Ep. 45 | Not All Income is Taxed The Same

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Welcome to the Teaching Tax Flow podcast, where the goal is to empower and educate you to legally and ethically minimize taxes paid over your lifetime.

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Good day, everyone, and welcome back to Teaching Tax Full of Podcast, jumping into episode 45 today. Not all income is taxed the same. So hang tight. Chris and myself are gonna run through this topic, give you a really good explainer on it as always. But before that, let’s take a moment to thank our sponsor.

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This podcast is brought to you by Legacy Lock. If you are new to estate planning or simply need to review your current plan, Legacy Lock makes it as easy as pie. Legacy Lock is a unique platform that enables you to easily complete your attorney drafted documents conveniently from the comfort of your home or office. Your first step to this peace of mind is simply visiting teachingtaxflow.com/legacy.

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Welcome back to the Teaching Tax Full podcast. Really, we need no introduction. We already know that you’re your favorite podcast out there. I’m John Chapalski from the TTF team as always. To my right, left, across the screen is always somewhere with me.

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I can’t get rid of this guy if I tried to, nor would I want to. Chris Pacuro. How’s it going, man?

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John, I’m doing great. Unfortunately, we are across from each other virtually as we record this episode. But you know what? We’ve been spending a lot of time with each other lately. I know.

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I feel lonely now that I’m I’m doing my own thing back in that’s cold here in Michigan today. I know it’s warmer in Tennessee as always. But as a as somebody always says, right, at a at a wedding, they’re like, we are gathered here today. Well, we are gathered here today to talk about income and, basically, how not all income is taxed the same. So, Chris, if you want to describe this for everybody out there.

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Right? Like, hit us with a couple examples when we say that because I’m sure we have, obviously, we know we have a lot of entrepreneurs, a lot of real estate investors, a lot of individuals that are a blend of everything. Right? Some are full time employees wherever they work, but then they have the side hustle, we’ll call it, or real estate investment. So walk us through this a little bit.

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What how do you explain that not all income is taxed the same? We know one of

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the three laws of teaching tax law is that tax agencies are our involuntary business partner. And what that means is that tax laws are written to encourage or discourage certain behavior. Certain industries are tax advantaged, certain industries are not. Certain activities are tax advantaged, certain activities are not. And we do we are far from having a flat tax on the federal tax level, and not only do we not have a flat tax, we have what’s called a progressive tax system, meaning the more income that you have, the higher rate you pay.

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To further complicate things, we have different tax rates, which is really interesting. And when we’re looking at how you tax how your income is taxed, we need to understand that if your taxable income is a hundred thousand dollars, and that was all from self employment income, meaning you were you were out there grinding, you could be paying a third of that to the government. But if your entire income was a long term capital gain, you could be paying almost nothing to the government. So how what we believe in teaching tax law and what we teach, as you said that not all income is taxed the same, is that we have to first determine if the income is taxed at your at gross your gross income or net. And what that means is that gross income means you don’t get any tax deductions to offset that income.

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Net income means you get to deduct your expenses. So, obviously, gross income is is not as good as being taxed on your net income. I’ll give you an example, John. Let’s say that you are, let’s say you are a self employed person. Now let’s say you’re a w two person.

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You, make a hundred and $50,000 on a w two, And, obviously, you could put some money away in a pretax four zero one k, etcetera, etcetera. But let’s just say you make a hundred and $50,000, but you are a pharmaceutical salesperson. You’re only reimbursed a a small amount for your your travel expense and your vehicle. You have a home office. You’re responsible for your own Internet.

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You’re responsible for your own cell phone. You might have a professional license that you have to take classes. So what’s gonna happen is you’re gonna pay a federal tax. We’re just talking on the federal side right now. On the entire hundred and $50,000, you’re also gonna pay into the Social Security and Medicare system, which is 7.65% on top of your whatever your marginal tax rate is.

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Check out the podcast, shameless plug on marginal tax rate, how that differs with your tax bracket. And, and and that’s it. Now, John, if you were in the same facts matter and you were self employed, you would get to deduct, or if you were an s corporation or a c corporation, and as you know, John, if you’re a single member LLC, you are self employed to disregard an entity. Under those scenarios, you would get to deduct all of your qualified business expenses. Shameless plug to what is a qualified business expense podcast.

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Put it in the show notes. Now John’s getting upset. There’s a lot of post production work.

