AskDong

Recently there’s a been some buzz around what Obama might do with taxes. Obama has basically said he would raise tax rates. While I try not to be too political on this blog, I don’t hide my politics either. I’ve got no problem with higher taxes when we’re running enormous budget deficits which we are. Does this mean I support every government spending program? Hardly, I think the Government is generally inefficient and wasteful. However, I think to balance the budge will require both spending cuts and tax increases. I personally support both.

I do think that one of the best places to raise taxes is on Capital gains. Capital gains rates are at historical lows. The maximum rate is Fifteen percent for long term holdings. According to the IRS 12 months constitutes long term. I know my girlfriend hardly considers 12 months a long term commitment. I’m not sure the IRS should either. Lengthening the holding term is one way of raising taxes as short term holdings are taxed at ordinary income rates. More capital gains would fall under ordinary income rules.

However, I believe raising the long term rates has merit. The fundamental argument for why capital gains should be taxed at lower rate than ordinary income is a good one. Invested capital does more for the economy than incremental labor. I believe this. Venture capital firms have created millions of jobs through their funding of once startups such as Apple, Amazon, and Microsoft. The extra shift I pulled at the Library in 1997 not so much. However the gap between long term capital gains and ordinary income is probably too much right now. There’s no reason for average Americans to pay in excess of 20-30% on their marginal income while only being taxed 15% on capital gains. Keep the rate lower, let’s say 10% lower than the equivalent marginal income rate. So someone in the 35% tax bracket would pay 25% instead of 15% as they do now.

On the other hand there is a real problem in that most Americans are not saving and investing enough. Raising the capital gains rate might potentially discourage middle class Americans from saving and investing. That’s a real problem, but one that the Government has tools to address. The government can giveth and taketh. By raising the capital gain rate, the Government would then be able to pay for additional retirement tax breaks. I love the ROTH IRA, and in 2010 it’s set to be available to everyone regardless of income, but the traditional deductible IRA needs some love as well. The Government should take the opportunity to extend the tax deductible IRA to everyone. It would be perfect opportunity for the Government simplify the code and allow everyone make tax deductible contributions up to some set amount. As things stand now, deductability is a function of how you’re empoyed. You’re in good shape if your company offers a 401K (15k a year of personal contributions and upto 40k including employer contributions), and potentially even better shape if you’re self employed (40k a year). If your company doesn’t retirement plan, and are not self-employed, you’re screwed. The most such person can contribute is the 5k allowed under traditional IRA rules . The government could easily fix all of this by allowing individuals to contribute upto 40k across all tax deductible accounts including tax-deductible IRAs.

According to my estimates, I will owe taxes next year come April 15th. I will owe enough taxes that I should be paying estimated taxes. I already missed my 1st payment on April 15th. I didn’t forget. I missed the payment on purpose. I had decided that I rather pay the penalty rather than pay the actual taxes. I made this decision because I believed the penalty rate was determined by the short term fed rate. Given that the short term fed rate is currently sitting at 2.75% as measured by the fed fund rate, I figured I would be doing about the same by leaving the money in a high yield savings account.

In my haste I missed that penalty rate is actually the short term fed rate plus 3%. The total penalty is 6% according to IRS.. So today I made my first estimated tax payment. Even if the penalty rate was the lower rate that I believed it to be, I think I might have still changed my mind and made a payment.

I’m no tax lawyer, and am confused somewhat exactly on how the penalty is assessed. In my original post about filing taxes, I stated that a safe way to determine what the safest minimum payment required by the IRS is 110% of the previous year’s taxes. That’s what I’ve chosen to do. However, if I choose not to make any estimated tax payments at all, do I have to pay the penalty on the full amount that I owe? For example let’s say my taxes last year were $1000, and this year I’m required to make estimated tax payments. I can make pay $1100 in estimated taxes even though I know I’ll owe $2000 in taxes. I pay the remaining balance of $900 on April 15th, and still avoid paying a penalty because made payments that were 110% of my last year’s taxes during the course of the year. However, had I chosen not make any estimated tax payments do I owe a penalty on the full $2000 or the $1100 that I was suppose to make? Since I know I’ll actually owe more taxes than my required estimated taxes, I’ve decided not to find out.

With the housing market in a bit of a slump and interest rates low, I thought it would be a good time to buy my first home. I am planning on buying a condo in the next few months.

My question is this — I know the IRS allows you to take out up to $10,000 from an IRA or a Roth IRA to finance a first-time home purchase. Do you have any thoughts on whether it would be better to take the money out of my Roth versus my Traditional IRA?

-s

Hmm, I would say it’s best to do neither. The IRS allows individuals to withdraw funds from the IRA penalty free, and in the case of the Roth IRA tax free (assuming the withdrawal is after 5 years). The withdrawal is considered a qualified distribution - not much different from taking distributions at retirement. Of course if you’re gains in the traditional non-deductible IRA are limited or non-existent, paying taxes may not come into play at all. Sound great, right? The fundamental problem with taking a distribution early even if it’s penalty and tax free is that you can’t put the money back in.

