Tax and Investment Basics

Introduction

• Paul Lin, an investment advisor and Certified Financial Planner, introduces a lesson on income tax and basic investing.
• Disclaimer: He is not a lawyer or CPA, and his advice should be validated by licensed professionals.
• He acknowledges that the information presented is compiled from various sources and not his original thoughts.

Income Tax Overview

• The lesson aims to demystify income tax, a crucial but often untaught subject.
• The complexity of tax rules is intentional, as many monetize this complexity.

Form 1040: The Core Document

• Form 1040 is a two-page document serving as the table of contents for one's tax situation.
• Supplementary pages (schedules and worksheets) explain how the numbers on Form 1040 were derived.
• Page 1: Income Reporting
  • This section is where all income sources are listed (job, investments, Social Security, pension, etc.).
  • The sum of these sources contributes to the taxable income number.
• Page 2: Tax Calculation and Reconciliation
  • Calculates the actual tax bill.
  • Reports taxes paid throughout the year.
  • Reconciles what was paid versus what should have been paid, resulting in a refund or balance.
• No advanced math is needed; basic addition, subtraction, and multiplication suffice.

Progressive Income Tax

• Different parts of one's income are taxed at different rates, known as the progressive income tax system.
• Imagine income as a "rainbow pile" of $1 bills$, with each portion taxed differently.
• The tax bracket only applies to the income exceeding the threshold, not to the entire income.
• Example: Earning six figures and being in the 24% bracket doesn't mean paying $24,000$ in taxes; it only applies to the income above the threshold.

Tax Rate and Bracket Span

• The presenter provides an income tax cheat sheet that shows the tax rate and the span of each bracket.
• The "taxes due" column helps to quickly determine how much is owed based on the income level.

Tax Deductions vs. Tax Credits

• A tax deduction reduces the amount of income subject to tax, shrinking the rainbow pile before the IRS calculates the bill.
• A tax credit directly reduces the amount of taxes owed, like an IRS gift certificate.
• Credits are more valuable than deductions.

Common Deductions

• Employees have limited deductions, mainly contributions to 401(k) and Health Savings Accounts (HSA).
• Business owners have more opportunities for deductions.
• Standard Deduction vs. Itemizing
  • Taxpayers choose between a standard deduction (a fixed amount based on filing status) or itemizing deductions (listing individual deductible expenses).
  • Itemizing involves filling out Schedule A and listing deductible expenses like charitable donations, medical expenses, and mortgage interest.
  • Choose the option that provides the larger deduction, but cannot do both.

Calculating Taxable Income

• Taxable income is the income remaining after deductions are subtracted.
• Use tax rate and cheat sheet to figure out taxes owed based on what income bracket you reside.
• California has a different system of deductions and rates (Form 540).
• The federal taxable number differs from the California taxable number.

Paying Taxes Throughout the Year

• Those who work for a company and receive a W-2 form will notice taxes are being withheld from their paycheck.
• Self-employed individuals must send quarterly payments to the government.
• Subtract credits from the total that's been paid throughout the year.

Penalties and Refunds

• Underpaying taxes can result in penalties, often around 10% plus interest.
• Overpaying taxes results in a refund, which represents dollars the government held throughout the year.
• Large refunds are not ideal, as that money could have been used more effectively throughout the year.

Taxation Perspective

• All tax rules either increase or decrease the rainbow pile, determining taxable income.

FICA (Social Security and Medicare)

• FICA funds Social Security and Medicare.
• Employees pay 6.2% for Social Security and 1.45% for Medicare.
• Employers match this amount, making the total contribution 15.3%.
• Owning a small business means paying double FICA.
• Social Security is a tax that is trickled back once you become eligible and then taxed again.

Capital Gains Tax

• Capital gains tax applies when selling an asset at a profit.
• Tax is paid only on the gain (selling price minus cost basis).
• Example: Bought a stock for $10,000$ (cost basis), sold for $13,000$, and a $3,000$ capital gain is taxable.
• Tax rate depends on taxable income; those with low income may pay 0% capital gains.

