Tax Tips- Personal Income Taxes

How to Calculate Long-Term Capital Gain Taxes

Long-Term Capital Gains (LTCGs) are taxed at three rates: 0%, 15% and 20%. In 2019 for couples filing joint income tax, the taxable income corresponding to 0% rate is up to $78,750; that of 15% tax rate is $78,751 ~ $488,850; 20% rate for income above $488,850. Taxable income includes all other income. When determining the tax rates of LTCGs, other income is applied first and LTCGs come after. For example, you had a salary of $80,000 and LTCGs of $100,000. Due to your salary income > $78,750, the lowest tax rate for your LTCGs of $100,00 is 15%.

Take another example. A couple had a total salary income of $50,000 (ordinary income) in 2019 and LTCG of $1 million. Take out standard deduction of $24,400, and the taxable income became $1,025,600. In that, ordinary income (income other than LTCG) is $25,600, and the corresponding personal tax on this income is $2,687. The $1 million LTCG is taxed as follows: $53,150 capital gain is taxed at 0% ($53,150= $78,750- $25,600); $410,100 capital gain is taxed at 15% that amounts to $61,515 ($410,100= $488,850- $78,750); capital gain of $536,750 is taxed at 20% that amounts to $107,350. The total taxes for the year amount to $171,552 ($2,687+ $0+ $61,515+ $107,350). Did you get it?

Tax Differences Between Passive & Non-Passive Incomes

Personal income can be broadly divided into two categories: passive income PI and NPI. Understanding the differences between these two types of income can go a long way in saving taxes. NPIs also known as Earned Income, commonly include wage income, self-employment income, and incomes from participating in managing businesses. PIs include interest, dividends, capital gains, rent, and unearned incomes. The following are several most common tax implications and differences.

1. NPIs, such as W-2 wages, self-employment income, operating income from partnership partners, are generally subject to social security and medical insurance tax, payroll tax or self-employment tax. PIs are not subject to social security and health care taxes.

2. The losses from PIs or those from NPIs can only offset losses from the same category. For example, supposedly you have two partnership companies, Partnership A where you are involved in the operations is profitable, and partnership B where you don't participate in the operations is a loss in a year. In that year, the loss from partnership B can't be deducted from the profit from partnership A. Instead the loss will be deferred to the following year. If there is no passive income in the following year, the loss will be deferred again until partnership B is dissolved. This situation although unfavorable, occurs quite often.

3. The income of minors (students under the age of 24) is likewise divided into these two categories: PIs and NPIs. In order to prevent parents transferring investment income to their children and avoiding taxes, the IRS has special tax rates for passive income for children. For example, in 2023 if a child has less than $1,250 in passive income that year, s/he will not pay federal tax, and the child's second $1,250 passive income can also enjoy a low tax rate. Income greater than $2,500 will be taxed at the parent's highest tax rate for the year.

However, there is no such limit on children's NPIs, and minors are given a $13,850 exemption in earned income in 2023. Many families use this to their advantage, especially those parents who own businesses. For example, a mom hires her son, and pay him $10,000 in a year. She deposits $6,500 of that into her son's Roth IRA retirement account. This has two advantages: one to reduce her tax rate, supposedly her max. tax bracket is 37%, while her son may only pay 15.3% self-employment tax. The second benefit is that depositing a Roth IRA at a younger age will save the son's taxes as profits from Roth IRAs are tax-exempt for life. Imagine how good it would be to pay no taxes on investment income for more than 50 years. Note without earned income, a child is not eligible to hold a Roth IRA account.

4. Deductions for overseas taxpayers or expats. Foreign tax deductions are also divided into two broad categories: the general category for earned income and the passive category for passive income. Foreign wage income belongs to the general category; foreign investment income belongs to the passive category. When deducting US taxes, the two categories can't be mixed together. For example, the tax deduction on China's high wage income is higher than the US tax rate, so your salary income in China may result in surplus foreign tax credits. However, those excess credits can't be used to deduct in foreign investment income.

5. In addition, when the annual household income exceeds $250,000, passive income becomes subject to an additional 3.8% net investment income tax (ObamaCare tax), while non-passive income is not subject to this additional tax.

One may ask what constitutes non-passive income in a partnership. The tax law states that if you put in more than 500 hours of work a year, your partnership income is considered earned income. Another scenario is that you spend more than 100 hours of work in a year, and no one else in the partnership spends more time than you, then your income is also considered non-passive income.

How Roth IRAs and Backdoor Conversions Help Avoid Taxes?