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It’s like somebody waiting until the day before a tax deadline and saying, oh, yeah. There’s something to throw in there. But also too, before you go too far, Chris, I do wanna make a good point too. You know, you’re over here throwing out shameless plugs. I’m gonna throw one out there.

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So we actually made a chart with all this on there. And if I remember right, I think it was a napkin drawing of some sort. I mean, we all know that that Chris is just this you know, he’s he’s an undiscovered artist. If nobody’s ever seen his napkin sketches, they are just beautiful works of we don’t know what they are, but they’re beautiful. I think we took one of those and actually created a chart for it.

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If you guys want a copy of that, it’s very easy. Just go to teachingtaxflow.com. You can set up for the basic, the the basic membership, which is actually completely free. We’re not gonna sell your information. Well, you know, the government already has it.

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I was gonna say we’re not gonna sell it to government. Tough. They already got it whether you like it or not. And you can download this you could view and and download this chart. Make it a lot easier.

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I’ll put the link in the show notes. So there, Chris, I’m making it work for myself. But back to you. I’ll throw the

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I have no absolutely. So that that is the that’s an example of gross versus net. You’d be able to deduct all of your expenses against that that income, and you’d be taxed on your net income. So there are certain income types that you’re taxed on your net income. That’s preferred.

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There are some that you’re taxed on your gross income. That’s not preferred. Okay? So that’s one that’s one thing to consider. So then we’re gonna talk about five different considerations, by the way, and when we’re talking about when not all income is taxed the same.

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And like you said, jump on, it’s in in grab a hold of that chart, in the teaching tax flow, educational library. And it’s really, John, you know, you make all this napkin drawing look good. The other factor to consider is under the tax cuts and job back of 2017, there was a new deduction board. It’s called the qualified income qualified business income deduction or section one ninety nine a deduction, and there’s some income that is eligible for this deduction. And what this deduction allows is for you to take up to a 20% federal tax deduction based on your net income.

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So, John, if we’re talking about you being self employed, let’s say you had a hundred and $50,000 worth of income. Let’s say you had $50,000 worth of expenses, you’d be paying tax on a hundred thousand dollars. But you would also get an additional 20% qualified business income deduction in that fact matter. So what you’re looking for is you wanna take advantage of of income streams that are eligible for the qualified business income deduction. Not all of them are.

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So one, am I paying tax on my gross or my net income? Two, is, the section one ninety nine a, is my income eligible for that? And there are some you might if if you’re listening to this and you have a you’re a w two person, and you’re thinking, jeez, how can I get the qualified business income deduction? There are certain investments and certain tax type of taxable income that you could be eligible for that, like buying rental property, or there are actually investments that kick off dividends and qualified dividends that are eligible for that. And if you have a brokerage account, if you get really bored and look at, like, the fiftieth page of your statement, you might see some of these QBI deductions.

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But so what you have to ask yourself is is my is my income eligible for qualified business income deduction? The third factor is, am I am I paying tax on my marginal tax rate, or am I eligible for my number four, the special capital gains tax rate? So there is a special clause in the tax code that’s effective right now that taxes long term capital gains and qualified dividends at a lower rate than your marginal tax rate. We know because you better listen to all the other podcasts that marginal tax rate is your number one KPI when you’re doing tax planning a strategy. KPI stands for key performance indicator.

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So your marginal tax rate is different than that tax bracket. And the question is is is this income that I’m receiving, am I paying to pay tax on my marginal tax rate, or am I eligible for the special lower tax rate? Now in a podcast like this, the most prudent thing to understand is that your special capital gain tax rate is typically 50% of your marginal tax rate. And at sometimes, that special capital gain tax rate can be zero with the proper planning.

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And, Chris, you mentioned planning again. Right? That’s a term that everybody likes to think that they plan, at least to some extent. Some people admit that they’re not good at it at all. When it comes to this, I mean, as as individuals’ lives kind of get blended.

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Right? I mean, there there’s a lot of income types. Obviously, as we mentioned earlier, there’s w twos. You got long term capital gains. You could be a partner in LLC.

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You could have alimony. So talk to us maybe about how somebody start to blend together and really why the planning aspect is so important because it like you had mentioned too earlier, there’s no flat tax rate. It’s not, you know, it’s it’s not an easy button in the in the game.

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A flat tax, and it’s not a linear line. It’s not a it’s not a straight tax, meaning it it’s a it’s a curvy odd line of tax. And and that’s a good point. So let’s talk about the special capital gain tax rate. In general, most people are gonna pay a 15% federal tax on any long term capital gains or qualified dividends.

