A Little Tax History

The first income tax suggested in the United States was during the War of 1812. The tax was based on the British Tax Act of 1798 and applied progressive rates to income. The tax was developed in 1814 but was never imposed because the treaty of Ghent was signed in 1815, ending hostilities and the need for additional revenue.

Several tax acts were proposed and passed in the 1860s. The Tax Act of 1861 proposed broad income taxation on any kind of income or wages earned by every person in the U.S. In 1864, a new tax act was passed to raise additional funds for the Civil War and reintroduced a sliding tax scale.

Historically, Americans’ willingness to pay taxes has waxed and waned with wartime. In the 1930s, federal income taxes never totaled more than 1.4 percent of Gross National Product. However, by 1943, the number of Americans paying federal income tax had increased by a factor of ten, and income taxes had increased to 8.3 percent of GNP.

Today, the Tax Policy Center estimates that individual income taxes will total 8.4 percent of GDP in 2015. By 2018, that total will rise to 9.2 percent of GDP. Now, considering that U.S. GDP is around $17 trillion, you see that we’re talking about a lot of money that Americans pay in taxes.

The American Taxpayer Relief Act of 2012, which was signed into law in January 2013, largely preserved the tax rates of lower and middle income Americans, but it significantly raised taxes on the wealthiest taxpayers.

As America tackles its massive national debt, this might only be the first of many tax hikes to come. Lawmakers have proposed many additional taxes aimed at upper income earners including some on retirement accounts, college savings accounts, and so-called “Fair Share Taxes”. Who knows where the tax rates will be 10, 15, or 20 years into your retirement?

And not only are taxes in general increasing, but if you are wealthy, you bear the largest tax burden. The average tax rate for all Americans is 10.4 percent; however, taxpayers who earn more than $250,000 pay a 21 percent effective tax rate. This income tax burden on the affluent has grown progressively higher over time.

Consider these numbers, which were put out by the Tax Foundation in 2013:

While only 14% of Americans earn more than $100,000 per year, they pay over 80% of all income taxes.
The top 1% of taxpayers pay over 37.4% of income taxes.
The top 10% of taxpayers pay over 70% of income taxes.

Tax Changes for 2015

The American Taxpayer Relief Act of 2012 (or ATRA) preserved the tax brackets for Americans who aren’t in the highest tax bracket, preserved important provisions like higher gift tax exclusions, and patched the Alternative Minimum Tax or AMT. Many of these provisions were indexed for inflation, meaning the threshold Adjusted Gross Income goes up each year. Here are the inflation-adjusted amounts for 2015:

The highest tax bracket starts at Adjusted Gross Income (AGI) over $413,201 ($464,850 for married couples filing jointly).
Limitations for itemized deductions go into effect for individuals with incomes of $258,250 or more ($309,900 for married couples filing jointly).
Personal Exemption (PEP) increased to $4,000 in 2015 from $3,950 in 2014.
The Alternative Minimum Tax (AMT) exemption amount for tax year 2015 is $53,600 for individuals and $83,400 for married couples filing jointly.

Just to clarify, these are the applicable numbers for the 2015 tax year, which won’t affect how you prepare your 2014 taxes.

For all practical purposes, we can assume that higher income taxes are here to stay. For most taxpayers, these new tax changes increase the importance of tax sensitivity in their financial planning by taking advantage of tax-deferred accounts, managing investment sales, and properly structuring retirement withdrawals. In order to minimize the taxes you owe, consider maximizing your contributions to tax-advantaged accounts such as 401(k)s, IRAs, and HSAs. If you are still working and your employer offers a nonqualified deferred compensation plan (NQDC) – a popular option for executives – you may want to consider participating as a way to defer part of your compensation (and the income taxes on it).

Capital Gains and Dividends

With respect to capital gains and dividends, the tax rates will remain unchanged in 2015. Taxpayers in the highest tax bracket will be taxed at 20 percent, while those in the lower brackets will pay either zero percent or 15 percent. Just to remind you, to qualify for special capital gains tax treatment, a security must be held for at least a year. Also, not all dividends are qualified, and must meet certain IRS criteria which we won’t get into today. Non-qualified dividends are taxed at your ordinary income tax rate.

Possible Tax Reduction Strategies

While you’ll definitely want to speak with an advisor and tax professional before making any serious financial decisions, there are a couple things you may be able to do to reduce dividend and capital gains taxes.

One of the best ways to reduce investment-related taxes is to move taxable assets to a tax-deferred account like a 401(k), IRA or even a Health Savings Account. We’re big proponents of this approach because it not only allows investments in the account to grow tax-free or tax-deferred, but making contributions to these accounts can reduce your overall tax burden each year.

Some annuity proponents encourage you to put money in tax-deferred annuities. This may make sense in certain situations BUT you are changing the gains from probable Long Term Capital Gains (generally taxed at a lower rate) to Ordinary Income (generally taxed at a higher rate). This may or may not be the best strategy so careful consideration must be taken before you purchase an annuity of any type.

Consider revisiting your asset allocation strategy by shifting your investments to assets that generate tax-exempt income, such as municipal bonds. Tax-exempt income is not part of the calculation when figuring the surtax on unearned income. Under the lower dividend tax rates, you might have been holding investments in your taxable account. However, with the new, higher tax rates, you may want to run the numbers on that strategy again.

