Behavior Incentive

Taxes are boring. Studying tax law is boring. Understanding taxes is powerful. The tax code is not static and not consistent. In fact, the tax code is a dynamic evolving use of public policy to encourage certain behaviors. Today’s topic is a clear example of this. In recent articles I have discussed at a high level the way salaries and self-employment income are taxed. Generating household income through employment or as a business owner or independent contractor is nothing short of a requirement for most people. Congress recognizes that most households cannot survive without productive labor and therefore feels no need to provide additional incentives to encourage gainful labor under the tax code, with few exceptions.1

Most people, however, do not view saving and investing as a requirement to survive. The federal government has an interest in people saving and investing so that the general population does not become dependent on the government due to a lack of financial wherewithal. As a result, certain types of investment income are taxed at a much lower rate than earned income. You can significantly change your after-tax household income just by understanding the incentives Congress has placed in the law. Investment income, at a high level, can be broken down into three tax categories.

Non-Qualified Investment Income

Non-qualified investment income is taxed at ordinary income tax rates which are the same income tax rates applicable to earned income. The major difference between non-qualified investment income and ordinary earned income is that investment income is not subject to payroll taxes. Avoiding payroll taxes can reduce the tax rate by as much as 15.3%.

The most common examples of non-qualified investment income are interest income, annuity payments, royalties, and short-term capital gains. These categories of income are always taxed at ordinary income rates.

Qualified Investment Income

Qualified investment income is taxed at reduced rates referred to as capital gain tax rates shown below. The two primary examples of income taxed at these reduced rates are qualified dividends and long-term capital gains.

Qualified dividends are payments to shareholders from domestic or qualified foreign C corporations out of its earnings and profits. In order to be considered qualified the taxpayer must also hold the stock for at least 61 days during a 121 day window which begins 60 days before the ex-dividend date.

Long-term capital gains are gains on the sale of capital assets held at least a year and a day. A capital asset is any property except inventory, depreciable or real property used in a trade or business, a patent, business accounts receivable, US publications, dealer held commodities, any hedging transaction, and supplies used in a trade or business. Depreciable or real property held in a trade or business for at least a year and a day is considered a 1231 asset and can potentially qualify for the long-term capital gain rates.

Dividends & Capital Gains Rates

RateBottom of the BucketTop of the Bucket
0%-75,900
15%75,901470,000
20%470,001

Tax-Exempt Income

The third high level category of investment income is investment income exempt from federal income tax. Tax-exempt income usually comes in the form of municipal bond interest income. Tax-exempt interest is yet another incentive introduced by congress to allow local governments and public agencies to service their debt at lower interest rates and still have a competitive effective after-tax rate of return to the investor. It is important to note that tax-exempt interest may be taxable under the alternative minimum tax calculation. The alternative minimum tax is beyond the scope of this article but should be considered when selecting various sources of investment income.

Household Take Home

To illustrate the power of behavior incentives in the tax code consider the following households. Each household is a married couple with no kids that has $100,000 in total income in 2019 and their itemized deductions do not exceed the standard deduction.

Household Take Home

Take Home
Self-EmployedEmployeeNon-Qualified InvestmentQualified InvestmentTax-Exempt Income
Income100,000100,000100,000100,000100,000
Tax20,31116,3348,684--
Take Home79,68983,66691,316100,000100,000

The household with self-employment income paid $20,311 in combined 2019 federal taxes while the households with qualified dividends and tax-exempt interest did not pay any federal taxes. This illustration demonstrates the real-life impact taxes have on a household’s take home pay. It is obvious that not all these options are available for every household. It is much easier to find a job with a $100,000 salary than it is to find $2,500,000 to invest and receive a 4% dividend of $100,000 annually, however, the way in which different categories of income are taxed should be a consideration as your household structures its financial future.

Conclusion

Investing is a game against time. The winners of the game understand the power of time and the impact of the various rules to the game, one of which is taxes. While creating a portfolio that can generate qualified investment income to replace your earned income might seem out of reach it all starts with intentional daily decisions to invest in your future. Those who excel are not just investing with dollars but investing their time to understand the rules to the game.

1There are several personal tax credits that require earned income in order to qualify. One large incentive Congress implemented for low income households with earned income is the earned income tax credit.