Taxes for Dummies – How Tax Works?
If you’re accumulating wealth, the topic of taxes will be a recurring and potentially quite frustrating part of your life.
This post assumes that the reader has absolutely no previous knowledge about taxes. I’ll try to be as straight forward as possible with a topic which is inherently confusing. So oversimplifying it can be quite a challenge.
But let’s tackle it together. There are at least four types of tax you should know about if you want to play this game:
- Income tax
- Capital Gains tax
- Dividend tax
- Wealth tax
By the way, if you stumbled upon my blog looking to build wealth, I highly recommend the following resources:
- The Book: Become an Investor: The Ultimate Guide to Long-Term Investing for Absolute Beginners
- The Free Series: How to Start Investing: A Complete Beginner Series
Income Tax
Income tax is a tax you pay on the money you earn.
Your gross salary is your pre-tax salary and your net salary is your post-tax salary.
If you earn money through traditional employment, the taxes due are withheld by your employer and sent to the government before they even reach your bank account. In other words, you’re getting your net salary.
If you earn money on the side, you’re being paid an amount on which you need to pay income tax. In other words, you’re getting your gross salary.
The amount you owe from your gross salary doesn’t necessarily fully fund a single thing – part of it may be social security contribution, part of it may be health insurance, etc. Of course, this varies per country. For the purpose of this post, we’ll define income tax as the full withheld proportion from the money you earn, so we don’t get stuck on terminology mismatches.
The income tax rates around the world range from 0% to almost 60% and it’s usually higher in more developed countries. For example, the income tax is 0% in Kuwait and United Arab Emirates, 20% in Estonia and Georgia, and above 50% in Denmark and Sweden.
You can use this calculator to calculate the net salary based on an yearly gross amount you input. It’s specific for The Netherlands, but straight-forward and simple enough to give a realistic representation. A Google search for “tax calculator [country]” should provide results for other countries.
In many countries interest income is taxed as regular income. So if you own a bond paying 1000$ per year and the income tax rate is 25%, your net earnings will be 750$ (1000 – 250).
Capital Gains Tax
Capital gains tax is the tax on the gains realized from an asset that appreciated in value.
Since the post is “for dummies”, appreciation means grows in value, while depreciation means losses value.
So if you bought Bitcoin at 10000$ and sold it at 11000$, you’d have made 1000$ gains. The tax you’ll need to pay for the fiscal year will be a percentage of the profits. So, if the tax rate was 10%, you’d need to pay 100$ in capital gains taxes.
Some countries lower or completely remove the tax liability for “long-term assets”. For example, let’s say you held Apple stocks for 8 years and decide to sell with a profit of $30k. You don’t need to pay anything on this. On the other hand, if you bought Netflix and sold it the same year after some mad gainz, you’ll need to pay capital gains on the profits.
The way it’s calculated also varies. Not only country by country, but also case by case. For example, if you bought an asset 5 years ago and sold it today, it’s easy to calculate the difference and tax it. But if you were buying stocks for 500$ each month and after 30 years you start to sell them, it’d be more difficult to define the base amount.
Depending on where you live, it can be either the easiest thing to do (e.g. 0% in Switzerland, 12% in Croatia, etc.) or pretty complex (e.g. France). If it’s the latter, you may not need to know the exact details about the accounting methods used, but it’s good to have a general idea of what to expect. Then, you’ll hire a tax adviser for a couple hundred bucks and dump your data on his lap.
But what if you lose money? Losses can be partially deducted from the taxes you owe to the government. In other words: capital losses are tax deductible.
Dividend Tax
Dividend tax is the tax on dividend income.
In most cases it’s paid similar to income taxes – companies withhold the taxes due and send the net dividends to the shareholders.
For example, let’s say you own stocks worth 1000$ and paying 5% dividend. You’re technically receiving 50$. If the dividend tax rate is 10%, 5$ will be withheld and given to the government, so you’ll actually receive 45$.
