As discussed in our individual tax section, taxpayers are subject to regular tax, alternative minimum tax, capital gains tax, surtaxes, and phaseouts. Knowing your true tax rate is difficult due to the number of different rates that may apply and is more complicated than knowing your “tax bracket.”
Your total tax as a percentage of all income is your effective tax rate. The incremental tax as a percentage of the next dollar of income is your marginal tax rate. While both the effective and marginal rates are important, the marginal tax rate is the basis for tax planning.
Understanding your balance sheet — and the types of investments on it — is an important tool in determining not only your marginal tax rate but also your overall tax efficiency.
To help understand how asset types affect your marginal tax rate, consider these asset types and the factors that affect the taxation of the income they generate:
- The human asset — compensation
Salaries, bonuses, options, and other forms of compensation are generally taxable while fringe benefits like health insurance and payments to retirement plans generally aren’t. You may want to consider timing income so that it’s paid in years when a lower marginal rate applies. - Investment assets
Your portfolio investments often have different income tax treatments depending on their types. Bonds may pay interest that’s taxable or tax-free. Stocks may pay dividends that are taxed at ordinary rates or “qualified” dividends that are taxed at preferential rates. Capital gains are generally taxed at preferential rates lower than ordinary income, but there are several exceptions. Proper planning requires that you weigh risk against reward (net of appropriately estimated taxes). - Business assets
If you’re involved in a business, directly or indirectly, it’s critical to understand how the business is structured for tax purposes since different tax regimes apply, depending on the business’s tax classification. It’s also important to understand “active” vs. “passive” activities for tax purposes (see page 3). This classification can have a significant impact on how income and losses are grouped and whether losses can be deducted.
What you owe should never be a surprise
Good income tax planning means you should never be surprised by how much you owe or when you owe it. A tax advisor’s understanding of your balance sheet helps them understand the assets you own and the tax implications of the assets’ income and related tax deductions.
As we near the end of the year, it’s important to review your current wealth management strategies to ensure you’re getting maximum returns on investments and that tax strategies are properly implemented. Understanding your balance sheet is the cornerstone of effective wealth management and tax planning.