IRAs, and 401k are tax shelters.  By holding money in these vehicles, investors avoid the annual drag of taxes or in the case of the Roth IRA taxes on gains period.  Every year we only get a certain amount dollars we can shelter, and it’s use it or lose it proposition.  It’s not like we can not contribute one year, and contribute twice as much the next year.  For this reason, I think it’s critical especially when you’re young to get those dollars in, and maximize the amount of money you’re sheltering from taxes for the longest time possible.

I would say if you can look to other sources of funding. I would even suggest borrowing from your 401K.  At least in the case of your 401k, you’re actually putting the money back in.  As long as you’re comfortable with job security and or your ability to pay back the loan if you were to switch or lose your job, I think borrowing from the 401k can a good option especially if the payback period is over a short period.  Yes, you lose some period of tax sheltering, but if the loan period is short it shouldn’t be a big deal.  The criticism of paying taxes twice because you’re paying with after tax dollars is generally overstated since the initial loan is tax free and it’s the only the interest (that you pay to yourself) that is actually taxed twice.

I filed my taxes the other day. I actually had most of my taxes already done almost a month ago, and just finished up some details. The Feds owe me about $350, and I owe the State about $600. These are numbers I can live with. Last year I had a rather large tax bill, and had to pay estimated taxes this past year. For whatever reason my company does not properly deduct taxes on my bonus, and as a result I am annually short on my taxes. How short I am varies quite a bit year to year depending on my bonus.

Ideally, I would rather just pay what I owe in taxes when I file my taxes. However, the IRS is not so willing to extend me or anyone else a free loan. Basically if you expect to owe more than $1000 in taxes then you’re required to pay estimated taxes. If you don’t pay estimated taxes then the IRS effectively penalizes you by charging interest on the amount that will be owed. The interest rate charged is based on the prevailing treasury bill rates.

So how do you estimate your taxes when you don’t know how much you’ll actually make for the next year?

1. Make a best guess
2. Pay 110% of the previous year’s taxes
3. Pay 90% of the current year’s taxes

The IRS does not charge a penalty if you pay at least 10% more in taxes than the previous year (option 2), and many people including myself use that metric to estimate what the quarterly payments should be. I know that very likely that I will have to pay more in taxes this year (2008) than I did in 2007. However by paying at least 110% of my taxes for 2007, I’m good in the eyes of the IRS. Of course, it’s quite likely someone owes estimated taxes because of a large one time items such as stock sales. Using the 110% rule is always safe, but would result in extra taxes being paid during the course of the year (which would eventually be refunded). The 110% rule is ideal for those who actually expect to owe more in taxes in the coming year. For those who expect to owe less they can get away with just paying 90% of what they actually think they’ll owe. When it comes to taxes it’s all about paying as little as you have to as late as you can.

Larry Page, and Sergey Brin of the I will do no evil folks of Google and Megalomaniac Steve Jobs have one thing in common. All three of them of earn a lot less than me in wages. Too bad that isn’t really saying something about me. All three of them take home a salary of $1 per year. Sergey and Larry have been earing $1 for a few years now. Steve has been doing it longer than those two. The nominal salary is intended to indicate a commitment to the company each of them works for (and founded). At the surface of it, it sounds like these CEOs have been able to eschew the greed that is so prevalent in the corporate world. However, like everything in life, it’s not so simple, especially in the case of Steve Jobs.

None of these billionaires are lacking in money. Their wealth is primarily determined by how the GOOG and AAPL stock performs. I applaud a compensation structure that rewards CEOs who truly add value to a company instead of just holding the job. Long term ownership is the key part of a proper incentive structure for senior executives. While I do believe that all three of these men have taken the $1 salary as symbolic gesture of how they feel about their work, I also feel that $1 salary is a bit of a sham.

In the case of Steve Jobs, his $1 salary is particularly disingenuous because he receives particularly generous compensation in the form of stock. The Googler’s $1 salary is a more genuine reflection of their compensation as they are not given gigantic stock grants. They have enough stock as is.

The problem of the $1 salary is that it’s another example of the problem with having two different tax rates for capital gains versus income. I have a problem with this in the realm of private equity, and with further reflection have an increasing problem with it in all aspects. Not only are capital gains taxed at lower rate, but income derived by capital gains avoid payroll taxes as well. The uber wealthy like Jobs and Larry Page can avoid paying social security and medicare taxes. Are they intentionally avoiding these taxes? In the case of Larry and Sergey, I doubt it. Steve Jobs, I’m not so sure of. Regardless of the reason for their compensation structure, it exposes flaws in what should be progressive tax structure.

At the same time I am conflicted. Fundamentally I do understand why it’s good to have a lower capital gains rate - to spur new investment. The problem is really with what is often an arbitrary distinction between regular income and capital gains. Salespeople who are paid by commission have as much income risk as as an executive who is paid by stock grants. Yet their incremental income is viewed very differently by the IRS.