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Here’s How You’re Taxed on Money You Don’t Earn

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Most people hate taxes, but if we’re honest, they’re important. Crucial even.

Why Taxes Are a Necessary Evil

Without taxes, the government wouldn’t be able to fund the military that keeps us safe and protects our national security interests.

It couldn’t provide the bare minimum (less actually, but at least something) to the poor, the disabled, and the elderly.

It couldn’t pay for maintaining our roads and bridges, and building new ones on occasion.

There’d be no way to pay for regulatory bodies that protect the air we breathe, the water we drink, the food we eat, the markets we invest in, etc.

The government couldn’t support the arts and sciences, and many more things we usually take for granted.

When Income Taxes Stop Making Sense

Having said all the above, there’s one specific problem with our income tax system that should be fixed before any more tax cuts get enacted.

It’s when we’re taxed on money we don’t really earn.

Here are two scenarios where this happens.

You Get Taxed When You Lose Money Invested in Mutual Funds

First, as I mention here, if you buy into a mutual fund late in the year after it had a great return, and then after you get in the fund loses some of its gains, you get taxed even though you lost money.

While the fund may still be up for the year, you personally didn’t participate in the initial run-up in value. In fact, you lost money.

However, you still get taxed on the fund’s remaining gains for the year despite the fact that not only did you not benefit from any of those returns, your investment actually lost money.

You Get Taxed Even When You Have a Negative Real Return

Second, when you have a positive investment return in nominal dollars, you’re taxed on the full nominal value of that return. However, inflation has reduced the value of those dollars, so your real earnings are lower. You might even have suffered a real loss.

Here’s a scenario that demonstrates how this can happen.

  • You invest $10,000 on January 1 in a bond that pays 3% interest per year.
  • The value of the bond itself doesn’t change that year.
  • Inflation runs at 3.5%.
  • Your marginal tax rate is 20%.

At the end of the year, you have $10,300 ($10,000 in the original bond, which we’ve assumed hasn’t moved in its value, plus $300 interest paid). Your nominal return is $300. However, inflation has eaten away 3.5% of the purchasing power of your money, so in real terms you now have $9939.50. That means that in real terms, you’ve lost 0.6%.

Still, you pay taxes on the full $300 nominal return, which at 20% tax rate costs you $60. This leaves you with $10,240 which in real terms is worth $9881.60 (96.5% of $10,240).

Congratulations. You just paid $60 in taxes on a real loss of $60.50!

Bottom Line

The US tax code is famously convoluted and complicated. The above are two examples where this results in your being taxed on money you don’t really earn.

You can avoid one of these by investing through a tax-advantaged account such as an IRA, or investing in exchange traded funds (ETFs). However, getting taxed on phantom returns is unavoidable until and unless Congress changes it.

Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.

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