Basics¶

Taxes¶

To have a good understanding of your finances, it is important to have a solid grasp of the basics of the US tax system and types of retirement accounts.

Marginal Tax System¶

The United States has a marginal tax rate system. Go watch this great video on what that means. It is important to note, and contrary to a somewhat common myth, that making more money and being bumped into the next tax bracket can never mean that you take home less money.

Deductions¶

The US government gives incentives for certain types of actions in the form of deductions. For example, if I donate $100 to charity the government gives me a deduction for the entire value of that. This means that I don’t have to pay taxes on that $100. If I already paid taxes on it, the government will give me a refund at tax time for the excess taxes I paid. Other than charity, some of the more common types of deductions include: home mortgage interest, state and local income taxes, real estate taxes, medical expenses, certain retirement accounts, student loan interest, and more.

Standard Deductions vs Itemizing¶

There is an additional complication to deductions though. The government defines a certain amount of money as the Standard Deduction [1]. If the sum of your deductions is less than the Standard Deduction, the government allows you to pretend you have deductions of that amount. This is known as taking the Standard Deduction. If the sum of your deductions is greater than the Standard Deduction, you would list out all of your deductions on your tax form which is known as Itemizing.

Capital Gains Tax¶

Most of the things we have talked about so far are in regards to income obtained through your job. Your employer gives you a check with some money witheld for taxes and you get the rest. Depending on how you use that money, you may have to pay additional taxes. For example, if you went out and bought a new hat you would have to pay sales tax on that in addition to the income taxes you paid (assuming you live in an area with sales tax). If you decided to put your money into a stock instead and that stock went up in value, you would owe a tax called Capital Gains [2]. This is important to understand because some types of retirement accounts will allow you to not have to pay income tax, while some types will allow you to not have to pay capital gains.

Retirement Vehicles¶

• What is a tax-advantaged account?

  • Let’s imagine that your employer agrees to pay you $100 and the income tax rate is 20% so you get a paycheck for $80. You decide to put all of that money into Google stock. Imagine Google stock shoots up and doubles in value. Your stock is now valued at $160. You will now need to pay taxes on the additional $80 that you made (capital gains). It is common to say that this money is being double-taxed since you were taxed originally when you made the money through income and then taxed again on the additional gains.
  • So what is a tax-advantaged account? If an account is tax-advantaged, it means you won’t have to pay taxes on it twice. Some types of account will allow you to not pay income tax on the money, some will allow you to not pay capital gains on the money, and some will allow you to not pay either tax.

• When you want to put money into a retirement account, there are usually three choices you need to make: tax-type, account type, and the investment. For example, I could have a Roth IRA invested all in Google stock. Roth would be my tax type (post-tax), the account type would be an IRA, and the investment would be in Google. Another example: I could have my traditional 401(k) invested all in Apple stock. Pre-tax would be the tax-type, 401(k) would be the account type, and Apple stock would be the investment.

• Tax-Type: Pre-tax vs Post-tax

  • There are generally two tax types for retirement accounts: pre-tax (often called Traditional) and post-tax (often called Roth). It is important to note the distinction between retirement account types and the actual investments. Pre-tax and post-tax specify the type of account while the actual investments would be things like Google stock or a mutual fund. You could have a pre-tax account with Google stock and a post-tax account with Google stock. We will talk more about actual investments in the next chapter.
  • Let’s talk about a hypothetical scenario to discuss these account types. Let’s say that you make $52,000/year, get paid weekly, and that you have an effective tax rate of 25%. So in a normal week without any retirement savings, your employer would pay you $1,000, but $250 would be taken out for taxes so you would end up with $750 for the week.
  • If you decided you were going to contribute $100 every week to a pre-tax account, what would change? Now your employer would pay you $1,000, $100 would go into your pre-tax account, $225 would be taken out for taxes, and $675 would end up in your check. The reason that only $225 is taken out for taxes instead of $250 is that you are not being taxed the 25% on the $100 that you are putting into your retirement account. That is why it is called pre-tax. When you are in retirement and decide to withdraw the money that has been accrued from this pre-tax account, you will be required to pay normal income tax on this at that time.
  • If you decided you were going to contribute $100 every week to a post-tax account, what would change? Now your employer would pay you $1,000, $100 would go into your post-tax account, $250 would be taken out for taxes, and $650 would end up in your check. Since this is post-tax, you are still being taxed on the money that you put into your account. The benefit of this type of account comes at retirement time. When you are in retirement and decide to withdraw the money that has been accrued from this post-tax account, you will not have to pay any tax. You can just withdraw the money. This also means that all of the increases in value for that account have grown tax-free.
  • It you didn’t use a retirement account and just invested the money yourself, you would pay normal income taxes on the money and then have to pay taxes again when you take the money out. With pre-tax, you don’t have to pay the taxes up front. With post-tax, you don’t have to pay the taxes at retirement. So the difference between the two is just when you will have to pay taxes on the investment.
  • Given that we now understand the difference between pre-tax and post-tax, which should you choose? The general opinion is that if you are young enough, the tax-free returns that you will gain on a post-tax account will outweigh the additional principal you could invest in pre-tax account. A lot of people will disagree with this though. If your retirement income is substantially lower than your non-retirement income, a traditional account may be better.
  • For the purpose of this guide, we will usually suggest post-tax accounts. If you have read other things and are very convinced that pre-tax is better for your circumstance, fine. To be honest, this is one of those things that people will discuss a lot but doesn’t really matter that much. This decision will not change whether you retire poor or rich. Maybe you will have to work an extra year or two if you decide wrong, but it isn’t the end of the world.

• Account Type: 401(k) vs IRA

  • We are not going to discuss pensions, 403(b)s, Thrift Savings Plan, or anything like that. Sorry. If you have anything like that, you should probably max that out before any IRA or 401(k).

  • Both 401(k)s and IRAs can be pre-tax or post-tax.

  • The two typical types of retirement accounts these days are 401(k)s and IRAs.

    • 401(k): this is an account provided through your employer. The money will come out of your paycheck. Depending on your employer’s options, you may have the possibility to contribute in a pre-tax or a post-tax 401(k). The actual investment choices for this account are limited to the options your employer has picked. Often these are pretty bad. You want to be very careful and look at what the expense ratio is for these options (an expense ratio is the percent that company that manages a fund charges you every year to run the fund). Generally, any expense ratio greater than 1% is not great.
    • IRA: this is an individual retirement account. Unlike a 401(k) this is not done through your employer. This is done on your own. You pick an IRA broker to give your money to and tell them what type of investment you want to have them put your money into. We will discuss one IRA Broker(Vanguard) more in the next chapter.

  • Khan Academy has a good overview of Traditional IRAs, Roth IRAs, and 401(k)s here.

• Investment:

  • We will discuss the actual investments in the next chapter.