AskDong

As my blogroll would indicate, I am avid reader of Greg Mankiw’s Blog even though some of our politics diverge. I’ve become somewhat backlogged on my reading, and only recently came across a december post in which he highlighted a study from the COB (Congressional Budget Office) on historic taxation. Dr. Mankiw given his views on taxation uses the study to highlight the fact that rich are not paying less in taxes today than they have historically. If anything they are footing a greater portion of the tax bill. Below is a chart of effective tax rates for the different income quintiles from 1979 to 2005. The chart on the right is normalized in that I’ve expressed the effective tax rate as ratio of the average tax rate. Everyone is paying less in taxes today on the most part, and the bottom quintile more than any other group.

Since taxation is something I know I have disagreed with Dr. Mankiw in the past, I was curious to take a deeper look into the actual report. My first questions was, “How is the effective tax rate being measured?” Many times studies will ignore payroll taxes such as social security and medicare which impact lower income families more since both are flat taxes and in the case of social security maxes out (i.e. only the first 97,500 of income is taxable by social security for 2007). I read through the COB FAQ and was reasonably assuaged that their methodology was appropriate.

However, looking more into the data it becomes clear that effective tax rates, and contribution to the taxroll is only one part of the story. The other and more important part of the story is income distribution. The rich are getting richer. The share of income that is accruing to the top quintile has been steadily increased, while the bottom quintiles has seen stagnation.  Below is a chart from the same study which shows the share after tax income by quintile over the same period.  The dip in 2000 I suspect is attributable the huge stock market declines which led to lower capital gain income for the top earners.  On the Y axis is the share of total after tax income each quintile earned.

Numbers don’t lie, but what conclusions we draw from the numbers are often a function of personal beliefs and politics. I’m not the the type of person who believes taxes for sake of taxes, but I am believer when poorer Americans are failing to make economic progress while rich Americans are making money hand over fist there’s something wrong. I certainly don’t feel like rich Americans should be punished for our success via higher taxes, but I also question why is that the poor have failed to enjoy the economic boon that the top of America has? I know personally I would not be opposed to paying higher taxes to make sure those at the bottom of the ladder have better health care and more opportunities for advancement.

In a victory for the Republicans, the House passed a one year patch of AMT.  As I had posted earlier, Democrats and Republicans had been at impasse.  Democrats wanted to provide AMT relief only with corresponding tax increases somewhere else, and Republicans didn’t seem to mind more debt.  It seems as the Democrats just caved.  Given that President Bush vowed to veto any bill that included a tax increase, I think the Democrats did the right thing by caving. While not an ideal solution, not doing would’ve been terrible for many American especially if gridlock is a result of politics than actual policy.

Effectively for the next year the AMT threshold is being raised to about 62,000 for joint filers from 45,000 had no fix been passed. This is not to say any joint filer who has income greater than 62,000 will fall under the jurisdiction of AMT, but rather they are just eligible to pay the Alternative Minimum Tax.  You still need to have enough deductions to “qualify” for AMT.   The factis there are still many high income earners would gladly pay 28% instead of what they pay right now.  I’m still keeping my fingers crosses that a brave congress will tackle not only the AMT issue, but put some serious thought towards tax reform.

We are in the season of giving, so in that vein I’m answering this question from a reader.

I am thinking about putting money in a Donor Advised Fund, but don’t really know what the pros and cons are of using a Donor Advised Fund versus givingn money directly to charity. What do you think?

-S

I looked into Donor Advised Funds a few years ago as vehicle for my charitible giving, but decided I didn’t have enough of idea of how I wanted to give to warrant setting up such a fund. I imagine many of you are scratching your heads just like I did a few years ago. Donor Advised Funds? A Donor Advised Fund is basically a mini foundation. It used to be purely the tool of the very rich who wanted to be like the uber rich. However Donor Advised Funds are actually relatively affordable to get into today. Fidelity let’s you open a account with the Fidelity Charitable Gift Fund with as little as $5,000. Schwab recently followed Fidelity’s lead and lowered their minimum on their Schwab Charitable Fund. from $10,000 to $5,000 as well. Vanguard lags behind both Schwab and Fidelity, requiring $25,000 to open account with the Vanguard Charitable Endowment

While the charitable funds are “run and operated” by the likes Schwab, Fidelity, and other financial institution, the accounts work very much like a standard brokerage account that you might have. You pick what funds you want to invest in, and you pick what charities you want to give gifts to. However, once the funds which can be cash, stock shares, and mutual funds are handed over, they are turned over irrevocably. The gift is made, and the money is no longer yours. This is both a minus and plus. Technically speaking the money is “owned” by the the charitable fund/endowment, and as a donor one only make recommendations for grants. One of the big benefits is that fund takes care of the paperwork of giving, and will also research different charities to make sure they meet minimum standards.

