The amount of tax you’ll owe as the result of a taxable event can vary depending on what state you live in as well as federal tax law and requirements. Some states don’t impose an income tax.
How Does a Taxable Event Work?
The Internal Revenue Service (IRS) determines the rules for events and transactions that affect federal income tax liability for businesses and individuals. This includes taxable and nontaxable income, employee withholding, and capital gains. Taxable events must be reported to the IRS and, in some cases, taxes may be automatically withheld. Many states levy taxes on individual income as well. Your take-home pay is reduced by the amount of state and federal taxes owed based on how much you earn when you receive wages from a W-2 job. The information you give your employer on Form W-4 determines the amount of withholding from your pay. Your employer then remits the money that’s been withheld to the government on your behalf.
Examples of Taxable Events
Receiving a paycheck from your employer causes you to owe federal taxes because wages are a form of taxable income. You would also be required to pay tax on unemployment compensation because this is a form of taxable income, too. Let’s say that you have money in an employer-sponsored 401(k) and you change jobs. You can leave the money in the plan, roll it over to another tax-deferred account, or you can cash out the account and take the money. Cashing out would be a taxable event, generally requiring that you pay income tax on the account balance, plus an early withdrawal fee of 10% if you’re under age 59½. You can defer paying taxes until you withdraw the money if you roll over the balance or leave it alone. Capital gains tax applies when you sell an asset for more than you paid for it and have invested in it, such as collectibles, stocks, bonds, and some real estate. The amount of tax you must pay on capital gains depends on the type of asset and how long you owned it. You’ll owe the long-term capital gains tax rate of up to 20% if you sell a stock for a profit that you owned longer than one year. The sale would be taxed as ordinary income (up to 37%) if you owned the stock for one year or less.
How To Limit Events That Result in More Taxes
It’s to your financial benefit to limit or minimize taxable events that result in more taxes due. Understanding the tax rules that surround taxable events can help you reduce the amount of taxes you owe.
Hold Investments for More Than a Year
An easy way to reduce capital gains tax is by holding ownership of stocks or other assets for more than a year before selling them. You’ll qualify for the long-term capital gains tax rate, which is often less than the short-term rate.
Roll Over Old Retirement Plans
Roll over any 401(k)s into a new employer plan or an IRA when you leave a job. You can delay paying taxes on the funds while letting the account balance grow.
Use Losses To Offset Gains
Tax-loss harvesting is another strategy investors use to minimize taxes owed. It involves strategically taking losses on certain assets, such as stocks, in order to offset the tax on current gains.
Use a Tax-Efficient Portfolio
Tax diversification uses a balance of taxable, tax-deferred, and tax-free accounts to net the highest after-tax income. Tax management can be complex and often varies by individual. It may be wise to talk with a financial advisor or tax professional about your particular situation.
