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: , , ,

Control Everything But Your Cash

August 24, 2011

We're running out of metaphors

There’s an argument for being contrarian, and a solid one. A true contrarian would have emerged from the recent housing crisis not only unscathed, but rich. In its simplest incarnation, contrarianism means exactly what it sounds like: buy when everyone else is selling, and vice versa.

The reason this doesn’t work when you follow it to the letter is that it means you would have sold Google stock when the rest of the world was pushing it up from $100 to $579; and you would have bought GM stock when everyone else was jumping off, anywhere from $72 down to its eventual delisting. Over the course of the stock market’s history, you would have lost money.

A popular hypothesis is that of the “permanent bull market”, which states that any downturn in the market, however long, is but temporary. Accounting for inflation, the Dow is well ahead of where it was when it started and it always will be over any given period if you just wait long enough. Therefore, just wait long enough.

The problem is that humans have life expectancies on the order of only a few boom-and-bust cycles. Generalities don’t really help when formulating an investment strategy. Yes, you can figure out which stocks to buy by analyzing fundamentals – in fact, we recommend it because we can get you started for a mere $3.50 – but even that implies that there’s a future worth investing in.

Not to go completely nihilistic on you, but ask yourself the following questions. Seriously. Don’t just read them, think about the answers.

  1. Is there a particular number the Dow could rise to that would give you confidence in the American economy?
  2. If so, what’s that number?
  3. When do you realistically think we’ll get there?
  4. (And did you factor in inflation?)

I recently asked the president of a publicly traded foreign company this very set of questions. Conducted orally, so he couldn’t see which one was coming next. Here were his answers:

  1. Yes
  2. 13,000
  3. (hesitating) 2013? Maybe 2014.
  4. (more hesitation)

Crossing your fingers and trying to convince yourself that things can only get better is better than being pessimistic, it would seem, but eventually you have to start quantifying things and weighing your situation against inflexible time horizons. Us each getting a year older every 12 months is the only constant. What the economy does is, of course, variable.

The following are not opinions:

America’s credit rating now at its lowest level ever, on par with Belgium’s.

If the Greek or Irish economy tanks, the damage can be somewhat contained. Not so for the country with by far the world’s largest GDP.

With a few notable exceptions, no member of either party in the United States government’s legislative or executive branches is remotely serious about reducing its size (and therefore reducing the size of its current and future obligations.)

Those same government functionaries have all but stated that their goal is to eliminate risk, which is a functional impossibility. Of course, the buzzwords they use are far more benign (“keep Americans in their homes”, “make the rich pay their fair share”, “put America back to work” et al.)

People are at least finally learning how to save.
(Ha! Just kidding. It’s true that that’s not an opinion, but it is a falsehood. People are borrowing more than they have in years.)

——–

The consensus opinion among the populace seems to be to wait and see. But an enterprising contrarian can’t decide to simply do the opposite of nothing.

At Control Your Cash we try to keep away from giving specific investment advice. Not because we’re not professionals, but because our M.O. has always been to teach people to fish. That being said, it’s time to champion hard assets.

Real estate is finite. With a growing population, it would seem that real estate’s value will always increase in the broadest of terms. (People need to live and conduct business somewhere.) Gold and other precious metals are finite, at least until alchemy makes a comeback.

“But technically, everything is finite”, you argue. Which would be true if we’re restricting our discussion to the tangible. But there is literally no limit to the money a worrisome government can create. If you don’t believe that, or think it’s an overreaction, go ask a Zimbabwean. Or a Weimar-era German, if there are any left.

Inflation isn’t just a devaluing of the currency. It’s a way to punish the poor at the expense of the rich (because rich people, almost by definition, keep a smaller ratio of their wealth in cash than poor people do. Rich folks can buy assets and hold onto them. Those whose wealth consists primarily of cash aren’t just too tempted to spend it, they’re too subject to the machinations of a market that conducts business in weakening dollars.)

Sooner or later, a government with overwhelming obligations and too many creditors will have no choice but to employ the nuclear option: if you owe lots of dollars, it makes sense to make each dollar you owe worth less. If you can do it, that is. You can’t. Governments can. And shortly, will.

**This article is featured in the Yakezie Carnival-September 11th, 10th Anniversary Edition**

Filed Under: Bad Examples, Capitalism, Consumer Debt, Net Worth, Personal Finance Tagged With: , , , ,

Make more, pay less

June 15, 2011

Look closely - especially if you're at work - and you can actually see her soul leaving her body.

