Tax deferral programs have served investors well in the past, but future shifts in the political environment and potential tax rate increases may cause this to change.
The title of this paper may have reminded you
of an old car repair commercial featuring the
punch line of ?Pay Me Now or Pay Me Later,?
accompanied by a grimy mechanic with a
sinister grin on his face. The message warned
that if you put off maintenance now, you risk
paying more later on in bills and aggravation.
The common philosophy for paying
income taxes has been the opposite.
?Pay me later? has been the best strategy
for the past few years, especially during
the most recent period (see Table 1)
when tax rates have declined to
modern-day lows.
Table 1
Top Federal Income Tax Rates on Regular Income and Capital Gains since 1916
Year |
Top Rate on
Regular Income |
Top Rate Applies to
Married Taxable
Income Over: |
Top Rate on
Capital Gains |
Notes on Capital Gains Treatment |
1916 |
15% |
$ 2,000,000 |
15% |
Capital gains taxed the same as regular income |
1917 |
67% |
2,000,000 |
67% |
- |
1918 |
77% |
1,000,000 |
77% |
- |
1919-21 |
73% |
1,000,000 |
73% |
- |
1922 |
58% |
200,000 |
12.5% |
Max rate of 12.5% |
1923 |
43.5% |
200,000 |
12.5% |
- |
1924 |
46% |
500,000 |
12.5% |
- |
1925-28 |
25% |
100,000 |
12.5% |
- |
1929 |
24% |
100,000 |
12.5% |
- |
1930-31 |
25% |
100,000 |
12.5% |
- |
1932-33 |
63% |
1,000,000 |
12.5% |
- |
1934-35 |
63% |
1,000,000 |
31.5% |
Sliding exclusion of 70%>10 yrs; 0%<1 yr. |
1936-37 |
78% |
2,000,000 |
39% |
- |
1938-40 |
78% |
2,000,000 |
30% |
Excl. 50%>2yrs; 67% 18-24mo; 0%<18mo; 30%Max |
1941 |
80% |
2,000,000 |
30% |
Excl. 50%>2yrs; 67% 18-24mo; 0%<18mo; 30%Max |
1942-43 |
88% |
200,000 |
25% |
Exclusion 50% > 6 months; 25% maximum |
1944-45 |
94% |
200,000 |
25% |
Exclusion 50% > 6 months; 25% maximum |
1946-47 |
86.5% |
200,000 |
25% |
Exclusion 50% > 6 months; 25% maximum |
1948-49 |
82.1% |
200,000 |
25% |
Exclusion 50% > 6 months; 25% maximum |
1950 |
84.4% |
200,000 |
25% |
Exclusion 50% > 6 months; 25% maximum |
1951-64 |
91% |
200,000 |
25% |
Exclusion 50% > 6 months; 25% maximum |
1965-67 |
70% |
200,000 |
25% |
Exclusion 50% > 6 months; 25% maximum |
1968 |
75.3% |
200,000 |
26.9% |
Vietnam War 10% surtax for part of year |
1969 |
77% |
200,000 |
27.5% |
Vietnam War 10% surtax |
1970 |
73.5% |
200,000 |
32.3% |
Transition on CG, Vietnam War 5% surtax; minim |
1972-75 |
70%/50% |
200,000 |
36.5% |
50% exclusion, minimum tax effects |
1976-77 |
70%/50% |
203,200 |
39.9% |
50% exclusion, minimum tax effects |
1978 |
70%/50% |
203,200 |
39% |
50% exclusion, minimum tax effects; late year reduction |
1979-80 |
70%/50% |
215,400 |
28% |
60% exclusion |
1981 |
70%/50% |
215,400 |
23.7% |
50% or 60% exclusion, etc., transaition |
1982-86 |
50% |
215,400 |
20% |
60% exclusion |
1987 |
38.5% |
192,930 |
28% |
28% maximum rate |
1988-90 |
28%/33% |
* see below |
28%/33% |
Realized gains taxed same as other income |
1991-92** |
31% (31.9%) |
84,300 |
28% (28.9%) |
28% (28.9%) maximum rate |
1993-96** |
39.6% (40.8%) |
255,100 |
28% (29.2%) |
28% (29.2%) maximum rate |
1997-2000** |
39.6% (40.8%) |
280,300 |
20% (21.2%) |
20% (21.2% maximum rate) |
2001** |
39.1% (40.3%) |
297,350 |
20% (21.2%) |
- |
2002** |
38.6% (39.8%) |
307,050 |
20% (21.2%) |
- |
2003-05** |
35% (36.1%) |
319,100 |
15% (16.1%) |
Capital gains rate also applies to dividends |
2006-07** |
35% (35.7%) |
338,525 |
15% (15.7%) |
- |
2008** |
35% (35.4%) |
351,250 |
15% (15.4%) |
- |
|
2009** |
35% (35.4%) |
360,050 |
20% (20.4%) |
Dividends return to regular tax rates |
2010 |
35% |
369,050 |
20% |
Note: All Bush tax cuts expire after 2010 |
2011 on |
39.6% (40.8%) |
378,250 |
20% (21.2%) |
20% (21.2% maximum rate) |
*1988-90 detail |
28% |
31,050 |
28% |
|
33% |
75,050 |
33% |
|
28% |
155,780 |
28% |
|
**Rates in parentheses include an additional tax on Adjusted Gross Income (phased out starting in 2006; repealed in 2010).
