Chapter 7
Taxes and the Stock Market
Income taxes, stocks, and bonds — the last chapter of the book, and the most practical: reading a paycheck, understanding the progressive bracket system, evaluating stocks and bonds, and choosing a diversified portfolio.
This is the last chapter of the book, and the most practical: taxes and the stock market. By the end of the chapter you'll be able to read your own pay stub, compute the federal tax owed on a hypothetical income across the U.S. progressive brackets, read a stock quote and a bond quote, and understand why a real-world investment portfolio mixes stocks and bonds rather than concentrating in one.
Sections 7.1–7.3 cover income taxes; Sections 7.4–7.6 cover stocks and bonds; Section 7.6 ties both halves together — and closes the book.
By the end of this chapter, you'll be able to…
- 7.1Analyze the system of income taxes to help develop financial literacy skills.
- 7.2Analyze systems of stocks and bonds to help develop financial literacy skills.
Sections
- 7.1Reading a paycheckGross pay is what you earned; net pay is what hits your bank account. Everything between them is a deduction. The first lesson of financial literacy is learning to read the gap.Read →
- 7.2Tax brackets and the marginal rateMoving into a higher bracket does not mean all your income gets taxed at the higher rate. Only the dollars above the threshold do. The math behind one of the most-misunderstood ideas in personal finance.Read →
- 7.3Filing, refunds, and the effective rateApril 15 is the day the math from the previous two sections settles up. The effective tax rate, computed at the end of the year, tells you what percentage of every dollar earned actually went to the federal government.Read →
- 7.4Stocks: shares, dividends, returnA stock is a tiny ownership stake in a company. Its price moves, and along the way the company may pay dividends. The return on an investment is the sum of both pieces.Read →
- 7.5Bonds: face value, coupon, yieldA bond is a loan made to a company or government, in exchange for regular interest payments and the return of principal at maturity. The flip side of a stock: lender, not owner.Read →
- 7.6Diversification and the stock-bond splitStocks pay more in the long run but swing wider in the short. Bonds smooth the ride at the cost of some return. A real portfolio is a mix of both, tuned to the investor's time horizon. The closing section of the book.Read →
Chapter glossary
All key terms introduced across this chapter, in the order they appear in the reading.
- Gross pay
- Total earnings before any deductions. The top line of a paycheck.
- Net pay (take-home)
- Earnings remaining after all deductions. The amount that actually arrives in the bank account.
- FICA
- Federal Insurance Contributions Act tax: 6.2% Social Security + 1.45% Medicare = 7.65% employee rate.
- Federal income tax withholding
- An estimate of federal tax owed, deducted from each paycheck based on Form W-4.
- Take-home percentage
- Net pay divided by gross pay, expressed as a percent.
- Progressive tax
- A tax in which higher slices of income are taxed at higher rates. The U.S. federal income tax is progressive.
- Tax bracket
- An income range with a single tax rate applied to it. The 22% bracket for a 2024 single filer runs from $47,150 to $100,525.
- Taxable income
- Gross income minus the standard or itemized deduction. The brackets are applied to taxable income, not gross.
- Standard deduction
- A flat amount subtracted from gross income to produce taxable income. $14,600 for a 2024 single filer.
- Marginal tax rate
- The rate of the highest bracket the taxpayer's income reaches. The rate at which the next dollar earned would be taxed.
- Effective tax rate
- Total tax owed divided by total gross income, expressed as a percent. Always less than the marginal rate in a progressive system.
- Refund
- Withheld minus owed, when withholding exceeds tax owed. The return of one's own over-withheld money.
- Form 1040
- The standard U.S. individual income tax return form. The arithmetic of Chapter 7 lives on the 1040.
- Share
- A single unit of corporate ownership.
- Dividend
- A regular cash payment made by a company to shareholders, usually quarterly, on a per-share basis.
- Capital gain (or loss)
- The change in the value of a position due to share-price movement. Realized when the shares are sold; until then unrealized.
- Total return
- Capital gain plus dividend income, over a holding period.
- Return on investment (ROI)
- Total return divided by amount invested, expressed as a percent. The standard comparable yardstick for investments.
- Face value (par)
- The amount the bond's issuer promises to return at maturity. Almost always $1,000 for U.S. corporate bonds.
- Coupon rate
- The annual interest rate the bond pays, as a percentage of face value. Fixed at issuance.
- Current yield
- Annual coupon divided by current market price. Moves inversely with the bond's price.
- Premium / discount
- A bond trading above face value is a premium bond; below is a discount bond.
- Asset class
- A broad investment category with similar risk-return characteristics. Stocks, bonds, and cash are the three classic ones.
- Expected return
- Long-run average annual return of an asset class.
- Volatility
- Year-to-year variation in returns. Standard deviation of the annual-return distribution.
- Asset allocation
- The percentages assigned to each asset class. The single largest decision in personal investing.
- Diversification
- Spreading investments across multiple asset classes to reduce overall portfolio volatility.
- Time horizon
- The number of years until the money is needed. Drives the appropriate stock-bond mix.