The age-old twin thieves of taxes and inflation have been on the DL (down-low) for quite some time. In our last blog post, we focused on how INFLATION is heating up and how our process protects our client’s during inflationary periods. In this post, we are turning our attention to the other thief – TAXES.
There are three generally accepted types of tax systems, and the US employs all three. (I know – shocking!) The three main categories are…
- Regressive
- Proportional (or sometimes called flat tax)
- Progressive
The difference in these systems is mostly measured in the way they affect or impact high- income earners and low-income earners.
Side bar: Notice that I didn’t say the way they affect the rich vs the poor. Some people mistakenly equate being a high-income earner to being rich. There are countless high rollers who blow through income like its going out of style. Most often these big spenders do not allocate their income in a way that enhances their balance sheet – a more accurate measure of wealth. Likewise, what about the single dad pulling down a six figure income, but who is supporting a half dozen kids who are in various stages of high school and college? There’s a high-income earner who I assure you is not rich – at least not in material wealth.
A regressive tax system levies the same percentage on products or goods purchased regardless of the buyer's income and is thought to be disproportionately difficult on low earners. Examples of regressive taxes are property taxes, sales taxes on goods, and excise taxes on consumables, such as gasoline or airfare. Excise taxes are fixed and are often already included in the price of the product or service.
A proportional tax applies the same tax rate to all individuals regardless of income or wealth for that matter. This system is meant to create equality between marginal tax rates and average tax rates paid. Proponents of proportional taxes believe they stimulate the economy by encouraging people to work more because there is no tax penalty for earning more. They also believe that businesses are likely to spend and invest more under a flat tax system, putting more dollars into the economy.
Finally, a progressive tax imposes a greater percentage of taxation on higher income levels, operating on the theory that high-income earners can afford to pay more. The U.S. federal income tax is a progressive tax system.
WHEN TAXES INCREASE: As a wealth management firm, we work in the realm of either high-income, high-wealth, or both. For our client’s, rising taxes pose an additional challenge in our efforts to preserve or propagate wealth. Just as we pointed out in our previous post that the pandemic has stirred the inflation monster, the measures being taken by the US Government to fight the pandemic have also awakened the tax beast.
According to a senior policy analyst at The Tax Foundation, the US tax system is becoming even more progressive. What does that mean? Well, there are two sides to every coin. On the one hand, it means there are fewer Americans who pay any tax at all in part due to new and/or expanded relief measures such as the child tax credit, standard deduction and the earned income tax credit. On the other hand, it means that those citizens who do pay income taxes are paying more.
The Urban-Brookings Tax Policy Center released in August of 2021 that nearly 61% of US households last year PAY NO TAX AT ALL! And that’s up from 44% in just the year before (2019). In other words, at the same time that tax rates and marginal brackets are likely to increase to offset deficit spending, fewer people are helping bear the burden. (So much for the rich not paying their fair share having any validity).
More often than not, the most visible outflows from wealth are a client’s core and lifestyle spending goals. An accurate modeling however, must also incorporate the “behind the scenes” subtractions of taxes and inflation. Even greater accuracy is achieved if tax calculations are in line with current tax law. In other words, as the rules change, the tax calculations in planning models should also change.
Along those lines, it bears mentioning that as returns are not experienced deterministically (i.e. the same rate applied every year), neither should taxes be applied deterministically, but rather dynamically from year to year. For example, the taxable income for a year in which a client is supported from excess cash will be dramatically different from let’s say the following year, when a taxable distribution is required from an IRA. To whatever extent is possible, taxable income should be forecasted each year and the appropriate tax applied.
By applying both of these BEST PRACTICES to goals-based wealth management plans, a more accurate accounting of taxes can be integrated into the analysis thereby contributing to the quality of Advice.
Mitigating taxes can also be addressed at the portfolio level. For Wealth Managers able to build a private portfolio for each household, numerous tax strategies become available...
- Tax Location Management
- Tax Loss Harvesting
- Trading Tax Minimization
- Gains Rate Maximization
Location Mgmt. is directing equities into taxable and tax-free accounts while weighting fixed income in tax deferred accounts. Loss harvesting is realizing capital losses to offset/shelter realized gains. Trade tax minimization involves mitigating the tax consequences triggered from doing trades in a taxable account. Finally, gains rate maximization is selling shares that qualify for the beneficial long term capital gains tax rate over doing trades on assets that are in a short-term gain position. This strategy also involves strategically delaying the sale of shares until they qualify for the favorable LT tax rate.
Ultimately, successful wealth management is often correlated to how well taxes and inflation can be neutralized.
This is the future of Advice. This is planning done right!