We’re hosting the Carnival of Wealth this week – a wrap-up of recent posts about personal finance throughout the…we hate the word “blogosphere”, but nothing else fits. If you want to submit, hustle. The deadline is Friday, and the Carnival goes live here Sunday. If you’ve got something compelling and not awful, submit it here.
Archives for January 2011
Read this and watch your taxes fall
January 17, 2011
U.S. Commissioner of Internal Revenue Doug Shulman. Never mind that this is apparently his Bar Mitzvah photo, nor that he opted for the festive ultraviolet at Sears Portrait Studio that day. Get a load of this actual quote: "I use a preparer...I've used one for years. I find it convenient. I find the tax code complex, so I use a preparer.”
Taxes are too high, but not necessarily as high as you think.
This post isn’t going to argue about the merits or weaknesses of our tax system, nor about the obscene amounts of our money that our elected officials spend on our behalf – spending that’s inseparably tied to the taxation and that shows zero signs of abating or even decelerating.
Stop 100 people on the street and ask them the difference between an effective tax rate and a marginal tax rate. 97 of them will stare at you and drool. The remaining 3 will know the answer, but won’t give it to you because they’ll be too busy wondering why you’re stopping random people and asking them finance questions.
The concept of marginality shows up in freshman college economics courses but rarely thereafter, even though it’s critical and often misunderstood. Let’s see if we can explain it without charts. Not that they wouldn’t help, but I can write several paragraphs in the time it takes to create a chart. Besides, dropping one in would create at least the semblance of a dreary academic lecture.
“The highest tax rate in this country is 35%! Why should I bother making money, when 35¢ of every dollar goes to taxes?”
3 reasons, in increasing order of importance:
1. That’s tax on income, i.e. wages and salaries. If you get paid in cash, how much of it you declare is your business. Just don’t get stupid and declare none of it. At least not under your real name. Or at least not under your real Social Security number.
2. There are other ways to earn money, namely capital gains. The IRS calls this “unearned income”, as if you were just walking down the street nonchalantly when a giant cartoon bag of money with a dollar sign on it fell out of the sky and hit you on the head. Capital gains are taxed at their own rate, typically lower than income and in some cases, zero.
3. Alluded to above, the difference between “marginal” and “effective”.
We have these things called “tax brackets” in the United States. Make $34,000 a year*, you’re in one bracket. Make $34,001 and that moves you into a higher bracket, meaning one in which you pay a higher percentage of your income in taxes. Make $373,651, that puts you in the highest bracket of all.
There are 6 brackets. The 3 referred to here are the 15%, 25%, and 35% brackets respectively.
Are we going too fast?
So if I make $34,000, I’ll pay 15% of it in federal income taxes, or $5100. If I make $34,001, I’ll pay 25%, or $8500.25. I make $1 more, but it costs me $3400.25. What a rip.
Alright, apparently we are going too fast.
No. One bracket starts where the previous one stops. If you make $34,001, the IRS treats you like someone in the 15% bracket for the first $34,000 of your income. And treats you like a mid-level tycoon for the remaining dollar, one that they charge you 25% to keep.
This is what a marginal tax rate means. You pay 25% only on the marginal income – i.e., the part of your income that gets you in that particular bracket. There, you just dodged a $3400 bullet.
It’s not even that bad. The 15% bracket also refers to a marginal rate. That bracket starts at $8375, which means that if you make $34,000 (or anything greater), you’re not paying 15% on $34,000 of it. You’re only paying 15% on $25,625 of it. The lowest tax bracket is the 10% bracket, which is for any salary or part of a salary under $8375.
