The objective of this article is to provide some helpful observations on an important planning topic – the tax game: basic tax information that all couples should understand. These are big broad topics. This article is not going to give you a deep grounding in any of them or make you an expert. It is designed to introduce you to fundamental basics, the kind of information that will help you plan for yourself and enable to broaden your knowledge base. The sole purpose of this article is basic education. So let’s get started.
Your involuntary partner is the government. It operates at the federal, state, and local level. Every time you buy something, every time you earn a buck, and just about every time money passes between you and some other person, it’s compulsory, it’s taxation, the same thing that triggered the Revolutionary War. You may ask, “Why should I fear my involuntary part?” It’s a fair question. I hate that fear is a motivator, a reason to do or not do something. The fear of failing stops so many from every finding their potential, but taxes are a different, a big exception to the fear factor.
You see, sooner or later, everyone develops an attitude, a philosophy about taxes. Ideally, the essence of that attitude would be love of country, support of others, an abiding desire to contribute, to pay a fair share, or something like that. The promise that if you’re like almost everyone else, none of these are near strong enough to overcome the cynicism, frustration, sometimes intense bitterness that often develops as you watch large portions of your hard-earned income march off to the government each month as you hear and read almost daily how politicians consume with our own political survival, waste billions in ways that no private institution could ever tolerate. As you go to a government office and try to get some service from slow, lazy, completely unmotivated, tenured public service who care little about their job and less about you even though you pay their salaries.
Decades of playing the tax game and helping others play it have convinced me that the best attitude, the best motivator, the best philosophy to keep you playing by the rules; something you absolutely do is fear.
When it comes to taxes, fear is justified. You see, if you cheat and get caught, your involuntary partner can turn into a mean, obsessed pit bull. That’s why people could go to prison every year for tax fraud. That’s why many more people every year get hit with huge tax deficiencies and penalties that suck up their financial resources often for many years.
Take a close look at someone who has had a messy run-in with the federal government, the IRS. They usually have lost much more than money. The process often sucks the energy, the life, the will to move forward right out of them. The collateral damage to the rest of their life can be huge. Fear is definitely justified here. And don’t ever fall for the phony rationale that many used to justify cutting corners on their taxes; that the odds of you getting caught are very small and tiny. Countless revenue agents and sophisticated government computers are working against you full-time on this one. This is one of those risks that are never worth taking no matter the odds. The downside is just too painful.
Beyond this fear factor, every person should know some basics about the tax game. The Congressional Budget Office recently reported that the federal government collected about $2.1 trillion in taxes in fiscal 2010 to sustain its operations. Actually, these collections didn’t come close to doing the job. Our government spent over $3.4 trillion during 2010 producing an annual shortfall deficit of about $1.3 trillion. That annual deficit was added to the federal public debt that topped $9 trillion in 2010. That 2010 annual deficit and the deficit in 2009 which exceeded $1.4 trillion were bigger than anything we’ve ever seen before by over 3 times and are more than we could have possibly imagined just a few years ago. And that $9 trillion public debt number ignores the unfunded future promises that the government has made to sustain our mammoth entitlement programs, primarily social security and Medicare.
When the future shortfall in these programs is factored in, the true unfunded debt becomes unfathomable exceeding according to the best estimates of more than $60 trillion. It’s why the Congressional Budget Office and nearly everyone else who honestly assesses the future repeatedly uses the word “unsustainable” to describe our nation’s economic future. It’s why everyone predicts huge tax increases in the future, massive cuts in entitlement promises, or some combination of the two. The bottom line, the future tax burden for all young Americans is real ugly and is only going to get worse.
But taxes reach far beyond the federal government. Every state county and city sustains itself with taxes. In nearly every state, we pay state income taxes. We pay sales taxes whenever we make a retail purchase. We pay special taxes when we pay a utility or phone bill or buy cigarettes, booze, an airplane ticket, gasoline, and a whole host of other items. We pay property taxes for the privilege of owning a home and real estate and licensing a car. The list of special taxes seems endless at times. And beyond all the direct taxes we pay, we ultimately pay for all the taxes that are imposed businesses from which we buy goods and services. In order to survive, all businesses must embed their tax burdens in the prices they charge us, their customers. No matter how you cut it, it’s just multiple bites from multiple biters.
For planning purposes, most of the different taxes we pay are not relevant. They just pop up as we go through our daily routines and spend money. Often we are paying a tax and don’t even know it. But there are three exceptions and they’re important. Let’s take a look at the big three taxes.