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Some people could pay a little more. Some people might have to pay a Medicare surtax. Some people could pay 0%. But in general, like I said, it’s gonna be about half of what your marginal tax rate is. To have an investment that qualifies for the special capital gain tax rate, it’s something that you’ve owned for more than a year.

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So let’s say, John, you bought stock in teaching tax flow. Maybe you got it before you went public. Right. Anyway Right.

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Shh. Don’t give away all our secrets.

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If you were to own that stock for five years and then sell it, you would that would be long term capital gain. So anything that you own more than a year and you sell at a gain is eligible for those long term capital gain tax rates. And conversely, if you own a let’s say you own that teaching task flow stock and you are paid a dividend, after you own that stock for a year, all those dividends are dividends are considered qualified dividends, eligible for the long special long term capital gain tax rate. So that’s where the and you said the plan. That’s where it comes things come into play.

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So for instance, let’s say you own a piece of land, and, you know, we’re at I mean, the stock market so can go up or down, but let’s say you own a piece of land, in your in the town where you live, in a charming town, right outside Ann Arbor, Michigan, and you you bought it a year ago. You bought it eleven months ago. And someone came to you and said, hey, I wanna build a house there. I wanna I wanna make an offer on this land. And you say, okay.

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And you talk to them, and then you then you call me. You say, hey, man. I’ve got an offer on this piece of land. What are you thinking? Now I’d say, John, it’s it’s August x or September x.

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It’s been eleven months. Why don’t you tell that person that you, you’re happy to sell it, but you will have a closing at least one year after the date you purchased the land. And that would make the tax half, probably what it would be if you had a short term capital gain. So that’s an example of just one simple transaction. Obviously, things get very complicated.

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And we’ll get to talk a little bit more on on what type of resources we have for people when things get complicated that we can help them with. But that’s an example of just doing a little bit of tax planning. It goes goes a long way.

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Absolutely. And that chart that we have is is really good. It lays it out. It’s got some nice color in it. I’m looking at it right now.

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Very easy. It’s got a lot of yes, nos in there. So it it’s a good road map.

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So in general, if you can find a something that you pay lower tax rate on, that’s preferable than your to your marginal tax rate. And then the fifth consideration, because marginal tax rate in capital special capital gain tax rate are my three and number three and four consideration. Fifth consideration, is this income subject to self employment tax, which is 15.3% tax on a about the first hundred and sixty, hundred and sixty five thousand dollars of your income or your w two wages. And in general, you want that I mean, you I’m not gonna say in general. You want that answer to be no.

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Right? Because that’s an that self employment tax is in addition to your marginal tax rate. So when you’re an employee, you pay half of that self employment tax. That’s at 7.65% that comes out of your paycheck. Your employer matches that 7.65%.

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But remember, you’re paying that on your gross income. When you’re self employed, you pay that tax on your net income, and you get the one ninety nine a deduction. So it might be beneficial. We just had a teaching tax flow, one of our premium members, engage us in our tax planning engagement, do a personalized tax plan, and the person is self employed. She’s actually in about somewhere between a hundred and 50, hundred and $200,000 of income, so she’s paying self employment tax.

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And her the person that she had an offer from one of her main clients, to bring her on as an employee. And, we ran the analysis, and and after you add it all up and deduct things, and it was better for her, especially with the $1.99 80 deduction, to remain, a a a a independent contractor from just just from a tax perspective. We’re not talking about the the legal ramifications and and that sort of stuff. So you really have to look at the numbers, and and, you know, where where they where they lie with that are you subject to the self employment tax? Now one more consideration would be if you are self employed.

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Let’s say your net income’s a hundred and $50,000 or your w let’s say you’re a w two person, and you’re considering being self employed and you think your income would be about the same. That’s where, John, we start talking about some of those more advanced tax strategies, like potentially electing to be taxed as an s corporation where you get some of the the hybrid of some of these these tax rates. One thing to consider also is that if you are listening to this and you’re, you know, on Social Security, your other income can greatly affect how much of your social security income is taxed. And then there’s, I call, a hidden tax. There’s several seniors that, I’ll give you an example.

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They’re on social they have social security. The maximum amount of social security that’s taxed is 85% of your benefit, and they’re paying into the Medicare system. So they pay a modest amount per month for Medicare insurance. And let’s say they have a a they need to pull they have a catastrophic life event. They pull out $200,000 out of a retirement fund or let’s say they sell some stock for a few hundred thousand dollars.

