Wise Money Decisions

The IRS is still working through the UBS tax evader cases, and now they’ve got another insider from another bank feeding them information on tax evaders.

I don’t know anything about Rudolf Elmer except what I read in the New York Times article Swiss Banker Blows Whistle on Tax Evasion. He’s not a character that’s going to generate much sympathy from the public. But he is helping the IRS and other tax agencies chase down wealthy clients of his former employer, Swiss bank Julius Baer, that allegedly evaded taxes.

In my work as a tax lawyer I have represented taxpayers on both sides of the line. Some were clearly victims of government overreaching, and others were clearly on the wrong side of the law.  My hunch is that many of the Julius Baer taxpayers whose names are turned over to the IRS will fall closer toward the latter than the former.

On the other hand the informant may really be the scumbag that Julius Baer wants us to believe he is, and the whole affair may be more about getting even with his former employer and less about exposing taxpayers that merit IRS investigation.

We shall see.

In any event, if you have been hiding income with Julius Baer, now is a good time to call a tax lawyer and figure out your options. 

A statement by IRS Commissioner Douglas Shulman got some attention today.

On C-Span Shulman talked about using a tax preparer:

“I’ve used one for years. I find it convenient. I find the tax code complex so I use a preparer.”

A lot of bloggers and readers are using the statement to argue the tax laws are too complex. 

That’s like saying Conan O’Brien is too juvenile for the Tonight Show. In other words, duh!  Tell us something we didn’t know already!

Nevertheless, it is a good soundbite to hear the Commissioner of the IRS “admit” that he doesn’t (can’t?) prepare his own taxes, whether it’s due to complexity or convenience.

Shulman rightly points out the ball is in Congress’s court, not his.  Bush put together a task force that studied ways to overhaul and simplify the tax laws. The task force released a report in 2005 that included some compelling ideas, but the report was largely ignored.

I’m a tax lawyer, which means the marginal value of my labor rises as the tax laws get more complex because fewer people can handle their own tax affairs.  Despite it being against my own financial interest, I would love nothing more than to see Congress simplify the tax system. 

When I think about how much money we spend to obey the tax laws, through government expenditures for enforcement as well as private expenditures for compliance, and then I realize that none of that money is used to build something or develop something or help somebody, well, it’s a thought I don’t like to dwell on.

Some interesting California statistics:

Domestic migration outflow: 49th highest out of 50 states. 

According to ”Rich States, Poor States” by economists Arthur Laffer and Stephen Moore, the Californians leaving for elsewhere are our ”highest achievers and those with the most wealth, capital and entrepreneurial drive.” 

Highest maximum tax rate: 2nd highest out of 50.

Highest corporate tax rate: 15th highest out of 50.

Highest taxed population: 12th out of 50.

Best business climate as ranked by the Tax Foundation: 47th out of 50. 

Most expensive state to do business according to CNBC: 3rd out of 50.

Best state to do business according to Forbes magazine: 40th out of 50.

State requiring special credentials or licensing of most occupations: 1st out of 50.

California has credential or licensing requirements for 177 occupations.  Including mine.

Highest workers’ comp costs: 2nd out of 50. 

Highest gas taxes: 1st out of 50.

Highest unemployment rate: 3rd out of 50.

Highest foreclosure rate: 1st out of 50.

Housing affordability: 50th out of 50. 

Highest average public school teacher salaries: 1st out of 50.

Highest average compensation for state employees: 1st out of 50.

Highest welfare grant level: 2nd out of 50.

Highest state and local government spending per capita: 4th out of 50. 

Highest eighth grade math scores: 42nd out of 50.

Highest eighth grade reading scores: 45th out of 50.

Highest fourth grade math scores: 46th out of 50.

Highest fourth grade reading scores: 48th out of 50.

Highest level of violent crime: 10th out of 50.

Worst traffic: 1st out of 50.

Highest cost to repair and expand transportation infrastructure: 1st out of 50. 

Depending on your political leanings, you may find a few of the numbers encouraging.  But most of them are discouraging no matter which side of the aisle you’re on.