Notes: The definition of taxable income varied very substantially over the years. Taxable income is much less than actual income.
Starting points for the top rate (indexed) are averages when multiple years are shown after 1987. Further Note: 1970-81 rates reflect a
lower top rate on earned income (second figure listed). CITIZENS FOR TAX JUSTICE, MAY 2004
The current 15 percent Long-Term Capital gains rate has
not been this low since 1933! In addition, most people do
not recognize that this rate is due to ?expire? in 2008 (see
Table 2 below) unless Congress acts to extend this
favorable rate or make it permanent. With no action by
Congress, this rate will automatically go back to 20
percent. The current Top Tax rate on Ordinary Income of
35 percent is also scheduled to expire and revert to 39.6
percent.
Table 2
Current Rates vs. Sunset
Maximum Federal Rate On:
| 2003 Prior Tax Rate
| Current Rate
| Sunset Date
|
Stock Dividends
| 38.6%
| 15%
| 12/31/2008
|
Long-Term Capital Gains
| 20%
| 15%
| 12/31/2008
|
Short-Term Capital Gains
| 38.6%
| 35%
| 12/31/2008
|
Ordinary Income
| 39.6%
| 35%
| 12/31/2010
|
Many economists also believe that low tax rates are
unlikely to continue in the current political climate. With
government deficits creeping up due to Homeland
Security, the war in Iraq, and domestic spending, the
conditions that favored lower taxes have changed.
Presidential candidate Senator John Kerry has gone on
the record as favoring higher taxes to fund these costs. Of
course, this will depend on whether or not there is a
President Kerry and whether he sweeps enough
Congressional candidates into office with him to change
the overall political will on tax policy. However, such a
scenario would make it very difficult to extend current tax
rates.
So far you may have the impression that we feel tax rates
are going up. Of course, we don't know this with absolute
certainty, but we think it is reasonable to believe that taxes
are unlikely to go down, and it's time to strongly consider
which techniques would best serve our goals in the event
that tax rates go up. We need to re-examine our long-held
belief that taxes should always be deferred.
Table 3
Pre-Tax Annual Investment |
Accumulated Investment |
After-Tax Investment |
After-Tax Accumulation |
50000 |
54000 |
32500 |
34710 |
50000 |
112320 |
32500 |
71780.28 |
50000 |
175305.6 |
32500 |
111371.34 |
50000 |
243330.05 |
32500 |
153654.59 |
50000 |
316796.45 |
32500 |
198813.1 |
50000 |
396140.17 |
32500 |
247042.39 |
After-Tax Accumulation |
237684.1 |
247042.39 |
Assumptions: 35% Ordinary Income Tax Until 2008 then 39.6%
15% Long-Term Capital Gains Rate Until 2008 then 20%
If we enter an era of higher tax rates, tax deferral
programs such as 401(k)s, IRAs and Executive Deferred
Compensation Programs may not serve us as well as they
have in the past. Table 3 shows the effect of a deferral
against an investment program currently taxed at Long
Term Capital Gains Rates. It's easy to see that the
deferral program has the edge in total dollars
accumulated, however, the liquidation at the higher tax
rate gives the 'spendable capital edge? to the non-deferral
program. Clearly, even in this scenario if there is a
company subsidy or match, the program should be used.
While a rate of return of eight percent is used in this
example, it's best to consider each individual case to see if
non-deferral investment opportunities deliver better return
opportunities, giving the non-deferral programs even more
?oomph.?
What about the assets with large unrealized capital gains
exposure? It is always painful to consider selling an asset
and paying taxes. We hate giving up an investment that
has been good to us in the past, and we NEVER enjoy
paying taxes. To make a decision like this, a comparison
of investment opportunities is in order. The hurdle rate for
a competing investment is much lower in the current tax
environment. In Table 4, the grid shows the amount of
increase in the Long Term Capital Gains Rate necessary
to create rates of return where it would be advantageous
to pay taxes now. Of course, if the expected rate of return
is higher in a competing asset, then there is little reason to
defer at these rates for tax reasons alone. This is
particularly true if the asset in question is the 'tail wagging
the dog? in your portfolio, preventing you from being
adequately diversified.
Table 4
The Liquidation Tax Hurdle
Years 2% 4% 8% 10% 12%
1 |
0.003 |
0.005 |
0.01 |
0.013 |
0.015 |
2 |
0.005 |
0.01 |
0.021 |
0.026 |
0.031 |
3 |
0.008 |
0.016 |
0.032 |
0.04 |
0.049 |
4 |
0.01 |
0.021 |
0.044 |
0.055 |
0.067 |
5 |
0.013 |
0.027 |
0.056 |
0.071 |
0.087 |
10 |
0.027 |
0.057 |
0.126 |
0.164 |
0.204 |
The window of opportunity for changing deferral options
may be open for many taxpayers. It may be difficult to
teach ourselves new tricks when it comes to doing tax
planning. It is often said that old habits die a long slow
death. However, if you believe that taxes will not be lower
for you or that tax rates are likely to go up, then it is wise
to consider your tax options now rather than to possibly
look back later with regrets. Pay me now may be the best
alternative based on today's tax and political climate. Let
us know if we can help.