Reflections on the tax law changes: income taxes favor investment.

February 28, 2013, by

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Lars is a tax guy. This has been a good skill for him. He likes it, kind of a math-like career foundation that makes him useful, earns him a good living, and has forced him (he recognizes) to develop people skills in order for things to go well. He's gotten more interested in estate planning and estate taxes in recent years, but income taxes have been his bread and butter for most of his career.

What Congress did at the beginning of January is an interesting combination of income taxes and estate planning stuff. It's mostly good for those who are wealthy or want to get there. There is still a favorable tax rate for capital gains (generally a maximum of 20%, compared with 39.6% on ordinary income), and the lower rate was also maintained for qualifying dividends. Of course there is policy justification for taxing dividends at lower rates; theoretically at least the corporation's income has already been taxed. But it's still a good deal for those who have stocks, like Lars. His portfolio will grow a little faster over time as a result.

There is an added 3.8% tax on investment income for those with high incomes. This is not quite as good for the well-to-do, and CPAs and clients are scrambling to figure out how to avoid it. It means the top ordinary income tax rate really exceeds forty percent (the 39.6% plus the 3.8%), and the top capital gains rate is 23.8% not 20%. Still, though, the highest rate on stock and sales and dividends is about half that on salary and interest income. This makes a meaningful difference over time.

Lars likes to have simple illustrations for his clients (here we go with the math thing). He thinks up this one using the highest rates. If A has dividend income of $50,000 from stocks she will net $38,100 after tax. If B has $50,000 of interest income from taxable bonds he will net $28,300 after tax. Assuming money compounds at only 4% a year, A's net dividend income will pool up to $762,899 in fifteen years. B's net interest will create significantly less: $566,668. Once again, women are smarter! No, that's not the point, but Lars might throw that in at the end with some clients, the ones who are a little quicker. That's the people skills thing.

This thinking doesn't apply to retirement plans, also important to Lars. For other than Roth plans, all income in the plan is tax-free until it is distributed to the plan participant, then is ordinary income when paid out. So stocks don't have the same tax advantage over bonds, in a 401(k) or IRA.