On Sale Now: Your Taxes

Catherine Mathis |

Today is traditionally tax-day. A Pew Research Center poll in July 2019 found that 71% of Americans agree paying taxes is integral to being a good citizen. From there the range of opinions about taxes (too much, fair or not, death vs. inheritance, etc.) vary widely. The point today is not to debate taxes on any parameter. As a lawyer would phrase it, we’ll stipulate taxes are a fact of life.

 

Should you Avoid Taxes or Evade Taxes?

“Any one may so arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose the pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.” Federal Judge Learned Hand, Helvering v. Gregory (1934)

Despite Judge Hand’s assertion, and in the realm of what most of us would categorize as ‘strange but true,” people give money to the U.S. Treasury every year to reduce the government’s debt. Not tax payments. People send in checks as a gift! In fiscal year 2019, these gifts totaled $4,991,216 which is about $65 per person in the U.S. Amazing. The government has reported on these gifts since 1988. The highest year for such gifts was fiscal year 2012 when a total of $7,749,618 was donated to the government for debt reduction.

Judge Hand’s key point is integral to the accepted principle that it is legal to avoid taxes but not to evade taxes. We avoid taxes when we take advantage of every opportunity the tax code gives us to pay less in taxes. An example of avoiding taxes is taking advantage of the Qualified Charitable Deduction. We evade when we intentionally lie about our income or deductions. An example of evading taxes is when we say our charitable contributions were $5,000 when, in fact, we only donated $500 – just a typo on the zero key.

Of course, serious tax evasion comes with lots of side effects. Tax evaders owe back taxes plus penalties and fines. They can also end up spending five years in a federal prison. Now, a stay in a federal prison is only an advantage if you have nothing saved for retirement, want a place to stay with regular meals offered, and have no relative to take you in?  On second thought, if a federal prison is your best option, you need a new financial planner ?!

 

Make the Tax Code Work For You

Typically, tax planning often consists of filing a tax return as close to the deadline as possible. There we are on April 14th sitting at the kitchen table inputting information into a tax program and trying to figure out if and how much we can deduct for the 10-year old TV we left at Goodwill in July. Instinctively we know preparing a tax return is not the same as tax planning.

We can best take advantage of the tax code by planning early in the year. Perhaps the ‘easiest’ way is to start thinking about next year when you file your current tax return. What could you have done differently last year that would have reduced tax bill? And when the evening news tells you there is a major change in taxes, you need to ask your planner or CPA what it means for you.

For example, on December 22, 2017, President Trump signed into law the largest tax overhaul in three decades, the Tax Cuts and Jobs Act (TCJA). The new law upended planning for taxes in 2018 and beyond. Let us look at one example.

 

For a person filing with the Unmarried status the Standard Deduction was raised from $6,350 to $12,000.

If a person files Unmarried and normally gives $5,000 to charity and has state income taxes of $3,000, they have a total of $8,000 in tax deductions.

Under the old law (2017), the person would Itemize their deductions because the $8,000 (charitable gifts and state income taxes paid) is greater than the Standard Deduction of $6,350,

But under the new law (2018-2025), the person would take the higher Standard Deduction of $12,000 which is far greater than the $8,000 in total deductions they have.

 

What is the tax planning opportunity?

By thinking forward and planning for two years at a time, an Unmarried filer could get the best of both worlds.

 

In the first year, the taxpayer gives nothing to charity and keeps the $5,000 in the bank.  Their only deduction is $3,000 for state income taxes paid.  In the first year, the person takes the new $12,000 Standard Deduction.

The next year, the person gives $10,000 to charity (which covers their normal $5,000 for two years) plus their state income taxes of $3,000, which is a total of $13,000. With $13,000 in deductions the person will now Itemize because total deductions are higher than the $12,000 Standard Deduction.

By planning ahead, the Unmarried filer in the example above avoids some tax by maximizing their use of both types of deductions over two years.

 

Your Taxes are “On Sale”

Now we get to the interesting part. Your taxes are “On Sale!” By definition, when something is “On Sale,” the price will go up in the future. So how does that apply to taxes? Let us see.

Numerous provisions in the December 2017 tax law (TCJA) expire for people on December 31, 2025. The law cut tax rates but only until December 31, 2025. After December 31, 2025, tax rates for people revert to the 2017 levels (inflation adjusted).

Let us look at 2017 tax brackets versus 2018 tax brackets in the table below:

UNMARRIED TAXPAYERS

2017 Standard Deduction = $6,350

 

2018 Standard Deduction = $12,000

2017 Tax Rates

 

2018 Tax Rates

10%

$0 to $9,325

 

10%

$0 to $9,525

15%

$9,325 to $37,950

 

12%

$9,525 to $38,700

25%

$37,950 to $91,900

 

22%

$38,700 to $82,500

28%

$91,900 to $191,650

 

24%

$82,500 to $157,500

33%

$191,650 to $416,700

 

32%

$157,500 to $200,000

35%

$416,700 to $418,400

 

35%

$200,000 to $500,000

39.6%

Over $418,400

 

37%

Over $500,000

 

As you look at these tax tables, recall these tax rates are applied to Taxable Income which is not the same as the salary you make.

