Death, Taxes, and Fighter Pilots: Two of These are Certain

It seems there are two prevailing sentiments about taxes:

“Taxation is the price which civilized communities pay for the opportunity of remaining civilized.”

–Hart

“A fine is a tax for doing something wrong. A tax is a fine for doing something right.”

— Anonymous

Regardless of which camp you prefer, federal taxation in the U.S. is confusing on a good day, and rivals a lecture on radar theory the rest of the time.  But what do we mean when we talk about taxes?

We frequently target “income taxes” when lobbing shots at Uncle Sam’s levies.  But at the federal level, there are at least eleven different tax systems:

• Income tax: 0-37%, progressively calculated against earned income. 
• Alternative Minimum Tax (AMT): a version of the income tax that serves as a goalie to prevent higher-income taxpayers from avoiding income tax.
• Social Security: 6.2% from both employer and employee on the inflation-adjusted “wage base” of earned income, $142,800 in 2021.
• Medicare: 1.45% from both employer and employee on earned income.
• ACA “Obamacare” Medicare Tax: .9% on earned income above $250K/$200K (MFJ/S)
• Net Investment Income Tax (NIIT): 3.8% on capital gains for those making above $250K/$200K (MFJ/S)
• Long-Term Capital Gains (LTCG): 0%-20% on investment gain (e.g. stocks, real estate) held over 1 year.
• Short-Term Capital Gains (STCG): Ordinary income tax rates on investment gain held 1 year or less.
• Dividend Tax: Either LTCG or STCG treatment on profits distributed to you in a taxable account. (e.g. Johnson & Johnson stock pays you a $1 per share dividend in a taxable brokerage account.)
• Excise Tax: Usually thought of a “sin taxes,” these are levies on certain products like alcohol or cigarettes. These are usually thought of as “hidden” taxes since they occur before the consumer sees them.
• Unified Gift & Estate Tax: A combined system that taxes transfers over a $15K annual exclusion and over an inflation-indexed $11.7M (2021) or $23.4M for married couples. Tax rates range from 0% to 40%.
• Generation Skipping Transfer Tax (GSTT): This tax (at the same rates as the Gift & Estate Tax) is on transfers to those 37.5 years younger than the transferor. It’s meant to prevent wealth-shifting to younger generations without taxation.

While it’s exhausting to consider the taxes we do have, there are several taxes we don’t have (at least at the federal level):

• Wealth Tax: Used to limited success in some European countries, an annual tax on accumulated wealth does not exist in the U.S. and is unlikely any time soon.
• Flat Tax: An alternative to our progressive income tax system (Make more? Pay more.), a flat tax would have all taxpayers cough up the same percentage, e.g. 10%, and simplify taxation by replacing other taxes. While appealing to many at face value it has several flaws that will likely keep it out of the federal code:
  • Regressive against lower income taxpayers: Poorer taxpayers generally spend almost all (or more) of their income and therefore pay more in sales tax and other state/local taxes.  A flat tax hits them harder, because…
  • Many low-income taxpayers pay $0 in income tax because of the progressive tax brackets and various credits, such as the earned income credit.
  • High-earners often receive money from capital gains and dividends, not earned income. A flat tax would skip those earnings.
• Sales, Property, and Transfer Tax: Currently only used below the federal level.
• Inheritance Tax: A few states tax the inheritor of an estate, and Maryland taxes both the estate and the heirs.
• VAT (Value-Added Tax): Common in Europe, these taxes are levied at each state of production rather than only a sales tax at the final stage.

Finally, there are some other “hidden” taxes that we may encounter as we age.

• Tax on Social Security Income: Depending on how much income you have when you start claiming social security, the up to 85% of the social security benefit itself is subject to income tax. Additionally, if you claim social security early and continue to work, you receive reduced payments equating to another hidden tax.
• IRMAA: The Income-Related Monthly Adjustment Amount adds additional heft to your Medicare premiums if your income is over certain thresholds.
• RMD: A required minimum distribution from your tax-deferred IRA/401(k)/TSP is necessarily a hidden tax—hopefully you were tracking that you’d have to pay at some point. But, if you don’t plan for how to sequence your retirement income, RMDs can add to your income in a given year and cause an surprise tax boost.

Lest this list of taxes drone on like the begats, let’s talk about what we can do to legally minimize our tax bill.  Since tax law changes constantly, you’ll need to stay on your toes and talk to your financial planner and tax professional to lead turn these issues.

• Income Tax is progressive—so deferring taxation in hopes of lower income later can reduce taxes now. Additionally, due to inflation, a dollar today is worth more than a dollar tomorrow. The most common deferral strategy is a Traditional TSP/401(k)/IRA.  This was the only game in town until 1997 when Roth IRAs came into being.  Now you need to consider, is my income tax bracket higher now than it will be in the future (that I can’t see)?
• Social Security Tax—is on earned If you own a business and elect taxation as an S-Corp, then distributions (not wages) avoid social security tax. If your main income is from the slums you lord over, that’s also usually passive income, so no social security tax there.  Finally, capital gains and dividends held for longer periods receive favorably lower income tax rates and don’t factor into social security taxation until you’re receiving social security payments.  It may not be practical to live on capital gains until your retirement years, but could be part of retirement tax-reducing strategy.
• Medicare Taxes—are similar to social security taxes except for the 0.9% and 3.8% and IRMAA which can be based off your AGI and therefore include capital gains. Medicare faces a crushing burden in the coming years as more baby boomers retire. Roth distributions don’t appear on your 1040 the way that capital gains, wages, and other sources of income do and therefore use of Roth retirement vehicles may be your best defense against Medicare taxes.
• Capital Gains and Dividend Taxes: The first strategy is to hold investments for the required period of time—usually over 1 year. The second is to continuously conduct tax projections, looking for years where you might be able to slip down a bracket from 15% to 0% or 20% to 15%.  A third strategy is to hold on to the asset and pass it to your heirs who can sell it without a tax bill under current law.  Finally, donating appreciated assets not only flushes the gains off your balance sheet, but provides a tax-deduction in most cases.
• Estate Taxes (Gift and Generation-Skipping): These are red herrings for most Americans. We simply won’t have large enough estates to ever worry about them.  You’re reading this far into an article about taxes, so you might build an estate-tax worthy nest egg and consider the following strategies:
  • Enjoy it while you’re alive. Yes, you’ll surely pay some taxes while doing so, but death is also certain and you can’t take it with you.
  • Gift or donate it out of your estate. You can give $15K per year to as many people on planet earth as you want with no tax effect.  If you donate too much for a deduction in one year, you can carryover the unused deduction to the next.
  • Trust strategies. There are myriad types of trust that allow you to shift income out of your taxable estate (which would need to be over $23.4M in 2021!) while receiving residual income from the trust during your lifetime.  While the domain of these strategies needs a textbook or seven, one such strategy is the Charitable Remainder Trust (CRAT).  A CRAT allows you to put money in a trust, direct the annual income from the trust to your desired recipient and then leave the remaining principal to the charity when you pass.

Cleared to Rejoin…

This article is necessarily incomplete, but should provide you a snapshot of individual taxation at the federal level and a few thoughts on how to legally manage it.  As evidenced by the entire professions, government agencies, laws, and court systems designed around it—our tax system can be wildly complicated.  The ultimate reality is that regardless of progressive or regressive taxes, the more you make and keep, the more you’ll probably pay.  But there are plenty of ways to skinny-down your tax bill.  Tax-planning is a continuous process that involves not just this year’s income and transactions, but those of a future you can’t know but have to constantly estimate.   Wouldn’t be nice if there were better certainties in life than death and taxes?

Fight’s on!

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