The statistics come from an article by Dave Cogdill, the Minority leader in the California Senate.

ABC has an article on their website titled, “They Earn $200,000 and Pay No Taxes: Find Out How These Rich Folks Avoided Paying Any Income Taxes.” 

The title is provocative and seems to be an attempt to appeal to a “class warfare” or “class jealousy” mindset.  What can be more unfair than wealthy people getting away with paying no taxes while the rest of us are stuck paying our fair share?

However, as I read through the article I discovered it’s all bark and no bite.

Here’s the story in a nutshell.  Each year the IRS releases aggregated data about federal tax return filings.  In 2005 (the most recent data available) there were nearly 7,400 returns that showed adjusted gross income (”AGI”) greater than $200,000 but reported no tax liability. 

How can someone earn $200,000 and have no federal tax liability? 

Two ways, according to the article.  First, in response to Hurricane Katrina Congress made rule changes to encourage charitable giving during the last few months of 2005.  The 50%-of-AGI limit on charitable deductions and the overall limit on itemized deductions was lifted for charitable donations made between August 27, 2005 and January 1, 2006. 

Second, in 2004 Congress began allowing taxpayers to claim a full, 100% credit for foreign taxes paid against the Alternative Minimum Tax.  Previously the credit had been limited to 90% of federal tax liability.

To sum up, there are a few thousand wealthy people that, in response to law changes made by Congress, decided to increase their charitable giving in latter 2005 or were allowed a full 100% credit (instead of the previous 90% credit) for foreign taxes paid.

It’s hardly the kind of unfairness that leads to revolution, or even hastily written letters to Congressmen.  As hard as I try, I just can’t imagine Patrick Henry getting upset about laws that encourage charitable giving.  And I did try.

There is a long list of things in our creaky old tax code that one could rightfully complain about.  Laws that encourage charitable giving or allow a credit for foreign taxes paid are not at the top of that list.

A few years ago two elderly California ladies concocted a brutal and dastardly scheme to make $2.8 million.  Their plan involved life insurance fraud and homicide.  They implemented the scheme over a period of years in the belief that a statute of limitations would prevent the insurance companies from contesting the fraud. 

Since this is a family site I’m not going to dwell on the details of the scheme.  If you’d like to satisfy morbid curiosity you can read the article (link above). 

Now the 77-year-old woman is in for life without the possibility of parole.  Her 75-year-old co-conspirator faces 25 years to life.  Prosecutors are not seeking the death penalty because both women will have died of natural causes long before the legal system could impose the death penalty. 

A Better Way to Make $2.8 Million by Age 77

Fortunately there are better, legal ways to make $2.8 million by age 77.  Let me illustrate what I believe is the easiest for the greatest number of people.

When you are 27 years old you commit to putting $243 per month in a brokerage account.  You invest your money in a diversified portfolio of low-expense funds with low dividend yields to minimize current tax liabilities.  You achieve an annual before-tax return of 10%.  You invest relatively tax efficiently.

By age 77 you have a portfolio worth nearly $3.7 million.  You sell everything, pay federal and state income taxes at capital gains rates (I’m assuming today’s capital gains tax rates for someone in California), and you have $2.8 million left.

Hmmm…. $243 per month sounds easier than insurance fraud and murder.  It takes 50 years of commitment, but the commitment is not very burdensome (only $243 per month) and doesn’t take a lot of time once you get the hang of it (passive index investing).

Inflation Hurts You….

Of course $2.8 million will not be worth as much in 50 years.  At 3.5% annual inflation it will be worth only $500,000 in today’s dollars.  How much more do you need to invest each month to overcome the effects of inflation? 

The answer is rather sobering.  You would need to invest $1,360 per month to end up with $21 million before tax.  You would pay over $5 million in tax when you sell everything at age 77, leaving you $15.6 million.  After compensating for inflation, your $15.6 million is worth $2.8 million.

Yikes.  $1,360 per month is a lot harder than $243.

I’ve got three tricks up my sleeve to make things easier.  The first involves inflation.

