Ordinary Income. Extraordinary taxes.

November 28, 2012

 

Manna wasn’t legal tender, but that doesn’t mean the IRS wouldn’t have tallied it.

 

A couple of days ago we pointed out how money doesn’t care where it came from. Some people think that their regular salaries should go towards daily expenses, while windfalls (inheritances, stock appreciation, house appreciation, etc.) can go towards less vital stuff like vacations and ATVs.

That’s an idiotic perception. If you have an asset to buy, defining “asset” as we do here at CYC (something that’ll build wealth), buy it. With your paycheck, or with a handout from Grandma. Or even a loan from Grandma, depending on what interest she charges. Otherwise, it shouldn’t matter. Regardless of its origins, money goes where it goes.

Well, that’s not entirely true. The only entity that cares how you came by your money is the Internal Revenue Service. Receive money one way, it’s taxed at a certain rate. Receive it another way, it’s taxed at a higher rate. Seeing as the IRS has the power of deadly force*, soon for the crime of not doing your duty for the Motherland and buying health insurance, it makes sense for us peons to accede to the agency’s capricious demands.

As far as the IRS is concerned, there are 2 ways you can receive income:

  1. ordinary income and short-term capital gains
  2. long-term capital gains.

This is simplified, obviously. A full accounting of every exception would take us years to write about.

Ordinary income? That’s:

  • Wages, salaries, tips, commissions, bonuses
  • Interest, dividends, and net income from a business that you own a piece of
  • Gambling winnings
  • Royalties
  • Rents
  • Pensions, assuming you’re one of the few people who collects one.

Meanwhile, capital gains are:

  • Money from the sale of a “capital asset”, like shares of a publicly traded company, or a house that you sold. Unless you’re a land developer and the house is your stock in trade, that kind of thing. The difference between short- and long-term capital gains is arbitrary but defined: hold on to an asset for a year before selling, that’s long-term.

We’ll spare you the numbers, but regardless of what tax bracket you’re in, long-term capital gains are always taxed at a lower rate than short-term capital gains and ordinary income are. There’s a good reason for this, too. Ordinary income (and to a lesser extent, short-term capital gains) carries little risk. If you punch a clock, you’re legally entitled to wages and can sue if you don’t receive them. If you wait tables, society expects that customers will tip you as part of (if not the bulk of) your income.

Long-term capital gains involve tons of risk. There’s no guarantee that that stock you bought years ago might ever result in a payoff. Contrast that with the biweekly checks you get after entering into a standard work agreement. By taxing long-term capital gains at a lower rate than ordinary income (and short-term capital gains), the IRS encourages people to hold onto their investments. If all income was taxed at the same rate, there’d be no incentive for anyone to defer spending (synonyms for which are “save”, “invest”, and “build wealth”.) We’d only chop trees down, never planting any.

So is this just an accounting curiosity, something for you to pass the time reading about on a boring Wednesday? Heck and no. Control Your Cash don’t play that game. If it didn’t apply to your life, we wouldn’t be spending time on it.

The more of your income you can derive via long-term capital gains, the less you’ll have to fork over to the IRS. We devote an entire chapter of the book to this. Chapter IX, the longest and most detailed one. (By far. Although it’s still easy to read, certainly no more difficult than our posts.)

Unless you want to move to Antigua – and before you do, remember that it’s easy to go stir-crazy on a 109-square mile island – you’re going to have to play the IRS’s arbitrary game. Both Wonderland croquet and Calvinball have more consistent rules. This wasn’t always the way, but America’s descent from beacon of freedom to patchwork of statism is a topic for another day.

Maximizing your long-term capital gains is the inevitable result of buying assets and selling liabilities, our 2-pronged guaranteed way to wealth. It means purchasing vehicles for passive, non-sweat income, no matter how modest or expensive: a $25 mutual fund contribution here, a real estate investment trust there. Anything that creates an income stream for you, or that should appreciate (such as a house). Hold onto it for at least a year, and you’ll pay less in taxes that you would if you’d earned similar income via more direct means. Hold onto it indefinitely, and…

You can defer capital gains, too. Sometimes indefinitely. Methods for doing this include structured sales, charitable trusts and 1031 exchanges, which we touch on in the book and will expand upon in future posts. Really we will.

The point is, don’t go to H&R Block with your W-2s and say, “Fix this for me.” And really don’t get a refund anticipation loan. You’ve got a few months to make this work for 2012, and to figure out how to not get burned in future years. Do it now. (By “do” we mean “buy”, and by “it” we mean click the link above. Which is also this link.)

 

*This is not an exaggeration. To quote P.J. O’Rourke, “If you don’t pay your taxes, you get fined. If you don’t pay the fine, you get thrown in prison. If you try to escape from prison, they shoot you.”

Filed Under: Capitalism, Economics, Making Smart Choices, Taxes Tagged With: , , ,

Warren Buffett is a Hypocrite, Part I

September 23, 2011

Amass an 11-digit fortune, and you should probably forgo a name tag

We’ve never done a post on The Oracle of Omaha, which makes us unique among personal finance blogs. We also didn’t misspell his name as “Buffet”, which also makes us unique among personal finance blogs.