All this being said, overall, a prudent investment strategy is based on your investment goals, appetite for risk, and time horizon; as important as tax issues are, they shouldn’t completely wag the dog.

Retirement Plans

The amount that Americans can contribute to most retirement plans increased in 2015 because inflation increased enough to justify raising contribution caps.

401(k) limits increased. Taxpayers may contribute up to $18,000 to their 401(k), 403(b), most 457 plans, and Federal Thrift Savings Plan (TSP) in 2015. The catch-up contribution limit for employees age 50 and older increased to $6,000.
IRA limits unchanged. The limit on IRA contributions will continue to be $5,500 in 2015. Individuals age 50 and older can contribute an additional $1,000.
Larger IRA income limits. The tax deduction for traditional IRA contributions is phased out for savers with a workplace retirement plan with incomes between $61,000 to $71,000 and $98,000 to $118,000 for married couples.
Higher Roth IRA income cutoffs. The AGI phase-out range for Roth IRAs is $116,000 to $131,000 for singles and heads of household and $183,000 to $193,000 for married couples.

Keep in mind that investors who earn more than these Roth income limits may still be able to convert traditional IRA assets to a Roth.

New IRA Rollover Rule for 2015

Beginning in 2015, taxpayers will only be allowed to make one rollover from one IRA to another in any 12-month period. That means that, regardless of how many IRAs you have, you can only take one rollover every 365 days. Now, this new rule doesn’t apply to trustee-to-trustee transfers where you, the account holder, don’t directly receive the money. It also doesn’t apply to Roth conversions or to rollovers from, say, a 401(k) to an IRA. The 60-day limit still applies to all rollovers, so you do have to get the money back into an IRA within the time limit or risk paying taxes and penalties.

Tax Consequences: Excess rollover distributions are subject to 10% withdrawal penalty plus any taxes due. Any contributions back to an IRA will be treated as excess contributions and taxed at 6% per year.

Roth Conversions in 2015

The American Taxpayer Relief Act introduced some new opportunities for Roth conversions. While a Roth conversion is not right for everyone, it does provide advantages for some investors. In particular, for those of you who may have money in 401(k)s, you may be able to directly convert those assets to a Roth 401(k).

Let’s consider a few of the factors. In a Roth conversion: you withdraw money from a traditional IRA, pay all the federal and state taxes due, and move the funds into a Roth IRA, where all future growth and withdrawals are tax-free. The potential advantages to a conversion are:

If funds used to pay the tax are not taken from the IRA, the taxpayer has more assets taking advantage of tax-free growth. When possible, it’s best to pay those taxes with funds outside your retirement accounts.
Roth distributions are tax-free, meaning they won’t be subject to the new Medicare tax or add to your gross income.
Tax rates may be higher at the time of withdrawal from the Roth IRA (particularly for taxpayers who will always be in the highest tax bracket).
The taxpayer can choose to undo the Roth conversion until Oct. 15 of the year following the conversion (2016 for conversions done in 2015 in this case).
There are no Required Minimum Distributions from a Roth IRA as there are from a traditional IRA when a taxpayer reaches age 70 and a half.
You can leave a Roth to your heirs, giving them tax-free income.

Of course, there are also potential disadvantages to converting a traditional IRA into a Roth IRA. The potential detriments of a Roth IRA conversion are:

If the Roth IRA earnings are quite low over the time the funds are held in the Roth IRA, the benefits of tax-free growth are lessened. If the Roth IRA loses money over its life, the Roth conversion is unlikely to be beneficial.
If the tax rates applied to IRA withdrawals during retirement are lower than the tax rate paid on the conversion, the Roth conversion may not be advantageous. This will depend on the length of the withdrawal period.
If converting a Roth IRA significantly increases your tax burden this year.
Benefits of the Roth IRA conversion are significantly reduced if the taxpayer uses funds from the IRA to pay the tax on the conversion.
Also keep in mind that if you’re planning to do a Roth conversion on an employer-sponsored plan like a 401(k), only vested amounts are eligible for conversion.
Finally, although it’s a real wild card right now, there are rumors that a “flat tax” could be implemented someday. If this were to happen, a conversion today with much higher tax rates could cost more in taxes while extractions in the future at a “theoretical” presumably lower flat tax rate would not provide as much tax advantage at the time of extraction of the funds.

With the changes to the tax code in 2013, including the new Medicare taxes on investment income, it’s important to confer with an advisor and run the numbers before considering a Roth conversion. The good news is that Roth conversions can be reversed afterwards, which gives you extra time to consider the potential drawbacks.

Where Do We Go From Here?

You may be feeling a little overwhelmed by all the complexities of these various strategies. Perhaps even more challenging than understanding all of this, is knowing whether any of this is right for you. We are here to help you cut through the clutter to pick investments and build a portfolio and plan that is best suited to your needs as an investor.

Sources available upon request

Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this content, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for you or your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter (article) serves as the receipt of, or as a substitute for, personalized investment advice from Searcy Financial Services, Inc.

The content of this letter does not constitute a tax or legal opinion. Always consult with a competent professional service provider for advice on tax or legal matters specific to your situation. To the extent that a reader has any questions regarding the applicability of any specific issue discussed in this content, he/she is encouraged to consult with the professional advisor of his/her choosing.