Because the gift is irrevocable, the deduction can be taken immediately. Like a standard gift of shares, the full value of securities is tax deductible. Being able to take the deduction immediately is great if you want to make a charitable gift, but haven’t decided to whom. In addition once the funds are in the account they are sheltered from any tax complications. A donor can effectively buy and sell without tax consequences to him or her personally and more importantly the money available for giving.
So what are the drawbacks to a Donor Advised Fund? The main one is that you can’t change your mind about giving. The money is gone. I don’t think this is actually a big drawback, however, as this is always the nature of giving (or at least it should be). However when most people set up Donor Advised Funds, they are often handing over money that they plan on giving for years to come. That fact highlights the major difference between giving to charity year to year and a Donor Advised Funds. Setting up Donor Advised Fund is sustained commitment to giving. It’s not a tool to be used to give gifts in any one year, but rather for a lifetime of giving. In addition there are some restrictions on grants. Grants cannot for instance be used for admittance to Galas, or used as part of personal commitment to ride or walk event. Generally speaking the limited and reasonable restrictions are in place from preventing donors from using the funds for his or her own benefit.

Congress has made the news in the last couple weeks for it’s inability to fix AMT, the Alternative Minimum Tax.  The alternative minimum tax was established in the late 60s (1969) to prevent the uber wealthy from continuing to exploit the many tax loopholes that existed from paying little or no taxes. Not only were many these tax loopholes closed during the tax reform of 1983, but more critically the levels at which AMT kicks in were never adjusted for inflation.  Because the levels were never adjusted for inflation, the AMT impacts many upper middle class families.

In the last few years, Congress has typically enacted temporary measures preventing the AMT from hitting a wider swath of the middle class.  However as we head towards the end of the year, Congress is split along partyl lines. Democrats want to tie any reduction in AMT revenue with a corresponding increase in tax revenue somewhere else. Republican congressman do not support such proposals, and President Bush has vowed to veto any tax bill that includes any tax increases.  As a result there is deadlock.  Personally I do think if we are going to fix the AMT problem, in the long run we will have to either raise taxes somewhere else or cut spending.  I’d probably prefer a little of both.  While the two different political parties may not agree on the solution, they do agree that something needs to be done. For that reason, I’m hopeful we will have at least another temporary fix by the end of the year. Personally, the AMT does not affect me. Being unmarried and without children, I don’t have quite enough tax deductions to be affected.

So who does the AMT affect? Primarily high income families in high tax states. In essence what the AMT is intended to do is ensure that citizens are paying some minimum level of taxes even after taking allowable deductions. This made much more sense in 1969 when there were numerous and egregious tax deductions that allowed many of the wealthiest families in America pay little to no taxes even though the top tax bracket was much higher than it is currently. The top tax bracket in 1969 was 70% versus 35% today. The AMT was really intended for the richest 155 families who were not paying their fair share of taxes.

So what can one do to avoid the AMT? While in many ways it’s very easy to avoid the AMT, it actually doesn’t make sense on the most part to actively avoid. Avoiding the AMT, generally means avoiding tax deductions. Not having deductions means paying more taxes under the standard tax code. That’s the beauty of AMT, it doesn’t kick in unless it means you’ll be paying more in taxes. An upper middle class family in high tax state with a few kids and a McMansions ends up being hit with the AMT because right off the bat they often have the following deductions (but not limited to).

