A Few Words on Taxation

Now that the elections are over, let's clear up some confusion over taxation. First, how do wealthy people like Mitt Romney get by with paying just 13.7% income tax? In our current cynical climate, many assume he must be getting some sort of seedy political favors from his friends in Washington, DC, but the truth is much less interesting. Fact is, people that wealthy can live on dividends and long-term capital gains (trading profits). For close to a decade now those income sources are taxed at just 15%, regardless of one's income bracket. I just had a spirited phone discussion with a buddy last night, and it took a few tries to convince him that a lower tax on dividends makes perfect sense. Like most people, he thought companies pay dividends as kind of a pass-through to their owners. No, no, no--dividends come from "net income AFTER tax." Starbucks paid $674 million of income tax as a corporation last year. AFTER that, they were left with net income of $1.385 billion. So, the profits of the company have been taxed at this point. If the board of directors wants to pass out 72 cents-per-share of that after-tax profit to the shareholders/owners, why should the owners get taxed at all? I don't think they should, but the Republicans were only able to convince the Democrats to lower the tax rate to 15% back when George W was in office. Of course, to get that benefit, you have to own the dividend-paying stock in a taxable account. If it's in your IRA or 401(k), nothing here applies to you. But, what the heck would a Mitt Romney need with an IRA? Defer $6,000 a year? Why? And, he'd have to have earned income to make an IRA contribution--his income is mostly from dividends and capital gains. Then, with huge charitable contributions, he can bring the rate down from 15%, as he did. He paid a huge amount of taxes, but the percentage was 13.7%.
The rest of us live mostly on earned income; therefore, our income is taxed at various tax rates. At the same time the dividend and long-term capital gains rates dropped to 15%, Congress put the following tax brackets into place: 10%, 15%, 25%, 28%, 33%, 35%. Most recently, everybody's first $8,500 of income was taxed at just 10%. Then, the next so-much was taxed at 15%, and so on. If you made, say, $400,000 after all deductions, you would pay tax at all six of those tax rates--the last $21,000 or so would be taxed at 35%. Unfortunately, unless Congress passes new legislation, those tax brackets are going to revert to where they were about a decade ago. The 10% bracket goes away--ouch--and the 35% bracket becomes 39.6%, with about a 3-point jump in all the other brackets.
Wow. Yes, the tax code is always in play, but right now it is about as uncertain as it's ever been. People who will retire in 10 years now have to factor in that they may retire in a higher tax bracket--that diminishes the benefit of deferring their income in a retirement account. They might want to use a taxable account, but if the lower tax rates on dividends and capital gains are taken away or reduced, that might not be so attractive either. Would we be shocked if Congress reduced or eliminated the tax break on municipal bond interest? Yes, but it could still happen. And that would do some nasty things: it would cause the price of municipal bonds to plummet, which would push their yield up astronomically, thereby increasing the borrowing costs of states, cities, school districts, etc. through the roof. Would politicians at the federal level pass off so much of a burden to the states? If it helps them get re-elected, I think they would do just about anything, don't you?
Notice how even a brief discussion of a few aspects of taxation can get very detailed. It's no wonder that political activists prefer to steer the debate towards meaningless phrases like "a tax on job creators" or "paying your fair share." They'd probably lose their audience real quick if they got down to substance. You, unfortunately, do have to know the basics of this blog post when you sit down to take your Series 7 Exam. Exam Help