Yes, he’s the greatest investor of all time. No one disputes this. The problem is when he starts talking about topics he either knows nothing about, or is being deliberately obtuse about. Amassing wealth doesn’t make you an authority on every subject. Case in point, his recent lament about taxes.

Buffett wrote in The New York Times that the current progressive tax system in this country, in which rich people bankroll most everything, just isn’t progressive enough. He pointed out, yet again, the absurdity of his secretary paying a higher percentage of her salary in taxes than he does.

Summarizing, Buffett claims that at least one of his employees allegedly pays an effective tax rate of around 41% on income, while Buffett himself pays 17%.

First, the former claim is a lie. The highest marginal tax rate in this country isn’t even 41%, let alone the highest average tax rate. The highest marginal tax rate is 35%, and given the income level at which the IRS administers it, to pay an effective tax rate of 35% you’d have to make $6 million a year.

So Buffett’s not comparing himself to the woman who answers phones at Berkshire Hathaway. He’s comparing himself to a manager who makes a higher salary than almost everyone in America, even more than your average NBA or major league baseball player.

We’re giving Buffett the benefit of the doubt here, assuming that he meant 35% instead of 41% even though those numbers are easy to distinguish. No one knows where he got the 41% figure from.

Furthermore, that 35% maximum rate is on taxable income. Anyone who’s ever filled out a 1040, or had someone else do it, knows that taxable income is considerably less than total income. There are these things called deductions and credits, which Buffett is presumably familiar with (and which any manager who makes $6 million a year must be familiar with, too.)

It makes for a great class warfare talking point: every dollar that I fail to make is somehow some richer person’s doing. And who better to inspire envy among the poor salaried millions than a tycoon who’s finally seen the error of his ways?

Buffett – and we salute him for this – has spent a lifetime earning money via capital gains, rather than salary. Do we think this is a good idea? Hell, we wrote a book about it.

Capital gains are taxed at lower rates than salaries are. The people who write the tax code, and make it the most cumbersome and impenetrable thing on the planet, ensure this. Of course they do. Legislators write the code to accommodate and exploit this, because they derive most of their income through capital gains.

Let’s assume that Buffett indeed has employees who are paying twice the proportion of their income in taxes as he is. What’s the fairest way to make things fair? Again, multiple-choice.

  1. Further soak the rich.
  2. Get government’s foot off the throat of the poor.

Raise the rich people’s taxes to make things even, or lower the poor’s? Rich people seem to enjoy being rich. Why not reduce rates on the salaried masses to put them in line with whatever Buffett’s definition of “rich” is, instead of the other way around? Instead of creating prosthetic limbs for amputees, Buffett wants to break the right arms of the able-bodied.

The reactionary answer is “Because it’ll reduce much-needed tax revenue.” It wouldn’t. People respond to incentives, and will have incentive to work harder, longer hours if they get to keep more of what they make. When I can keep 84¢ of my next marginal dollar, there’s a better chance I’ll work for that dollar than if I only get to keep 67¢.

It’s the height of arrogance to complain about the tax system not because it hurts you, but because it benefits you. Especially when there are so many ways for Buffett to fix this perceived injustice. Sure, he could cut Washington a check for whatever amount he feels he should be paying. He could increase his employees’ pay enough to offset any tax advantage.

Or, and this is the least likely of the three, he could rework the dividends that flow through his corporations so that he could receive all his income as salary, rather than capital gains.  The chance of this happening is roughly equivalent to the likelihood of Buffett running a 4-minute mile.

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We’ve been pushing the concept of a diagonal tax since we were old enough to understand the concept. Everyone gets a basic personal deduction – say $20,000 – and pays some percentage – say 17 – on the rest.

The guy making $6 million would thus pay 16.94% of his income in taxes. The guy making $30,000 would pay 6% of his income in taxes. The guy whose net worth increases $10 billion in a year would pay 16.99997% of his income in taxes.

People who want to soak the rich should love this system. It treats the rich and the hyper-rich almost identically, biting them almost 3 times as hard as the working stiff, relative to what all three make. If that’s not enough, just manipulate the deduction and percentage numbers until it all makes sense.

 **This article is featured in the Yakezie Carnival-October 2, 2011 Welcome Fall Edition**

Filed Under: Bad Examples, Economy, Education, Estate Planning Tagged With: , , , ,

6 out of 8 people reading this are idiots

April 15, 2011

Come on, make his job easier

And hopefully, 8 out of 8 noticed that that headline is mathematically inelegant.

It’s Recycle Friday! And under normal circumstances, it’d also be tax day. Instead, you’ve got an extra 72 hours to mail your check this year.

What’s that? You’re not mailing a check? You’re getting a refund? Oh, you poor impressionable thing. Let us set you straight. Come with us back into the archives: a dimly lit corner with a table for two. You and us. We’ve got absinthe on ice (it was a gift from a sponsor) and Sade crooning on the Bose system. Now spend a little quality time with us as we break out a post from last February. Enjoy.