Time Value of Money

• A dollar today is worth more than a dollar tomorrow.
• Assets and loans are time machines for money.
• Assets send money to your future self. The reward for doing that is your APR, or appreciating foregoing spending it today.
• Loans transport money from the future to today. The cost is the interest rate.
• Businesses borrow money at low rates and invest at high rates, keeping the spread (banks).
• Treat your household as a bank.

Inflation

• Inflation occurs when the government overspends and creates new money, devaluing existing dollars.
• A trillion dollars is an unimaginable amount of money.
• Today's inflation calculations often exclude food and energy costs, unlike calculations in the 1970s and 1980s.
• Inflation is said to be double-digit.

Low Interest Rate Debt

• Paying lenders back when you have low interest rates can be advantageous at times due to inflation.
• Example: Having a student loan compounded at 4% when the money is being diluted at double digit percentages.

Student Loans

• If the interest rate is reasonable and low, will you be better off slowly trickling payments to the lender for time to erode the debt? An interesting question.

Retirement

• Inflation can ruin retirement due to cost of living increasing over time.

Interest Rates and Compounding

• Using calculator.net to manipulate loans.
• If you know four of the five variables, you can always solve for the missing variables.
  • PV stands for present value.
  • I stands for interest rate.
  • N is the number of compounding periods.
  • PMT stands for Payment.
  • FV is future value

Investing Basics

• To beat inflation, one must own assets like stocks and bonds.

Stocks

• Owning a company without running it.
• Buying a share of Apple, for example.

Index Funds

• Indices such as the Dow or S&P 500.
• Indices are based on values from certain stocks.
• Diversification: Instead of learning what the 500 companies do, just buy all 500.
• Buying index funds can act as copies of the index.

Bonds

• An IOU or a miniature loan.
• Lending money to the government through treasury bonds.
• Get payment over time, and then get back all the money that you pay at the beginning when the term is over.

Diversification

• The presenter provides a chart illustrating the need for diversification.
• Past performance is not an indicator of future performance.
• Diversified portfolios will stay in the middle, never the best or the worst but consistent.

Investment Risk Quiz

• An investment risk quiz will help determine what model the template is based on based on your risk profile.

Investment Vehicles

• Every investment in America can be put into these four categories.
  • Red Money: Traditional 401k, IRA, etc.
    • Get a tax deduction when funding this type of account, but pay taxes with money comes out.
  • Green Money: Roth IRA, 401k, etc.
    • Mirror image of red money. No tax deduction when the account is fueled, but everything is tax free when it comes out.
  • Yellow Money: Nonretirement account, brokerage account, trust, real estate, cryptocurrency, etc.
    • Accessible before 59.
    • Pay capital gains tax in this type of account.
  • Orange Money: Cash value, life insurance, after-tax IRA, etc.
    • Putting money is like yellow money. When pulling out, you are paying regular income tax instead of capital gains tax.

Conclusion

• The lesson included going over income tax, capital gains or ordinary income, or pretax deduction.

Q&A

• IRA vs. 401(k): IRA stands for individual retirement accounts, while 401(k)s are company-sponsored.
• Order of Operations: Cash reserve, retirement accounts, then medium-term money.
• Profit Margin on Household: If you are unable to save at least 10% of your income, you're gonna have problems in the future.
• W-4 Estimator: Filling out the w-4 estimator and answering all of the questions can help you figure out how much money you overpaid during the year and taxes.
• Debt: Inflation strangely erodes the value of debt.
• Gifts: View gifts as discounts.
• Minimum Income: The first fifteen grand will be wiped out by the tax deduction for a single person.
• Stock Options: Definitely more risk because you're basically taking a bet.
• Cars: Try to put down as much as you can and not finance as much as you can and stretch out the loan because you are using Leverage (borrowed money) to buy a sinking asset. Low interest rate is beneficial.
• Refinance Loan: It can be a good thing to refinance because that means you're not under water plus and minus every month.
• Investment Platform: Most platforms are commodities.
• International Stocks: Protect yourself with country diversification. AIFA index acts as this.
• Standard Deduction: Standard deduction more when you own a business than everything else