Read the rest of this entry »

When I bike to work I pass two gas stations.  One was selling the lowest grade at $4.01 this morning.  It’s the first time I’ve seen the low grade above $4.  The other had low grade at $3.91.  Guess which one I frequent? 

It’s a trick question.  I don’t frequent either.  I go as infrequently as I can.  The weather’s nice and I’d rather bike to work.

A few days ago I pointed out that gasoline accounts for 70% of the average gas station’s revenues, but only 30% of its profit. 

Now I have additional data to offer.  According to the U.S. Energy Information Administration most stations receive only 7 to 10 cents per gallon sold.  That’s their revenue.  After expenses they’re left with a just a few cents of profit per gallon sold. 

Where Does the Rest of the Money Go?

Here’s the breakdown  for a $3.04 gallon of gas, according to the Energy Information Administration:

Crude Oil

More than two-thirds pays for the crude oil.  It’s the reason that gas prices go up when oil prices go up. 

Saudi Arabia can produce a $110 barrel of oil for as little as $1, while a U.S. company drilling in the Gulf of Mexico might spend as much as $70 to produce one barrel.

Taxes

The taxes vary depending where you live.  The average state adds 22 cents of gas tax, while the federal government tacks on another 18 cents. 

Guess which lucky residents of which lucky state get to pay the highest state tax?  Here’s a hint, it starts with ‘C’ and ends with ‘alifornia’.  According to the American Petroleum Institute, California adds 45.5 cents per gallon.  Yikes. 

If you’d like to see your state’s gasoline tax click here.

Ship and Sell

This includes the cost of moving the gas to gas stations via trucks or pipelines.

Refining

Refining is the process of turning crude oil into gasoline.  Refining companies have to buy crude oil at market prices.  Their bottom line is hurt by high oil prices.

Conclusion

When I buy a gallon of gas most of the money goes to the oil producers.  The U.S. oil companies do very well with high oil prices, but it’s the Saudi Arabias of the world that make a killing because of their rock bottom production costs. 

The corner gas station makes a few cents per gallon.  That’s less than 30 cents when I fill up the Accord. 

When I was a kid I filled up my lawn mower a few gallons at a time.  It must have barely been worth the wear and tear on the station’s pump - except it was worth it because I bought so many baseball cards at that station.

Last week I mentioned that one reason I haven’t started my taxes is the likelihood I would receive a corrected 1099.  Sure enough, the next day I received a corrected 1099.

I came across this Kiplinger article that explains why so many 1099’s have to be corrected and reissued.

For a couple years I’ve thought about whether to do a traditional IRA or a Roth IRA.  I haven’t come to a firm conclusion.  Until this week.

Whether to do traditional or Roth is important because the “wrong” decision can mean paying thousands of dollars of extra tax. 

I put “wrong” in quotations because contributing to either is a wise money decision.   Choosing between the two is like picking between A&W and Parker’s root beer.   On any given day one might be slightly more delicious, but you can’t go wrong because both make your life better.

Also note that you don’t have to choose between the two.  You can do both.  And it’s probably smarter to do both.  More on that later.  But it’s also nice to figure out whether one is better than the other.  If one is better, you’d like to focus on it more.

Your Current and Future Tax Rates Drive the Decision

This article assumes an understanding of the tax advantages of IRA’s and 401(k)’s, both traditional and Roth.  If you’re not sure how IRA’s reduce your taxes, you may wish to do some background research first.  Try this Motley Fool article on traditional versus Roth IRA’s (I haven’t read it, but Motley Fool is usually good at explaining basic concepts like this).

It’s well understood that the key factor in choosing between traditional versus Roth is your tax rate now versus your tax rate later.  If you have a higher tax rate now, you want to contribute to a traditional IRA.  If you have a lower tax rate now, you want to do a Roth.

There Are a Few Other Reasons

For most people the decision is driven by the tax rate expectations.  But there are a few other smart reasons for choosing one over the other.  Someday I’ll do a more exhaustive look at all the reasons that might push you toward one or the other, but for now I’ll mention two:

• Traditional and Roth IRA have different restrictions on when you can withdraw contributions and earnings without incurring a penalty;
• Making contributions to a traditional IRA may lower your income sufficiently that you can take advantage of a deduction or credit you’d otherwise be phased out of, such as the student loan interest deduction or the child tax credit.