So at $373,651, in the 35% bracket, you’re paying the following:
| 10% on $8350 | $ 835 |
| 15% on the part between $8350 and $34,000 | 3843.75 |
| 25% on the part between $34,000 and $82,400 | 12,100 |
| 28% on the part between $82,400 and $171,850 | 25,046 |
| 33% on the part between $171,850 and $372,650 | 66,629 |
| 35% on the remaining dollar | .35 |
| Total | 108,452.10 |
Is this a big deal? Sure it is. If you were paying 35% on all your income, your tax bill would be $22,000 higher. This total tax bill above represents an effective tax rate of 29% – your total tax as a ratio of your income.
But even the numbers in this example are unduly liberal, because they don’t account for the tax credits and deductions we’re all entitled to – for everything from making mortgage payments to saving receipts for charitable donations. (That’s not even counting the tax benefits available to someone who registers as a corporation rather than as a regular wage earner, instead of merely drawing a salary and letting her boss enjoy said benefits.)
The Beatles wrote a song about marginal rates, “Taxman”. Opening line:
Let me tell you how it will be/
There’s 1 for you, 19 for me.
That’s right – at the time, the highest marginal tax rate in the UK was 95%.
The government set such an absurdly high rate to make “the rich” pay “their fair share”, two subjective phrases that mean nothing. Apparently, whomever thought up such a rate (and its cousin, the 77% marginal rate the United States imposed in the late ‘60s) thought that there existed taxpayers who were
-smart enough to earn lots of money, yet
-too dumb to devise a way around those taxes.
The imposing authorities forget that taxpayers are ambulatory, and that work is voluntary. Why pay 77% in the US when you can pay a lot less by moving to Switzerland or Antigua? Or if you don’t want to pack up and move, then why even bother working beyond a certain point? What incentive is there to contribute anything extra to the nation’s output when you get to keep almost none of that contribution?
Beyond that, plenty of high-income earners put their money in shelters. You know what tax shelters are in theory, but keep in mind that they exist for non-economic reasons. If you’re making good money, you likely don’t put it in a tax shelter to help that money grow, to invest in a new product, or to employ people. You often do it for completely antithetical, defensive reasons – setting up a third party to funnel money through, channeling it offshore, etc. It doesn’t help the economy grow, it just keeps it out of the hands of the IRS. Which is a laudable goal, but a secondary one.
*Assuming you’re single. If you’re married, or recently widowed, or something called “head of household” (long story, and a topic for another day), the cutoff incomes differ.
How to invest with inflation still in the distance
Every Friday we review and rework a post we’d written months earlier for someone else’s site. This lets us test our theories, and the content-to-input payoff with these posts is pretty sweet, too.
This is from Consumerism Commentary. Updated notes in blue:
People have feared inflation ever since… well, since the dollar’s last rampant bout of inflation in 1977. However, there’s every reason to believe that this time inflationary pressures are too overwhelming to discount. (The consumer price index rose 1.1% in 2010. In other words, inflation remains low thanks to the Fed’s tight monetary policy. Now if we keep predicting inflation, sooner or later we’ll be right. But for the last 10 months, prices have been even stabler than they were the previous 10 months – when annualized inflation was 1.9%. In short, we were wrong in the short-term.) Or two colossal reasons, at least:
1. Legislative and executive leaders of the federal government, for whom fiscal restraint is a dirty term. No matter how laudable their objectives, they propose to spend and borrow an ungodly amount to achieve them. Any non-politician reading this blog knows the term “regardless of cost” can never be taken literally, but our elected betters think otherwise and aren’t concerned about the inevitable results.
2. A federal funds rate that resembles Carlos Pena’s batting average, or Countdown with Keith Olbermann’s Nielsen ratings. Here’s a really quick primer, because a lot of people act like they know this stuff but don’t:
The Fed (Federal Reserve) is the nation’s central bank. It actually creates our money out of thin air, which it sells to the federal government to conduct its business with. Commercial and investment banks like Chase and Wachovia (whoops. Wachovia, now a subsidiary of Wells Fargo) also borrow from the Fed. The interest rate those banks pay is determined by the Fed and called the federal funds rate, which thus serves as a basis for just about every interest rate in the economy.