Dissatisfied in your job? Here’s the time-tested solution: tough it out, be thankful you have one, and come in next weekend just to emphasize the latter point.

Or you can tell The Man which orifice he can shove his company picnic and break-room coffee into, and go out on your own. Incorporate.

There are several volumes’ worth of reasons to do this. We can’t go into all of them now, but one of the best-kept secrets of incorporating is the regressive Social Security tax.

You might not be familiar with the concept of a regressive tax, but it’s easy to grasp. There are 3 species of tax:

-A proportional tax is one levied at a fixed rate. Sales tax, for instance. If your jurisdiction charges 7% sales tax, then any item subject to the tax costs 7% more than the list price whether the item goes for $1 or $100,000.

-A progressive tax means the higher the base amount, the higher the rate. Income tax in the United States (and most everywhere else, as far as we know) is an example.

That leaves the rarest bird in the aviary, regressive taxes.

You mean there are taxes where the greater the amount subject to the tax, the less you pay? That’s absurd. And illegal, right?

It’s cute that you think that. Not only do regressive taxes exist, they’re authorized by the same federal government that you entrust to have your best interests at heart. To fund the 2 biggest and least tenable programs in its tentacles – Social Security and Medicare.

Out of all the confusing, capricious, seemingly arbitrary taxes we pay, Social Security and Medicare taxes might be the most senseless.

The federal tax collectors (sorry, we don’t know most of their names, but Doug Shulman is the Internal Revenue Commissioner) take about 15.3% of your salary in the form of Social Security and Medicare “contributions”. Collectively, these are dubbed FICA – after the Federal Insurance Contributions Act. Remember, Social Security was invented because federal officials of a bygone generation decided that Americans were too stupid to save for retirement. Therefore it would take a benevolent government populated by financial geniuses to make those critical investment decisions for our grandparents, our parents, you, me, and our descendants. Medicare is essentially the same thing, but earmarked for a different purpose.

If you never look at anything but the net pay amount on your paychecks, take some time to read the other numbers. Just once. That 15.3% breaks down like this:

-6.2% employee’s Social Security taxes
-1.45% employee’s Medicare taxes
-6.2% employer’s Social Security taxes
-1.45% employer’s Medicare taxes.

Hopefully this is obvious, but you’re wrong if you think your employer pays its share of these taxes as a necessary cost of keeping so wonderful a worker as you on the payroll. She doesn’t pay these taxes, she merely collects them. You pay them. Your employer factors these taxes into your salary when she hires you. If your employer wasn’t required to pour 7.65% of your income into the subterranean trench that is the federal government, she wouldn’t. Instead, she’d much rather attract you and other employees with wage levels that are 7.65% higher than what you think you’re currently making.

How is this regressive? Sounds proportional to me.

The Social Security portion of your FICA taxes is capped once your annual income exceeds $106,800. You pay the 2.9% in Medicare taxes no matter how much you make, but the Social Security portion can’t go above $13,243.20. (Half of that levied directly on you, the other half levied on you via your employer.)

So the higher your salary – past $106,800, anyway – the smaller the proportion of it you pay in Social Security taxes. On the one hand, this gives you incentive to work hard and earn money. On the other, it’s the kind of inequality that French revolutionaries chopped off people’s heads for.

If you’re an independent businessperson, and you structure as an S corporation or a limited liability company, you can run around the system instead of through it. Incorporate, and you can pay out part of your company’s profits to yourself as salary while paying out the remainder as dividends. The former is subject to FICA, the latter isn’t.

What’s the downside?

You’d be surrendering the “certainty” of a regular, constant paycheck. As if there exists an employer who could guarantee such a thing in perpetuity anyway.

Still, it sounds promising. So why doesn’t everyone do this?

The usual reasons: fear of the unknown, lack of faith in themselves, etc. The same negative thinking that’s been holding most human ingenuity back since we figured out fire and the wheel.

Note: Some people blather that sales taxes aren’t proportional because the less you earn, the higher a ratio of your income you pay in sales taxes.
First off, sales taxes aren’t levied on income, they’re levied on sales. See “income tax”, above. Second, there’s no way around this. Unless you think state legislatures and municipal governments should mandate that merchants ask people how much money they make before determining how much tax to collect.

**This article is featured in the Carnival of Wealth #43**

Filed Under: Entrepreneurship, Finance, Healthy Living, Personal Finance Tagged With: , , , , ,
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