ROTH IRA is popular because its profit is not taxed as it grows and when it is withdrawn. For families with an annual income (Modified Adjusted Gross Income) < $198,000, ROTH IRA allows those families to deposit $6,000 per person per year as of 2021 (up to &7,000 at the age of 50). In addition, you can choose to convert an IRA or 401K to a ROTH IRA, and you need to pay taxes on the pre-tax portion in the conversion year.

ROTH IRA does not have a minimum distribution requirement, meaning it is not required to withdraw a percentage each year after the age of 72. There is no penalty for withdrawing the principal before the age of 59.5. However, prior to age 59.5, after withdrawing the accumulated principal there would be a 10% penalty when withdrawing the profit, and the profit is also taxed. There is no tax or penalty to withdraw earnings after age 59.5. After the ROTH IRA account has been opened, the profit cannot be withdrawn within 5 years. Even if you are at or over 59.5, there will be a 10% penalty plus tax on the withdrawal of the profit. For converted Roth IRA, each conversion has to be completed for 5 years prior to withdraw profit without penalty.

If the ROTH IRA is inherited, it is required to be completely withdrawn within 10 years. The account needs to be emptied in the 11th year after the death of the relative. Inheritances between husbands and wives are exempt from the 10-year withdrawal restriction. Beginning in 2018, after the IRA has been converted into a ROTH IRA, the money cannot be converted back to the IRA (banned recharacterization).

People have used ROTH IRA to their advantage. For example, Peter Thiel, founder of PayPal, ended up with $5 billion profit in his ROTH IRA tax-free as he bought Paypal stocks with ROTH. Congress has proposed reform to ROTH IRA, some of which includes: 1) ROTH IRA account balances >$10M must be withdrawn by 50% each year. 2) Account balances >$20M must be withdrawn in full. 3) From 2032 on, IRA conversion will no longer be allowed if the annual income of an individual exceeds $400,000 (couples >$450,000).

High income families who are not allowed to have ROTH IRA have taken advantage of backdoor ROTH IRA. Those families can deposit $6,000 into a non-deductible IRA, and then convert to ROTH IRA. However, if you have other existing IRA accounts, the non-deductible IRA will cause part of the income to be taxed in the year of conversion due to the Pro-Rata rule.

The IRS requires the Pro-Rata rule to be followed for IRA conversions, as the taxpayer’s existing IRA account may consist of 100% tax free IRAs and non-deductible IRAs. That requires inclusion of all existing IRA accounts into the calculation. Conversions that are taxable for the year are calculated on a prorated basis, including the SEP. Take a simple example, you have two IRA accounts on 12/31/2021 with a total market value of $20,000, and you have transferred $6,000 non-deductible IRA to ROTH IRA in 2021. The tax-free ratio is calculated as $6,000 ÷ ($20,000 + $6,000) = 23%. Although the $6,000 is a non-deductible IRA, the taxable part after conversion in 2021 is (100% - 23%) x $6,000 = $4,620. The 401K account balance is not required to be included in this calculation. Therefore, If your current 401K accepts rollover IRAs, you can potentially deposit all pre-tax IRAs into the company's 401K account prior to the backdoor conversion to enable the $6,000 backdoor conversion tax-free.

Benefits for Taxpayers in the 2022 Inflation Tax Adjustment

The inflation adjustment announced in Oct. 2022 has allowed thousands of Americans to receive more tax deductions and allowances in 2023.

Among dozens of changes triggered by soaring prices for food, gasoline and other items, the standard deduction for tax year 2023 was raised by ~7%.
For families that file jointly, the standard deduction will increase by $1,800 to $27,700; For taxpayers filing separately, the standard deduction will be increased by $900 to $13,850; For the head of household (e.g., single-parent family), the standard deduction will increase by $1,400 to $20,800 in 2023.
The adjustment to individual income tax brackets, while the percentage remains the same, raises the income threshold for entering the new income bracket by ~7%. For Americans whose wages aren't rising in tandem with inflation, raising the tax threshold helps.
The annual adjustment is designed to combat "bracket creep", when taxpayers' income begins to grow faster than the tax threshold set forth in the IRS tax law, leading to higher tax payments.
The gift allowance will be increased by $1,000, so people can gift up to $17,000 without paying taxes in 2023.
In 2023, the max lifetime tax exemption for individuals who give/inherent will increase nearly $900,000 to $12.92 million.
Foreign wage income waiver will increase to $120,000 from $112,000 in 2023.

The annual adjustment is based on formulas that take inflation into account, while the US is facing its highest level of inflation in 40 years. Per the Wall Street Journal, these are the largest automatic increases in standard deductions since the tax system was tied to inflation in 1985.

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