Most countries’ central banks set a single rate. The Fed instead sets a range — the more you borrow, the less you pay. This of course favors larger banks, although “favors larger banks” has been a relative term ever since the federal government confiscated $678 per United States citizen and gave lent it to AIG. Since December the range has been 0% to 0.25%, an all-time nadir. (Well, how about that. It hasn’t moved since. And Carlos Pena finished the season at .196, the worst batting average in the majors among guys who qualified for the title.) Inflation has kept pace (see above), barely registering and keeping the dollar’s value intact while jobs disappear. The range eventually has to rise, since it can’t go in any other direction. Once it rises, in concert with the demand for additional dollars that government spending is creating, inflation should ensue.
What does this mean in practical terms? It means getting your assets the hell out of cash, or at least out of U.S. dollars.
(Note: We’ve long advocated quoting the price of a dollar in terms of gold, instead of the other way around. Details here, but suffice it to say that the dollar has lost an annualized 28% of its value since this post first ran.)
The immediate temptation is to shop the world for the currencies the dollar will lose the most money against. There are candidates such as the New Zealand dollar and the CFA franc, but again, your investment will only then be as safe as that government’s fiscal conservatism.
One strategy that goes a step farther is to look at blue chip stocks that don’t trade in U.S. dollars. If the stock’s fundamentals are strong enough, it shouldn’t matter if it’s measured in Swedish kronor, Swiss francs, or almost any currency short of Zimbabwean dollars. Even if a localized bout of inflation causes the stock’s nominal price to artificially rise, its real price should remain consistently strong.
Here are some examples of giant corporations that don’t necessarily trade on the Big Board nor NASDAQ:
Yes, Toyota. Exhale. And while extolling the benefits of a particular security might make the author come across as a boiler room stock promoter, I’m not telling you to buy anything. I’m telling you to look critically at the reasons for a stock’s atypical behavior.
The fun part! What did those stocks do since then?
Let’s start by looking at which ones we chose. One of those companies had some bad if undeserved PR since we posted. That company’s public image would have taken a historic beating, the worst of the year, if another company on the list didn’t have a problem was 1000 times worse. Yeah, BP won’t want to relive last summer anytime soon. We chose these stocks 3 weeks before the Gulf of Mexico disaster, too.)
This is all syncopatic, to use a pseudo-word. We’ve also written at length about what a bargain BP stock is. But that was after Deepwater Horizon.
Royal Dutch Shell, up an annualized 41%.
BP, down an annualized 43%. However, it’s up almost an annualized 100% since its July nadir and continues rising.
Toyota, down since April on the Nikkei but making huge strides since the fall. Here’s the chart. Toyota was trading at 3750 when our exercise began. Prices in yen:
If you think a week of questionable publicity in one market can turn the world’s largest and most respected automotive company into a bad investment, you shouldn’t be investing in anything more demanding than an index fund. A few months from now, no one will remember the recent uncomfortable performance that the parent company of two of Toyota’s major competitors forced the company to undertake.
Furthermore, this is a perfect time to go contrarian. Toyota shares have dropped 20% in the last month. Think about why that might happen to a stock.
Gold is the traditional inflation hedge, but when you see an investment being sold during commercial breaks on general-interest TV shows, that opportunity has clearly evaporated. Besides, gold’s value has quadrupled in the last 8 years. (And has been growing even faster ever since.) That’s swell, but if you’re looking to preserve wealth, remember that time continues to move forward, not backward.
What about Treasury Inflation-Protected Securities, whose defensive strength is written right into their very name? These are a type of U.S. bond whose interest rate, as you can probably figure out, factors inflation in. TIPS are great in theory, as long as you can trust the government’s consumer price index numbers and you can trust the government’s ability to honor its debts. “Full faith and credit of the United States government” doesn’t mean quite the same now as it did when the phrase was coined.
**This post is featured in the Totally Money Blog Carnival 2**