The tables are progressive which means you pay the tax rate on each portion. For an Unmarried filer, you pay 10% on $9,524.99 (2018),the next portion is 12% on the amount between $9,525 and $38,700 and so forth. Such calculations are true for people with the Married Filing Joint status which is shown in the following table:

 

MARRIED FILING JOINT TAXPAYERS

2017 Standard Deduction = $12,700

 

2018 Standard Deduction = $24,000

2017 Tax Rates

 

2018 Tax Rates

10%

$0 to $18,650

 

10%

$0 to $19,050

15%

$18,650 to $75,900

 

12%

$19,050 to $77,400

25%

$75,900 to $153,100

 

22%

$77,400 to $165,000

28%

$153,100 to $233,350

 

24%

$165,000 to $315,000

33%

$233,350 to $416,700

 

32%

$315,000 to $400,000

35%

$416,700 to $470,700

 

35%

$400,000 to $600,000

39.6%

Over $470,700

 

37%

Over $600,000

 

The Highest Tax Rate Ever is – well in a word, Unbelievable

In the tables above, the top tax bracket dropped from 39.6% to 37%.  A rate of 37% still seems like a high rate.

What was the highest marginal tax bracket in U.S. history? In the depths of the Great Depression in 1932 the top marginal tax rate was raised to 63%. While mind boggling, that was not the highest marginal tax rate. By 1944, the top marginal tax rate reached …drumroll…. 94% on income over $200,000 (the equivalent of $2,947,057 on this date). That is a lot of income, but still, 94%! Why bother making that much money if it all goes to taxes?

The top marginal tax bracket did not get back under 50% until 1987 with the Reagan tax cut.

 

Lower Tax Rates – So What?

What is the potential impact of a lower tax rate? Here is an example. You want to convert $20,000 from an IRA (taxable retirement account) to a ROTH IRA (growing tax free for retirement). Because the tax code is progressive, when you convert the $20,000 you have to pay tax on the $20,000 amount at your highest marginal tax rate.

 

            You are Unmarried with Taxable Income of $125,000 and you convert $20,000 from your IRA to your ROTH IRA; Taxable Income is now $145,000.  How do differing tax rates impact your conversion?

            In 2017, the tax rate is 28%.  $20,000 x .28 = $5,600 in taxes due to pay for conversion.

            In 2018, the tax rate is 24%.  $20,000 x .24 = $4,800 in taxes due to pay for conversion.

 

What a difference a year makes! The move costs you $800 less.

 

The Byrd Rule (not for the birds)

You have six tax years left to take advantage of lower tax rates. But wait, Congress could extend the lower tax rates beyond 2025. Sure, that could happen. Congress did not arbitrarily pick December 31, 2025 for the current tax rates to expire. The expiration of the tax cut was forced by the Byrd Rule. The Byrd Rule (named for Senator Robert Byrd from West Virginia) prohibits tax and spending bills from increasing the federal budget deficit beyond a ten-year budget window.

The Trump tax cuts (2017 TJCA) were projected to increase the federal budget deficit. And voila – to get a tax cut the new rates could not be in effect after December 31, 2025.

With the coronavirus crisis, the Federal government has correctly responded by spending trillions of dollars that were not part of the plan. When you combine the fact that the federal budget deficit rose in 2018 and 2019 before we add in the effects of coronavirus with spending to address the COVID-19 crisis, it is unlikely that tax rates remain low after December 31, 2025.

The concern is not just that tax rates revert to 2017’s level inflation-adjusted, but that rates are higher because of deficits. We just don’t know!

We do know that we have ‘attractive’ tax rates now (as if a tax rate can ever be attractive).

 

Okay – now what?

You want to take advantage of low tax rates. In planning we generally do this by filling up a tax bracket. Here are the tax brackets for 2020:

 

Unmarried

Married Filing Joint

Standard Deduction

$12,000

$24,000

              Tax Rate

10%

Up to $9,875

Up to $19,750

12%

$9,875 to $40,125

$19,750 to $80,250

22%

$40,125 to $85,525

$82,250 to $171,050

24%

$85,525 to $163,300

$171,050 to 326,600

32%

$163,300 to $207,350

$326,600 to $414,700

35%

$207,350 to $518,400

$414,700 to $622,050

37%

Over $581,400

Over $622,050

 

If you are Married Filing Joint with Taxable Income of $190,000, then you still have $136,600 in the 24% tax bucket to ‘take advantage of’ before you tip into the next, higher bracket.

 

Here are a few opportunities:

  •  Make an IRA to ROTH conversion to move retirement income into tax-free growth
  •  Make a Section 83(b) Election on Non-Qualified Stock Options
  •  Manage your Standard Deduction versus Itemized Deductions with multi-year plans
  •  Max out retirement contributions

 

Taxes are complicated and inter-related. One move here can cause something else in the tax return to change value. Impact on state income tax can vary. While taxes are not for the faint of heart, don’t “gift” the Federal government extra money by not checking out opportunities!

If you under-pay tax or forget to include an income item or some other mistake, the IRS will write you a polite note pointing out the error. You’ll get the chance to amend the return and pay the taxes due (perhaps with a penalty). It is all a one-way street. If you could have saved money with a tax move, the IRS does not trouble itself to write and tell you that fun fact.

Nothing in this blog post is tax advice! These are planning thoughts shared to spark insights and questions. You should consult your tax adviser and your financial planner.

“The art of taxation consists in so plucking the goose as to get the most feathers with the least hissing.” Jean Baptist Colbert, Finance Minister to Louis XIV - and better yet Stephen Colbert’s ancestor.

 

This blog post is not offering investment or financial planning advice, tax or legal advice, or any form of specific suggestions/recommendations for the reader. Examples are just that – broad examples to illustrate a point. Please review the Disclosures Page for more information. 

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