Back to the Tax Rate Issue

If you had a crystal ball and could foresee that you will have the same tax rate in the future as you have right now, a traditional IRA and a Roth IRA are financially equivalent.  The problem stems from not knowing your future tax rate.

A few days ago Jonathan at MyMoneyBlog put up Daydreaming: How Can I Retire In 10 Years?   I liked the post for two reasons.  Not only is retiring early a topic dear to my heart, but Jonathan wrote something that sparked an idea.  Here’s what he wrote:

“[After retiring] if I have no other income from sources like pensions or annuities, this means I should lean towards contributing to Traditional IRAs and 401(k)s exclusively right now instead of Roth’s since my tax rate in retirement should be very low - much lower than I might have guessed before.”

Jonathan recognized a reason why his future tax rate may be lower than his current tax rate.  He correctly reasons that he should lean toward a traditional. 

Read the rest of this entry »

The Tax Foundation keeps track of how much the average American spends on taxes such as federal and state income taxes, social security, medicare, sales and excise taxes, and property taxes.  Comparing the sum of these various taxes with the average American’s income results in some surprising conclusions.

According to the Tax Foundation the average American will spend 30.8% of his/her income on taxes in 2008.  Yikes. 

To put this in perspective, if you dedicated all of your income starting on January 1 to pay your annual tax burden, you wouldn’t be finished until 113 days later on April 23^rd - “Tax Freedom Day.”  Only after that would you start to make money for yourself. 

There is perhaps some irony that Tax Freedom Day falls so close to April 15^th, the day personal income tax returns are due.

Which Tax is the Largest Culprit?

Income taxes are the largest culprit by far.  Of the 113 days the average American works to pay taxes, income taxes are responsible for 42.  The rest break down as follows:

Federal, state, and local income taxes … 42 days

Social Security and Medicare … 28 days

Sales and excise taxes … 16 days

Corporate income taxes … 13 days

Property taxes … 12 days

Taxes Are More Expensive Than Food, Clothing, and Housing

The Tax Foundation also calculates the number of days the average American works to pay for basic livings costs:

Food … 35 days

Clothing … 13 days

Housing … 60 days

Health and medical care  … 50 days

Notice that taxes cost more than food, clothing, and housing combined.

It’s a Hypothetical Average

Now of course we don’t work the first 113 days of each year to pay taxes.  Instead we pay them a little bit at a time.  But Tax Freedom Day is a useful visualization to help us understand the extent of the tax burden Americans face. 

Tax Freedom Day is calculated using the tax burden of the average American.  Some taxpayers pay a greater percentage of their income and some pay less.  Tax burdens differ because of progressive tax rates, different tax rates for different types of income, and the various deductions and credits that disproportionately affect a taxpayer’s tax burden depending on his circumstances.

The tax laws do not treat all types of income equally.  No matter how much you pay in taxes, it makes a lot of sense to be aware of how different types of income are taxed.  For example, income earned from labor generally is taxed more heavily than income earned from capital.

Conclusion

It’s sobering to realize how many hours I work to pay my taxes each year. 

I can’t control how the government writes the tax laws, but I can utilize those laws to reduce my tax burden as much as possible.  It’s important to take advantage of things like tax-advantaged retirement accounts, tax-favored health insurance, deductions and credits, and the lower tax rate on capital gains. 

To quote the well-known judge Learned Hand in a federal tax case from 1934 (Helvering v. Gregory):

“Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands: Taxes are enforced exactions, not voluntary contributions.”

Yesterday I pointed out that I normally wait to do my taxes until late March or early April in case my stock broker sends me updated information. 

My stock broker must have read my blog because today I opened up the mail and what did I find?  (drum roll…)  An updated statement from my stock broker! 

Once again, I’m glad I waited to do my taxes.  It just goes to show that sometimes it’s better to put off until tomorrow what you can do today.