That means you, who’s looking forward to getting a tax refund on April 15. It might not be the dumbest thing you can do with your money, but it’s in the top 8.

Congratulations, getting that check means you let the government (definitely federal, probably state) enjoy your money all year long, as your employer dutifully paid the IRS every two weeks before you got your share. Of what you earned.

Remember that packet of papers the HR wench gave you when you started your current job? They included IRS Form W-4, which orders your employer to withhold some minimum amount of income tax from your paycheck. The implicit message from the government is you’re too stupid to budget, Citizen.

(You also can’t handle saving for retirement, and we don’t want you making too many decisions about your health care either. But those are issues for future posts.)

Many people, 75% of you according to some estimates, gladly choose to have their employers withhold more than enough to cover their taxes from each paycheck, thinking of this as “forced saving” in a gross misinterpretation of the term. The logic goes that rather than come up short on April 15, you can spend the whole year not thinking twice about your eventual tax bill. Best of all, when all those other suckers are lining up at the post office on Tax Day, not only will you not have to, you’ll be “receiving” money from the IRS. You outsmarted the system!

You didn’t.

You don’t want to get a big check from the IRS on April 15. You want to incorporate as a business, and send the IRS small checks on April 15, July 15, October 15 and January 15.

If you’re not an entrepreneur – i.e., if most of your income is still tabulated on W-2 forms rather than 1099 forms – you still don’t want to get a big check from the IRS on April 15. If anything, you want to cut them as big a check as possible.

“As big as possible” meaning not that you should give them all your money minus your living expenses, but as much of your tax bill as you can save until the last possible moment.

Look at it this way. Lots of merchants give cash discounts. The auto repair shop would rather have your money immediately than wait until the end of the month to receive it from MasterCard (after they subtract their cut, of course.) Continuing in that vein, the longer the merchant has to wait for your money, the more they expect. That’s why most invoices call for increased payments after 30, 60, 90 or 120 days, which is obvious.

The IRS has the second part of that down, being only too happy to assess penalties if you’re late.

So does that mean the IRS reduces your tax bill if you pay early?

(Sorry, broke a blood vessel from laughing too hard.)

If there’s no benefit to paying early, why on earth would you do it? Let the time value of money do its work. The longer you can hold on to it, the better it is for you.

Retailers use the annual ritual of receiving a check as a seasonal mating call. Come to our car lot, and we’ll double your IRS refund on the purchase of a new Camry! Turn your refund into a plasma screen!

A million years of human evolution, and our brains still haven’t developed to the point where they can instinctively appreciate the wisdom of deferring things beyond the obvious benefit.

Get the minimum deducted from each biweekly paycheck. (You don’t have to wait until the anniversary of your hire date. You can do this at work today if you want.) Take the difference between that and what you would have had deducted otherwise, and invest it in your 401(k). When it comes time to pay your taxes you’ll have enough to buy that plasma screen or Costa Rican vacation and then some.

If you’re not convinced by this point, then you have no willpower and will have to wait until we release a book called Let Someone Else Control Your Cash. Even worse, in the last few months we’ve seen just how hollow the phrase “full faith and credit of the (United States) government” goes.

For instance, the state of Hawai’i recently announced it was delaying its tax refunds until July 1. This isn’t to commemorate Canadian independence day, we’re guessing.

UPDATE: It isn’t. Make that August. Late August.

That leaves 49 solvent states. Well, except for Virginia. Oh, and Georgia, which kept its citizens waiting until mid-July and beyond last year. You knew New York would be a part of this too, right? How about Alabama? And North Carolina, you can step right up too. Etc.

States routinely budget in billions of dollars, making it easy to assume they have giant reservoirs of cash. They don’t. Californians pride themselves on having an economy that would be the world’s 8th largest were California a nation, but their state government doesn’t even temper the news when it announces it’ll be paying its creditors with IOUs.

America’s largest corporations by revenue are ExxonMobil, Wal-Mart, Chevron, ConocoPhillips, Ford and General Electric. Imagine what would happen if any of them decided to pay vendors or employees with postdated checks. Somewhere between the customer boycotts and class-action suits, the state attorneys general would be among the first to publicly call these companies out.

But remember, it’s businessmen who are evil.

Hmmm…if the state, or IRS, doesn’t owe you money (that was yours to begin with) in the first place, you’ve denied the taxing authority the chance to defraud you or make you wait.

Chances are pretty good that in the next year, your municipality will float a bond issue for more money for your neighborhood firemen. Or initiate a ¼% sales surtax. You’ll vote yes, probably because of the residual effects of 9/11. A few months later, when the firemen have spent all the money on lasagna and mustache grooming and matching blue shirts for their daily trips to the gym, try not to draw a correlation to your delayed tax return. Which you shouldn’t be getting anyway, if you learn how to Control Your Cash.

**This article is featured in the Carnival of Wealth #35**

**This article is featured in the Yakezie Carnival Easter Sunday Edition**

Filed Under: Consumer Debt, Economics, Taxes Tagged With: , , , , , ,
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