How Is Income Taxed Differently Than Wealth?

Many people use the words income, rich and wealth interchangeably. These words are often used in conversations with professional athletes and high-income professions such as doctors and attorneys. Investopedia defines ultra-high net worth individuals (UHNWI) as people with investable assets of at least $30 million, excluding personal assets and property such as a primary residence, collectibles and consumer durables.

I define wealth as having investable accounts that will not run out in your lifetime. Simply having income does not mean that you also have significant wealth. I’ll focus on taxes and retirement savings to show what I mean. (For related reading, see: How Credit Scores and Real Estate Impact Your Wealth.)

Wealth Tax and Income Tax

If you are like many taxpayers, when you think about paying taxes, you think federal income tax. At the federal level, there are different rates depending on if it is earned income or wealth (long-term capital gains). When it comes to taxes on income, the highest tax rate is 39.6% and the lowest tax rate is 10%.

Filing Status and Income Tax Rates 2016*

     

Tax Rate

Married Filing Jointly or

Qualified Widow(er)

Single

Head of Household

Married Filing

Separately

10%

$0 - $18,550

$0 - $9,275

$0 - $13,250

$0 - $9,275

15%

$18,550 - $75,300

$9,275 - $37,650

$13,250 - $50,400

$9,275 - $37,650

25%

$75,300 - $151,900

$37,650 - $91,150

$50,400 - $130,150

$37,650 - $75,950

28%

$151,900 - $231,450

$91,150 - $190,150

$130,150 - $210,800

$75,950 - $115,725

33%

$231,450 -$413,350

$190,150 - $413,350

$210,800 - $413,350

$115,725 - $206,675

35%

$413,350 -$466,950

$413,350 - $415,050

$413,350 - $441,000

$206,675 - $233,475

39.60%

More than $466,950

More than $415,050

More than $441,000

More than $233,475

Let’s say your job pays you $500,000 and you pay the highest earned income rate (marginal tax rate of 39.6%). It was nice that your contract said that you would be guaranteed $500,000, but due to the tax bite, you only net $317,000. Now, if your income came from the wealth tax (long-term capital gains), it would be taxed at 20%. You would gain $83,000.

 

Earned

Long-Term
Capital Gains

Income

$500,000

$500,000

Rate

36.60%

20.00%

Tax

$183,000

$100,000

Net

$317,000

$400,000

Difference

 

$83,000

Retirement Savings is Not Retirement Wealth

Some people (of course, not you) refer to 401(k)s or IRAs as retirement wealth. In most cases, they represent accounts that will be used to create retirement income for as long as there is money in the account. Money with a high probability of running out is not wealth. In contrast, if pensions don’t default, they won’t run out of money. However, 401(k)s and IRAs don’t have those guarantees. In fact, I have not found a non-certified financial planner professional that has a plan to turn IRAs into lifetime retirement income. (For related reading, see: If You Win $1 Million, Can You Minimize the Taxes?)

If you have $1 million in retirement balance that you use for income, you don’t have wealth. Traditional IRA and 401(k) balances have never been taxed. That means that if you pull out $50,000, you will pay $5,684 in income tax on $50,000. If you withdrew the whole thing, you’d pay $356,875, only being able to spend $643,125. These numbers don’t include state taxes and other applicable taxes and fees.

Paid Out

$1,000,000

$50,000

Tax

$356,875

$5,684

Spendable

$643,125

$44,316

What Is Your Wealth Vision?

I recommend a custom designed financial life plan where you define what you think wealth means—on your own terms. (For related reading, see: How Compounding Benefits Your Retirement Savings.)

 

*This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor