Income Tax Rates: The More You Know, the Less You Pay

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One thing you may have noticed in preparing your tax return is that different types of income don't all get taxed at the same rate. Knowing how much tax you'll pay on each kind of income will help you figure out the best way to cut your tax bill this year and beyond.

Ordinary Income
For most income, the set of tax brackets ranging from 10 percent to 39.6 percent apply in calculating your total taxes. That includes not only wages and salaries but also business income, money you make from property rental, and most interest payments you receive.

In addition, some dividend income gets treated as ordinary income. And if you sell investments at a profit during the first year you own them, short-term capital gains get taxed at ordinary income rates.

In general, ordinary income rates are the highest you can pay, and qualifying for lower rates makes sense whenever possible.

Tax-Free Income
The ideal tax rate is zero, and a few investments provide tax-free income. The most common are municipal bonds issued by state and local governments, which produce interest that's free of tax.

But some investment vehicles actually transform what would otherwise be taxable into tax-free income. Roth IRAs make all the interest, dividends, and capital gains free of tax when you take money out during retirement, while 529 plans do the same for money used for educational purposes.

Dividends and Long-Term Capital Gains
Certain dividends qualify for a preferential tax rate. For top-bracket taxpayers, that rate is 20 percent. But those in the lowest two tax brackets pay nothing in taxes on qualified dividends, while those in between pay 15 percent.

The same treatment applies for most long-term capital gains. If you sell an investment at a profit after having held it for longer than a year, then the gains from the sale get taxed at the same rates as qualified dividends as described above.

Income From Sales of Collectibles
Profits from selling collectibles, such as coins, stamps, and precious-metals bullion, don't qualify for the low long-term capital gains rates above. Instead, a special 28 percent maximum rate is imposed on collectibles gains. If your ordinary tax rate is less than that, though, you'll pay the lower rate.

Know Your Taxes
By realizing that various types of income get taxed differently, you can tailor your investing strategy to take advantage of favorable rates and reduce your tax bill accordingly. That could make next April's tax bill look a lot better than what you pay this year.

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