Federal Income Tax Code - Simplified
If you studied the IRS Tax code and all the supporting documents to help you understand it you’d be reading about 70,000 pages or more of text. The way your money is taxed can be broken down into 5 broad categories.
The IRS Tax code and supporting documents number over 70,000 pages
The 5 Categories of Tax Treatment for your money:
Taxable Money - pay the tax now
Tax Deferred Money - pay the tax later
Tax Deductible Money - reduce the tax by reducing income with deductions
Tax Free Money - pay no tax at all
Tax Credit Money - they give you money straight up
Now, wasn’t that simple? Believe it or not it takes CPAs and tax prepares to have knowledge of those 70,000 pages (or at least where to look) to decipher it all.
Key Observation:
The list above puts the tax treatment of your money in order of the advantage to you. #1 being the least advantageous with #5 Being the best. The more money you can move down the list the better off you’ll be.
Key Strategies:
Tax credits usually involve taking specific actions or having specific behaviors for which the government wants to reward you. This might be for things like investing in specific green technologies or having children or saving for retirement if you are low income.
Tax free money is hard to come by. This could be things like Roth IRA money, non-modified endowment life insurance cash values, HSA qualified withdrawals and so on.
Tax deductible money is a great tax advantage because you don’t have to pay taxes on the income that can be deducted. Owning your own business for example allows you to take tax deductions for qualified business expenses. Contributions to retirement accounts are sometimes tax deductible as well. Employee type earned income is difficult to tax deduct but some group benefits may qualify like health insurance premiums .
Tax deferral only delays the tax calculation. Be cautious of tax deferral - you might be in a higher tax bracket in the future which could result in “reverse tax planning.” Tax Deferral is things like unrealized capital appreciation, 1035 exchanges, Qualified Retirement Plans, Deferred Compensation or IRAs.
Taxable money is taxed now. Sometimes this is to your advantage and sometimes it is not. Earned income is taxed at income tax rates and realized capital gains are taxed at capital gains tax rates. Your tax bracket(s) may vary with income, type of income, and other factors. Be mindful of government policy risk - tax laws can change with the political winds.
Hope that clears things up with the 70,000 pages! Phew - you can thank me later!
Keith Kail - Founder
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