I wanted to give an example with an actual country, but dividend taxes vary so much to be generalized that I just assumed 10%.
For example, in Spain it’s between 19% and 23%, in Finland it’s 30%, and in USA it’s between 10% and 37%. As I said, dividend taxes are tricky.
But even trickier is if you invest in companies outside of your country of residence. Then, the tax will be withheld based on the country from which the company pays out the dividends, you’ll receive them and will have to or not have to pay tax in your country, based on the dividend tax system and an existence of a tax treaty between the two countries.
A tax treaty is a deal between two countries set in place in order to avoid double taxation. For example, if a resident of Country #1 receives dividends from a company from Country #2 and there is a treaty between the two, he won’t owe anything to Country #1’s government – the tax was already withheld in Country #2.
But we can add another layer of complexity.
What if a person resides in one country, uses a fund based in another country, which invests in securities originating from a third country? I won’t tackle this scenario, because it’s not really “for dummies”. Also, because I already did it elsewhere. I’ll just say that dividend tax should be taken seriously.
In many cases, for a long-term investor in the accumulation phase, the best thing to do is to hold accumulating ETFs and enjoy capital gains.
Wealth Tax
Wealth tax is a tax on savings and investments.
It’s basically a tax on the net-worth exceeding a certain level.
For example, a government decides a threshold, let’s say $100k, and taxes individuals on the wealth they have above that limit at a certain rate, for example 0,5%. So, if you had a million dollars under this fictitious jurisdiction you’d pay 0,5% tax on $900k, which is 4500$.
I already mentioned that the net-worth is what’s taxed, but for extra clarity: the liabilities are deducted from the tax base. So, to enrich our example, if you have a million in assets (cash + investments + real estate), but have an outstanding mortgage amount of $400k, your “net-wealth” is $600k. So, you have $500k excess of the non-taxable amount and would pay 0,5% on that, amounting to 2500$.
Debt can be good if used properly.
I dislike taxes. However, I understand why we pay income tax and dividend tax, and can live with paying capital gains tax. But punishing residents simply because they were disciplined, hard working, and saved is immoral! Especially because wealth tax is levied on amounts that are already taxed, whether by income taxes, capital gains taxes, or dividend taxes. It’s unethical and should be illegal, but my opinions don’t belong in this post… Indeed, don’t get me started…
Good news is that many capitalist societies don’t enforce wealth tax.
However, almost every country taxes “the rich” at a higher rate, which brings us to:
Progressive tax
I used straight forward examples to describe how taxes work in simple terms, but often the taxes are progressive – the higher the income / gains / dividends / wealth, the higher the tax rate for that range. For example, let’s say you earn an income of €100k in The Netherlands. The first €20k will be taxed at 36,5%, the amount between €20k and €68k will be taxed at 38%, and the amount above €68k will be taxed at 52% (I rounded to nearest thousand for the salaries and to ,5% for the tax rates). The term for these sections is tax brackets. Progressive taxes are common for different types of taxes in many countries.
Additional thoughts
This is by no means an exhaustive list of all taxes.
However, as an investor / early retiree / professional nomad / expat with financial literacy researching where to establish your tax residency or as a beginner looking to understand taxation better, these are the few you have to know about.
But depending on your situation, there may be others that are applicable. For example, there are property taxes, municipal taxes, road taxes, value-added tax / sales tax, corporate taxes, estate tax, import tax, gift tax, inheritance tax, waste tax, motor vehicle tax, dog tax, tourist tax, land tax, transfer tax, betting / gambling / lottery tax, etc., etc., etc. My head hurts even thinking about this all… Not because it’s beyond my comprehension, but because I feel like a slave when I’m taxed at every step I take. But again, my opinions don’t belong in this post.
Hope you have a clearer idea about what taxes are and how they work. If you found some value in this post, I’d appreciate a share.
Until next week!
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