Our tax systems, I’m referring primarily to federal and state income taxes, have gotten ever more complex and will likely continue that track. This is, in part, due to the social choice on taxes, which is to provide incentives for behaviors that are deemed desirable, and disincentives for behaviors that are deemed less desirable. Taxes are also based on the notion of raising revenue, to the extent possible, to fund government operations. History shows that, ironically, there are levels of taxation where increased tax rates reduce government receipts and reduced tax rates increase them. Who knew?
With my own history as a tax professional I've seen firsthand the effects of high tax rates. At the start of my professional career, the maximum individual tax rate was 70%. This was after several years of top marginal tax rates of 90% and above. The interesting thing about these high tax rates is the effect they have on decision-making. You may first think I'm talking about tax-evasion and tax avoidance. Note that the distinction between evasion and avoidance is significant, in that evasion is illegal and avoidance is not illegal. Although the motivations for both evasion and avoidance become greater as the marginal tax rate increases, let's stick to the law-abiding world. Tax avoidance can cover a broad range from quite benign, such as the holding of tax-exempt municipal bonds rather than taxable corporate bonds, to quite aggressive and extreme tax shelter structures designed to change the appearance and character of transactions from one thing into another.
The garden variety tax shelter around at the start of my career was the exploratory oil & gas well. The independent producer (this treatment was limited to small producers) could spend, say $100,000 drilling a well. If the well hits, (produces oil and/or natural gas) then the revenue belongs to the producer (and other risk-taking participants) generally for the life of the well. The revenue is (was) subject to taxes and had some extra tax benefits associated with the production itself. If the well was a dry hole, the independent producer could deduct the cost of drilling the well, for the most part, on his/her tax return. Think through this with me. The upside belongs to the producer. The downside is subsidized by the Treasury to the extent of 70% plus state tax. So, the downside exposure for the producer was in the vicinity of $30K, not $100K.
This was not intended by the folks that enacted the 70% maximum tax rate, let alone the 90% tax rate. But it sure was the consequence. The increased demand for tax shelters caused a rush for tax-shelter- driven drilling projects, many of which would have never seen a drilling rig had the demand not been juiced by the unintended tax subsidy. I saw this up- close and first hand. Too many of the tax shelter deals were just lousy prospects and lousy investments. This was a tragic misallocation of capital; a waste. High tax rates make tax shelters attractive. Tax shelters are almost never good investments, although most of them are sold that way. At this firm, we have never been proponents of tax shelter vehicles.
Since the mid 1980's the maximum federal tax rate has varied back and forth between 35% and 40% give or take. This rate seems fairly high, yet low enough to moderate most of the egregious tax shelter activity.
Our approach has always been to try to mitigate taxes in a reasonable and responsible way. There are concrete steps that can be taken to reduce and/or defer tax costs. This is but a partial list.
In the portfolio:
- Asset location - place the tax efficient assets in the after-tax account and place the tax inefficient assets in the pre-tax account.
- Minimize trading Trades always trigger tax effects. The tax effects of normal growth in the portfolio can be deferred for many years with careful trading management and careful selection of investment vehicles.
- Avoid mutual funds with high turnover rates – (see above), and/or high expenses.
- Track trade-lots individually and select the lots sold for each sale. - This is a "method of accounting" that must be applied and followed appropriately and in scrupulous detail. Consult your tax advisor.
- Loss harvesting - when available, can contribute to the long-term deferral of tax on gains.
- Remember money earned through long-term capital gains spends just as well as money earned through interest income; and it is taxed more favorably.
- Maximize 401(k), SEP, SIMPLE or other elective deferral opportunities - this works when the deferral takes place in high tax rate periods and the income recognition takes place in low tax rate years.
- Use appreciated securities for charitable contributions. Subject to some percentage limitations, the entire value of the security is deductible and there is no recognition of income on the disposition.
- Manage capital gain recognition to make use of available low, or zero capital gains rates.
- Consider accelerating IRA income into years between ages 59½ and 70½ (before the start of Required Minimum Distributions) to take advantage of lower tax rates (if available to you) in those years.
- For seniors, manage gain recognition with an eye on the Modified Adjusted Gross Income (MAGI) levels that trigger increases in Medicare premiums.
- With the new higher standard deduction, it can be helpful to bunch itemized deductions in alternating years to obtain the benefits of the deductions.
- Qualifying Charitable Distributions from IRA accounts for those over 70 1/2 are an excellent way of assuring tax benefit of charitable giving as well as managing MAGI (see above).
Even as we are bothered with the complexity of tax compliance and of return preparation itself, and with the cost of our taxes, we are mindful of how fortunate we are to live where we live, and when we live.
We are here to help with this.
Reminder to get your quarterly Credit Report from: TransUnion
The table below shows the returns through March 31, 2019 for selected investment asset classes. In most cases, the results below are appropriate benchmarks for the related mutual funds in your investment portfolio.