The first is the federal income tax. The legendary complexity of the federal income tax causes many to completely reject the notion of trying to understand anything about this tax. But there are a few basics that are clearly worth knowing about. A young couple getting started is given a few tax breaks. The first is the standard deduction which in 2011 is $11,600 for a married couple, up from $11,400 in 2010. The second is a personal exemption of $3700 for each spouse, up from $3,650 in 2010. No income taxes are paid on these amounts. These tax-free breaks go up a little each year. So for example, in 2010, the first $18,700 a couple earns is income tax-free. No federal income taxes are paid on this base amount. Beyond this amount, in 2010, the next $16,750 earned by a married couple was taxed to 10%; the next $51,250 was taxed at 15%; the next $69,300 was taxed at 25%; the next $71,950 was taxed at 28%. The next $164,400 was taxed at 33% and everything over $373,650 was taxed at 35%.
So take, for example, Dave and Linda, a couple that expects to earn $120,000 in 2010. If they use the standard deduction and had no other deductions, the first $18,700 of their income would be tax-free; the next $16,700 would be taxed at 10% (that’s $1675 of tax); the next $51,250 of their income would be taxed at 15% for a tax amount of $7,678; the remaining $33,300 of their income would be taxed for $8,325. So applying this stair step rate structure of their income would produce a federal income tax liability of $17,685 for 2010 – roughly 14.7% of their total income. How did Dave and Linda actually pay this amount? Since Dave is employed by a company, his employer would withhold taxes from his paychecks incrementally throughout the year. The tables used by the employer incorporates the standard deduction and personal exemptions. As a self-employed person, Linda would be required to estimate her tax liability for the year and pay the estimated amount in quarterly payments on April 15th, June 15th, September 15th, and January 15th. Dave and Linda, like all other Americans, would be required to file a joint income tax return with the internal revenue service by April 15ht of the following year that calculates their exact total income tax liability for the year. If they paid their employer with hell too much, they get a refund from the government. If they didn’t pay enough, then they have to pay the shortfall and potentially, some interest and penalties.
So how do young couples like Dave and Linda reduce their federal income taxes? There are various ways but here are two common ones that Dave and Linda actually use. First, in 2010, they funded the 401(k) plan offered by Dave’s employer to the tune of $6,000. This was one of those savings on tax vehicles, SUVs, that we discussed earlier. This excluded $6,000 from their income which resulted in an income tax savings of $1,500. And as it an added sweetener, Dave’s employer matched about 30% of Dave’s contribution. Second, Dave owns a home that he brought to the marriage, and this allowed them to deduct the interest on the home’s $270,000 mortgage that was an interest deduction of $15,400 for the year, and the real estate taxes paid on the home along with other state local taxes they’ve paid and their charitable contribution. These state local taxes and other contributions totaled $4,000. The grand total of their home mortgage interest and their local taxes and contributions called their “itemized deductions” totaled $19,400. They get an additional deduction for these items only to the extent that they exceed the standard deduction of $11,400. They don’t get both a standard deduction in these itemized deductions; they only get the greater of the two. These two changes, the 401(k) deduction and the larger itemized deductions created by their home ownership reduced their taxable income by $14,000, which in turn, reduced their federal income taxes by $3,500 (25% of this amount).
So with these added tax benefits, their net federal income tax for the year was estimated to be $14,185. Looking down the road, Dave and Linda will get some additional federal income tax breaks when a child arrives. An additional exemption and potentially a $1,000 tax credit. That’s a dollar for a dollar tax reduction for each child. Things get easier tax-wise as the family grows.
So how do the rich reduce their income taxes? How is it possible for high income people to reduce their taxes, particularly in view of the progressive rate structure that I’ve just described? You often hear that the rich get all kinds of tax breaks. Truth is, the tax code is designed to give special tax breaks to those who earn their money from invested capital rather than from their labor. The rationale for such breaks is that all elements of our economy including job growth are fueled by capital and as a result, reducing taxes on capital grows the economy which produces more jobs, which produces more income, which produces more taxes and on and on.
There are more investment tax-saving strategies than most can count. Here are four popular strategies often used by those who have capital to invest: First, they invest their money in municipal bonds that generate tax-free interest that the government does not tax. Second, they invest in stocks that pay dividends that now are taxed at a maximum rate of only 15%. Third, they invest their money in capital assets, stocks, bonds, real estate, etc that grow in value and that when sold, produce capital gains that are taxed at a maximum rate today of only 15%. Finally, they invest their money in income-producing assets such as real estate that generate pay-per-depreciation deductions that, in turn, shelter from taxes a portion of their other income.
