Definition Income tax is the money paid by individuals to federal, state, and, in some cases, local governments, and includes taxation of ordinary income and capital gains. Generally, U.S. citizens, residents, and some foreigners must file and pay federal income tax.
important In general, federal tax applies to many kinds of income. If you’re an employee at a startup, you need to consider four kinds of federal tax, each of which is computed differently.
confusion When it comes to equity compensation, it’s possible that you’ll have to worry about all of these, depending on your situation. That’s why we have a lot to cover here:
Definition Ordinary income tax is the tax on wages or salary income, and short-term investment income. The term short-term capital gains tax may be applied to taxes on assets sold less than a year from purchase, but profits from these sales are taxed as ordinary income. For a lot of people who make most of their money by working, ordinary income tax is the biggest chunk of tax they pay.
Definition Employment taxes are an additional kind of federal tax beyond ordinary income tax, and consist of Social Security and Medicare taxes that are withheld from a person’s paycheck. Employment taxes are also referred to as payroll taxes as they often show up on employee pay stubs. The Social Security wage withholding rate in 2020 is 6.2% up to the FICA wage base of $137,700. The Medicare component is 1.45%, and it does not phase out above the FICA wage base.
Definition Long-term capital gains tax is a tax on the sale of assets held longer than a year. Long-term capital gains tax is often lower than ordinary income tax. Many investors hold assets for longer than a year in order to qualify for the lesser tax burden of long-term capital gains.
Definition Alternative minimum tax (AMT) is a supplemental income tax that applies to certain individuals in some situations. This type of tax does not come up for many taxpayers, but higher income earners and people in special situations may have to pay large AMT bills. AMT was first enacted in 1979 in response to reports that 155 wealthy individuals had paid no income tax in 1966.* It is not the same as ordinary income tax or employment tax, and is calculated according to its own rules.
danger AMT is relevant to you if you’re reading this. It’s important to understand because exercising ISOs can trigger AMT. In some cases a lot of AMT, even when you haven’t sold the stock and have no money to pay. We discuss this later.
Source: IRS and the Tax Foundation
A bit on how all this fits together:
Ordinary income tax applies in the situations you’re probably already familiar with, where you pay taxes on salaries or wages. Tax rates are based on filing status (if you are single, married, or support a family), and on which income bracket you fall under.
Income brackets. For ordinary income, since the 2018 tax year, the income brackets are at 10%, 12%, 22%, 24%, 32%, 35%, and 37% marginal tax rates—see Notice 1036 or a Tax Foundation summary for 2021. Be sure you understand how these brackets work, and what bracket you’re likely to be in.
Investment gains, such as buying and selling a stock, are similarly taxed at “ordinary” rates, unless they are long-term, which means you held the asset for more than a year.
You also pay a number of other federal taxes (see a document summary for all states), notably:
6.2% for Social Security up to the FICA base wage (your first $137,700 in 2020)
1.45% for Medicare
3.8% Net Investment Income Tax (NII) (enacted as part of the Affordable Care Act,* also called “Obamacare”) on investment income if you make over $200,000 (single) or $250,000 (married filing jointly).*
important Long-term capital gains are taxed at a lower rate than ordinary income tax: 0%, 15%, or 20%.* This covers cases where you get dividends or sell stock after holding it a year. If you are in the middle brackets (more than about $40K and less than $445K of ordinary income for 2021), your long-term capital gains rate is 15%. You can find more detail on tax brackets at the Tax Foundation.
AMT is a complex part of the federal tax code most taxpayers don’t worry about. But it comes into play when exercising ISOs. Most people do not pay AMT unless it is “triggered” by specific situations, typically high income (more than $500K) or high deductions. Whether you pay AMT also depends on the state in which you file, since your state taxes can significantly affect your deductions. If you are affected, AMT tax rates are usually at 26% or 28% marginal tax rate, but effectively 35% for some ranges, meaning it is higher than ordinary income tax for some incomes and lower for others.* AMT rules are so complicated you often need professional tax help if they might apply to you. The IRS’s AMT Assistant might also help.
important Section 1202 of the Internal Revenue Code provides a special tax break for qualified small business stock held for more than five years.* Currently, this tax break is a 100% exclusion from income for up to $10M in gain. There are also special rules that enable you to rollover gain on qualified small business stock you have held for less than five years. Stock received on the exercise of options can qualify for the Section 1202 stock benefit.
State tax rates and rules vary significantly. Since federal rates are much higher than state rates, you usually think of federal tax planning first. But you should also know a bit about tax rates in your state.