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You know what happens? Because their income shot up that year, their social security is still taxed at 85%, But what happens is their Medicare premium that they’re paying goes up because it’s a need based. And it could triple just because they have one big year, and that’s that’s when we talk about your true marginal tax rate. There’s so many different factors.

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That’s a great point. That’s actually a really good example. Right? Because there’s you know, I I I can’t remember the number off the top of my head, but usually, I think it’s out there of like, oh, I or somebody’s retired. Right?

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And they get offered a a part time job working at the corner store. They say, oh, no. I can’t make any money because then it completely throws off everything I have, or they might have a number in their mind that’s, you know, I can’t work more than a couple hours a week or something because once I once I breach a certain point, is that is that really true, or is that something that is just a a fable for lack of better terms? Well, the because I know you’d mentioned once you get to a certain point, then everything starts to you know, you’re you’re taxed at a higher rate, obviously.

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Right. I mean, there are there are so there are people on Social Security that if you look, they’re in the 12% marginal tax bracket. Let’s say it’s a married couple. They’re they’re no. I’m sorry.

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They’re in the 12 tax bracket that their marginal tax rate is 30%. It because if they take money out of their retirement account, then they’re gonna trigger a not only is that taxable, but a higher percentage of Social Security benefits are taxable. And that’s when we start getting into some of these advanced tax strategies and the importance of of doing a personalized tax plan with your tax preparer. And and, unfortunately, as you know, John, we were we you’ve you’ve been on the road with me the last couple months, attending conferences, speaking at events, and that’s why we that’s one of our reasons we did teaching tax flows to to help people with tax planning and strategy. It’s an underserved and unserved community, but with so determining, you know, to to mitigate that social security tax exposure.

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And, you know, is it fair that you have to pay tax on social security benefits when when you didn’t get a tax deduction when you put the money in? No. Let’s just say it’s not. I don’t think it’s fair personally, but that’s the way it is. Right.

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But, yeah, I’d say takeaways from from this episode, First thing, jump into that lesson. Jump into that course in teaching tax flow. I’d love to say it’s a shameless plug again, but it’s free. You’re gonna really we’ve got a full mini lesson on this subject with that chart. That chart is gonna be phenomenal.

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Things to consider. Is the income that I’m earning am I taxed on my gross income or non income? Am I eligible for section one ninety nine a? Am I paying tax on my marginal tax rate? Or am I qualifying for the special capital gain tax rate on that income?

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And is the income subject to self employment tax? So I’m gonna run through that real quick. I’m gonna give you the preferred answers. Right? Tax, gross or net, you want net.

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Section one ninety nine eligible, you wanna say yes. Marginal tax rate versus special capital gain rate? You’d prefer yes on special capital gain rate. Self employed employment tax? The preferred answer would be no.

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Alrighty. So, everybody, go get that sheet. Walk through it. Compare your situation. As always, reach out with any questions.

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So, Chris, we, we appreciate you as always being able to, I haven’t said this in a while, extrapolate the knowledge from your brain. So this has been a good one. I think we went over a lot of stuff. And, honestly, I think this topic relates to I’m I’m gonna make the assumption again on this is that this is the the general demographic, I should say, of our audience. I think a lot of people do fall into this, and this is something that I feel that we explain a lot in chunks.

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This was excellent because it basically maps everything out. So I think this was a was a great show. Chris, thank you again for for letting us do this. And, again, anybody else any questions, shoot us a message, contact us. I’ll drop the link in there for our private Facebook group as always and as well as the direct link to the course where you can actually just take a peek at this chart yourself.

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So until next time, we’ll see you next week. John still here from the teaching tax flow team. Wanted to thank you for hanging in with us on this episode as as we jumped into and ran through not all income is taxed the same. So possibly for this episode, you had no idea what we were talking about. However, hopefully, now you know.

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Obviously, there’s some different variables in there and everybody is a little different, but hopefully, you got a better grasp on what we mean by that title. So, as mentioned in the show there, if you look below or to the right or the left or above in the show notes depending on where you’re listening to this episode, there’ll be a link in there. Click on that link. Jump into the related teaching tax flow course completely free if you wanna join as a basic member. Check it out.

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More information in there. It’s a good walkthrough video done by Chris, the man, the myth, the legend behind teaching tax flow and run through that. Let us know what you think. Any questions, shoot them over. We’re happy to answer them.

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So, hey, Ted again. Great episode coming up next week as well, which you will hear about shortly. Until next time.

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