Bottom line, those with big dollars to invest have huge flexibility to structure their affairs to save big taxes. It’s a flexibility that’s usually beyond the reach of most hardworking Americans. There’s on other twist to the income tax that should be mentioned. The alternative minimum tax, something our politicians like to rail about often adds to the complexity. This is an additional tax that is imposed on those who are entitled to too many extreme but legal tax breaks. A person who milks too much out of the system can get hit by these AMT. Many consider the AMT dirty pool; our gain that it’s unfair to offer tax breaks and then they penalize a person for taking advantage of too many of those breaks. Hence, politicians are always promising to get rid of the AMT. For most people, the AMT is not a problem unless they have extraordinarily large deductions for state and local property taxes have an extreme number of personal exemptions, that is that many, many children have exercised valuable incentive stock options or have some combination of these items.
So much for income taxes. Let’s now turn to the payroll tax — America’s most brutal tax. It has a history that all young Americans should know something about. The roots of this tax reach back to 1935 – the year social security was born as part of Roosevelt’s new deal for the American people. At that time, the life expectancy for the average American was only 64 years, and middle- and low- income Americans paid no income taxes. The politicians of the day impose a modest payroll on all working Americans to fund Social Security. They knew most Americans would never collect much, if any, Social Security. By the ‘70s, Social Security benefits were rising faster than wages and the whole system was projected to go bankrupt by the early ‘80s.
In 1982, a bipartisan commission appointed by President Reagan and headed by Alan Greenspan was formed to fund social security. The result was a sweeping bill in 1983 that accelerated billions of dollars of future tax increases and increase the normal retirement age from 65 to 67 over an expanded time frame. Reagan and his congressional buddies proclaimed victory, claiming that Social Security would be solid to at least 2068.
A major component of this 1983 saving legislation was the promise that huge surpluses would be generated during the years preceding the retirement of the baby boomers that would be used to fund the boomer’s benefits for a long time. The big tax hikes of common – let’s look at how the tax works today. It’s simple and it’s mean. The payroll tax is simple because it’s so easy to calculate; a piece of cake compared to the income tax. If you work for a company in 2010, 7.65% of your pay, up to $106,800 was taken for payroll taxes. Your employer put up another 7.65%, but don’t for a minute think that that employer share didn’t come right out of your pocket. Every employer in America factors in that tax cost in setting compensation levels. So the real payroll tax hit is 15.3% before any income taxes, and if you’re self-employed, you pay that whole 15.3% yourself because there’s no employer that hides half the tax behind. There are no deductions, credits, or graduated rates; just 15.3% taken right off the top or one dime of income taxes.
Now, what if you earn $500,000 or $2 million in 2010? You still pay 15.3% on that first $106,800, but only 2.9% on the excess over that amount. There’s a cap each year on the amount of earnings that are subject to the full 15.3%. This cap goes up a little each year just enough to keep pace with the increases and the income of middle America. So this tax is really no big deal for the rich; it’s bite is deluded as their incomes escalate. But for low and middle income America, this tax is a killer much worse than any income tax buyer. For 80% of Americans, the payroll tax hit on their incomes exceeds their federal income tax liability often by many times.
How about a person young or old who gets, say, $100,000, $200,000, $1 million from rents, dividends, interests, other passive investment income or capital gains each year? That person today pays not 1 dime of payroll taxes because that person does not earn income from labor. The payroll tax today is only for those who labor for their money.
For 2011, the income cap remains at $106,800. No increase for that year. But there is an unprecedented 2% reduction in payroll taxes for 2011 – a special 1-year tax break that Congress inserted in the tax bill passed in late December of 2010 to help spur the economy. As for Dave and Linda’s situation, the payroll tax bite on their income in 2010 was over $17,300 – more than their income tax hit. Of this $17,400, Linda will need to pay directly about $7,600, about $4,800 will be withheld from Dave’s paychecks and an additional $4,800 will be paid by Dave’s employer – a de facto reduction in Dave’s pay. For their budget purposes, Dave and Linda combined the payroll tax bites they pay directly – a total of about $12,400 with their estimated income tax hit of roughly $14,000 dollars to arrive at the annual total of $26,400 that was factored into their spending plan – the spending plan as we’ve previously discussed.
