talk about debt and how to use it to your advantage.
Because taxes affect all income, let’s learn how our tax system works and how we can reduce our taxes.
Taxes are paid based upon the tax bracket you fall into. Tax brackets are determined by your net income amount.
Your tax bracket is the rate you pay on the “last dollar” you earn.
The highest bracket you pay tax on is called your marginal tax rate.
Following are the Federal tax brackets for 2014 and California tax brackets for 2014.
Federal Income Tax Table for 2014
|Tax Bracket||Married Filing Jointly||Single|
|39.6% Bracket||$457,600 and above||$406,750 and above|
California Income Tax Table for 2014
|Tax Rate||Married Filing Jointly||Single|
Looking at the Federal Income Tax Bracket chart, a single person with $50,000 in taxable income would be in the 25% bracket. However, they would only pay 10% on their income between $0 and $9,075, 15% on their income between $9,075 and $36,900, and then 25% of their income between $36,900 and $50,000.
Federal taxes owed on a $50,000 taxable income:
$870.00 on income between $0 and $9,075 (10% bracket)
$3,997.50 on income between $9,075 and $36,900 (15% bracket)
$3,662.50 on income between $36,900 and $50,000 (25% bracket)
$8,530.00 Total Federal tax owed
Even though this person is in the 25% tax bracket, they only paid 17.06% of their taxable income in federal taxes. This is quite a bit better than 25%.
This number also does not include the standard deduction that the IRS allows each taxpayer (with lots of qualifying rules). For a single person this amount is currently $6,100. This would reduce the taxable income to $43,900, resulting in a tax bill of $7,005.
So, the amount of income and the type of income you make determine your taxes.
Let’s now go over the four basic types of income that you can receive: earned income, portfolio income, passive income, and capital gains.
Earned income is money earned from a job or profession, usually in the form of a salary paycheck from an employer, but also as commissions.
This income is the most heavily taxed of all the forms of income.
Earned income is subject to taxes coming right off the top; that is, the government deducts federal, state, Medicare, Social Security, disability, and other taxes before you get your pay. Employers also deduct health insurance, union dues, and other items from your paycheck. Also, any retirement contributions are deducted out of your check.
The amount you earn in salary or commissions before any deductions is the gross amount; the amount you actually take home is the net amount.
Most people are disillusioned to see how little money they receive from their paycheck after the government and everyone else has taken their cut. The net amount is usually far lower than their gross amount.
There are a few major drawbacks to earned income. The first is that earned income requires you to physically work for your income, and it generally stops coming in once you stop working. There is no residual aspect to earned income; you work, get paid, and have to work again to get paid again.
But the most damaging drawback is that you have little control over how much you pay in taxes and when you pay taxes. Taxes are taken out before you receive your net amount.
Unless you are very highly paid as an employee, it is difficult to become wealthy when so much of what you make goes to taxes and other deductions.
Maybe you have heard about Taxpayer Freedom Day, which usually is in mid-April each year. For many wage earners, they work from January to mid-April just to pay taxes to the government! Then the rest of the year’s income is for themselves that they get to keep.
Some people look at working from 8 AM – 11:30 each day as working just to pay the government’s taxes.
Because of these major disadvantages with earned income, the wealthy look to reduce earned income as much as possible.
They are wealthy because they don’t work for earned income; they work to earn the other more tax-advantaged types of income.
Unfortunately, as an employee there is little you can do to reduce taxes, aside from contributing to a tax-deferred retirement account.
So, if you are an employee or self-employed, your goal is to take money earned from your job (earned income) and learn to invest it in assets that generate portfolio or passive income which is taxed at lower rates.
Learn the secrets the wealthy use to become wealthy in this FREE eBook. It’s a must for anyone who wants to become financially successful!