• State and Property Taxes
• 2nd Mortgages/Home Equity Lines
• Dependents
• Medical Expenses

Other less common but potentially more odious complications are:

• Stock Options - Under AMT you pay taxes on difference between the market price and the strike price at the time of exercise
• Depreciation - This is important for business and property owners who pass depreciation into their personal taxes
• Misc. Itemized Deductions

All these deductions can reduce the effective tax rate below 28% at which point AMT kicks in.  AMT ensures that wealthy tax payers are paying at least around 28%.  Personally, I prefer a more transparent tax code that ensures everyone pays his or her fair share in taxes.  The AMT partially serves that goal, but far from a transparent manner, hence being named the “stealth tax.”  One reason the Government is loathe to solve the AMT problem is that it has basically allowed it to give with one hand and take with the other.  For example the 2000 tax cuts by themselves should’ve been a great boon to upper middle class families, but for many families it just meant they ended up paying the AMT.  There was still a substantial tax cut for the rich, but not as much as advertised for the moderately so.  The key is not avoiding AMT, but ensuring your tax foot print is minimized both under the regular tax code, and under AMT.

The most notable and seemingly arbitrary difference in treatment under AMT versus the standard tax code is related to municipal bonds.  Typically income from municipal bonds are exempt from local (assuming you live from the state the bonds originate) and federal taxes, however income from “specified private activity” municipals bonds fall under AMT while “general obligation” bonds do not.  For example let’s say I held bonds issued by the State ofMassachusetts to construct a new waterfront stadium that gave off income of 100 thousand dollars a year, and had no other income source. Under the regular tax code I would owe nothing in taxes, however under the AMT I would owe almost 28% because a stadium is considered specified private activity.  However, I could’ve easily held instead “general obligation” bonds issued by the state that would not be subject to the AMT.  General obligation bonds are simply debt issued by local governments not tied to any specific project.  The other deductions that are treated favorably under AMT are mortgage interest (on a primary home), and charitable giving.

People are often mystified by the mechanism of borrowing money from a 401K.  Many experts advise against borrowing as a rule.  I generally agree, but like anything in life there are exceptions to the rule.  Still, I think people are often confused about both the drawbacks and advantages of borrowing.

Advantages

• Interest is paid to yourself, however the interest is a market rate (currently 9% in my 401k which was as low as 5% a few years ago)
• No need to qualify for loan

Disadvantages

• After Tax Dollars used to pay interest will be taxed again
• Wastes Tax Deferral Advantage
• Balance of the loan is due upon job severance

I think the part that confuses most people is the after tax nature of the loan payments, and how tax deferral works.  Loan payments made to the 401K come from after tax dollars, and as a result are taxed again at withdrawal.  However given that no taxes are due when the loan is made, effectively only the interest payments into the loan are doubly taxed.   The principal payments are matched in amount by the “tax free” loan.  For example let’s say I had 10,000 in my 401k, and borrowed all 10,000 with a 10% interest rate for 1 year.  I do nothing with the 10,000, and the next year I pay back the entire amount with interest, $11,000.  The $1000 in interest is coming from after tax dollars and required $1250 in pretax dollars (assuming a 20% income tax bracket), but the $10,000 in principal is funded by what I took as a loan.  Now let’s say I decide to retire the next year and withdrawal the money, I will owe $2200 in taxes on the full $11,000 balance. Had I decided not to borrow against my 401k, and was able to achieve a 10% return independently, I would still have owed $2200 in taxes on the full balance. Where I’m paying extra taxes is the $250 I already paid to make my interest payment.

Tax deferral is the biggest benefit for 401k plans.  By borrowing against the 401k, you’re giving up the ability to grow money annually free of taxes.  Let’s say for example I were to borrow money from the 401k to put into investments outside of the 401k.  We also assume these investments are identical to what is in my 401k.  In my 401k, the 10,000 I borrowed would’ve grown to $11,000 after a year assuming a 10% return.  In my taxable account the money only grows to $10,800 because I need to pay taxes on it during the year.   As a result, every year taxes act as drag on my investment reducing what’s available for reinvestment.  There is no such drag within the 401k.

Though as with many things related to taxes,  the actual outcomes can be more complicated.   Capital gains (gains made by buying at one price and selling at a higher price) verus income (which includes interest payments) are taxed at different rates.  In addition capital gains are not payable until sale which is in effect a form of tax deferral.  In theory it’s possible to actually lower the total tax bill by borrowing against the 401k and converting what be taxable as regular income into longer term capital gains which are taxed at a lower rate.   However for most people in most situations, borrowing against the 401k will increase the total taxes that ends up getting paid.