I Paid More Than Half My Income in Taxes, What Happened? By: Byron Moore, CFP

  • April 27, 2015

Question: My CPA shocked me this year with the news that I owed the IRS more than half the income I earned. He said it had to do with my investments. I switched brokers last year, but I don’t understand why that mattered. They tax you for that?

 

Answer: You may a victim of your own success.

 

The first thing to understand is that you (and all the rest of us) are taxed by the federal, state and local governments in several different ways.

 

First, most wage earners pay a payroll tax. That’s the line item on your paycheck stub labeled “FICA” (for Federal Insurance Contributions Act).  FICA is the federal law that requires your employer to withhold three separate taxes from your wages: 6.2% Social Security tax, 1.45% Medicare tax and, beginning in 2013, a 0.9% Medicare surtax if you earn over $200,000.

 

Second, and separate from the FICA (or payroll) tax, you pay a tax based on how much income you earn. This is known as earned income. As you earn more money and reach higher levels of income, you pay a larger percentage of that income in federal income taxes.

 

For example, in 2014, a married couple earning a combined income of $50,000 would owe about 13% of their income in taxes. If they both got raises and earned a total of $100,000, they would owe about 17% of their income. But if they really hit it big and had a total $500,000 income, they would owe about 29% of their income in taxes. These figures are approximations and simply offered as examples.

 

Third, you pay a tax on the income you receive, though you did not earn it in a traditional wage-earning job. This is known as unearned income. This category covers everything from interest earned on a bank account (remember when we had that?), to rent payments you receive on that rent house you own, to interest, dividends and capital gains earned on a portfolio of investments.

 

From the way you described your situation, it is the unearned income category that seems to be the source of your “tax surprise” this year.

 

When you first start out as an investor, you put a few bucks into a mutual fund, hopefully it grows a little and (unless it is in a tax advantaged account like an IRA) you and the IRS get a note from the mutual fund telling everyone how much you made that year.

 

If you invested $10,000 and earned 10%, your account would have grown by $1,000. That $1,000 is added to your total income taxes for that year.  So if you earned $50,000 at your job and received $1,000 of unearned income from your mutual fund, your total income would be $51,000.

 

Fast forward thirty years and let’s assume your account is worth $1,000,000 (sweet!). If it had a really spectacular year and earned 15%, your account would have earned $150,000 for the year on top of the million already there. Now let’s say you are earning $100,000 per year in your job.

 

When it comes time to do your taxes, you’ll have to report $250,000 of taxable income to the IRS: $100,000 of it earned from working and $150,000 of it earned from investing. Your total tax bill would be about $58,000 – more than half the income you earned.

 

Also, since you moved brokerage accounts last year, it is possible the broker sold all of your investments and converted them to cash to facilitate the movement from one broker to the next. If you did that, you may have “realized” some capital gains in your portfolio that you otherwise would not have. That could have made your tax bill quite a bit higher.

 

There are a variety of tax reduction techniques you may consider to reduce an income tax bill made higher from investments. Some make more sense than others and all should be judged in the context of your specific circumstances. Consult qualified tax and investment advisors when considering any of these.

 

Just keep in mind that paying taxes because your investments are doing so well is the kind of problem everyone wishes they had.

 

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Byron R. Moore, CFP® is managing director / planning group of Argent Advisors, Inc. Email him at bmoore@argentadvisors.com. Write to him at 500 East Reynolds Drive, Ruston, LA 71270 or call him at (318) 251-5800. The opinions of any single advisor do not necessarily reflect the opinions of Argent Advisors, Inc. No forecasts can be guaranteed.  Argent Advisors, Inc. does not offer tax, insurance or legal advice.  The information contained in this column should not be construed as a substitute for personalized investment, tax, insurance or legal advice.