The huge payroll tax has produced surpluses for the government as promised in 1983. Trillions of dollars of excess payroll taxes have been collected over the last 26 years to pre-fund the benefit of the baby boomers. What happened to this money, where it is at – that’s part of the big con many call the deceit, the shell game, the fraud. Every dime in this money generated from a flat rate tax imposed on the labor earnings of primarily low-end and middle-end America has been used to pay general operating expenses of the federal government unrelated to Social Security. This promised reserve has been blown. All Social Security has to show for these blown surpluses are non-marketable IOU’s from the federal treasury that promise that the money taken plus all interest that accrues on that money will be paid back in the future when the money is needed to pay Social Security benefits, that is, when the baby boomers start stepping up to the plate to collect their promised benefits.
And where will the government get the money to pay these IOUs plus interests in the future? You got it. Future tax increases. And who’s going to pay these future tax increases that will be necessary to pay off IOUs that represent taxes already paid and collected once? The young of America. The bottom line is that the government’s plan for the boomers boomeranged. This plan hatched in 1983 to pre-fund the Social Security burden of the baby boomers once from the very start a gimmick, an accounting scheme, a shell game, as many call it, that has allowed the government to shift a big part of its current operating budget onto the backs of lower income and middle income Americans while shifting the full future funding burden of all retirement benefits for the boomers to future generations.
Plain and simple, it’s a disgrace. Let’s now turn to the third big federal tax – the federal estate tax. This is a tax you should know something about even though the tax poses no direct tax burden for most people and nearly all young people starting out. You see, the federal estate tax does not even kick in until a person’s estate exceeds a certain amount known as the unified credit exemption equivalent or, as some say, the free amount.
In late December 2010, there was a heated battle in Congress over what that free amount should be along with the issue of whether the Bush tax cuts should be extended. A compromise was finally reached amidst a whole slew of political theatrics. As part of this compromised deal, the Republicans got their dream deal for estate taxes for the next 2 years – 2011 and 2012. For anyone who dies during these 2 years, the estate tax free amount is increased to $5 million, the highest of all time. And for a married couple, there’s a provision that automatically doubles this to $10 million; again, something brand new. But these numbers were only for 2 years. If Congress does not reach an agreement on an extension of these benefits by the end of 2012, the free amount will be only $1 million starting in 2013 with no automatic doubling between spouses. So the ultimate fate of the federal estate tax like many other important tax provisions has been kicked over for another 2 years as our country struggles to crawl out of a debilitating recession and our elected officials wrestle without the government is going to cope with unprecedented deficits that potentially threaten the future of all Americans.
The best guess of most is that when Congress finally does deal with this tax, the free amount number will ultimately be set between 3-1/2 and $5 million. And there’s a long shot that the deal may be struck in Congress where the complete repeal of this tax is used as trading bait to get something that the proponents of the tax badly want in return. When the value of a couple’s estate blows past this free amount, if there is no planning, 35% of the X’s value will be sent to the federal government if the death of the surviving spouse occurs in 2011 or 2012. Plus an added percentage may need to be sent to a state government if the person resides in a state that has an estate or an inheritance tax. Twenty-one states have such a tax.
After 2012, that is starting in 2013, the federal rate jumps to as high as 55% unless Congress can agree to something different going forward. That’s the 50% freak out that so many high net worth individuals experience in the planning process. And remember, Uncle Sam doesn’t want 50% of your business or your assets. Uncle Sam demands cash.
So you may ask, given the high threshold of this tax, why do we even need to know the tax exists? It’s not about the direct impact of the tax on you now. It’s about the potential harm you may suffer if the tax is imposed on others close to you. Two potentials: One rare and one not so rare.
The first potential, the rare one, is if your parents have an estate tax exposure. If they do, sooner or later, it’s going to end up on your lap and directly affect, in a big way, a negative way, your financial future. Smart planning over time can seriously reduce or completely eliminate the pain. So you may have a real vested interest in the quality of your parents’ estate planning.
The second not-so-rare scenario is the person who works for a company that has an owner who faces a serious estate tax problem. Fearful of not having enough liquidity, that is, enough cash to cover the estate tax hit and transition the business to another generation, the owner just elects to sell out to a big corporate enterprise. The huge corporate buyer gets a new revenue source and the former owner of the business walks with millions of dollars. The big losers in this scenario often are the employee – half of who lose their job as the company’s operations are consolidated in to the big corporate buyer and the local community that loses a solid employer who used to support local vendors, employ local people and support community efforts. Business consolidations usually are bad for employees and communities and few things encourage such destructive consolidations more than an ugly estate tax exposure.
So sometimes in evaluating a potential employer, it may pay to look through to the actual owners of the company and try to size up the risks of the owners having to sell out or wanting to sell out and hurting the employees in the process.