Posted By: CFP&WM On: Mar 17th, 2010 In: In the news Money Matters

Five Different Flavors of Income Tax

Senior Spectrum – March 16, 2010

As a teenager I worked in an ice cream store. There were 31 flavors, so I think you know the store in which I worked. The good thing about ice cream is all the flavors are good. The problem with taxes is some flavors are better than others.

The first flavor that we are most familiar with is “Fully Taxable”. The sources of income subject to full tax would be our wages, bonus, business income, partnership income, bank account interest, alimony, pensions and rent that you might receive. The tax rates are 10%, 15%, 25%, 28%, 33% and 35% depending on your total income.

With the current financial status of this country, it’s pretty clear that these income tax rates will be going up at some point in the future. There’s an election coming up in November and I would bet a “ dollar to a donut” that the rates would go up for next year.

The second flavor of income tax that’s better than the full flavor is “deferred tax”. This includes individual retirement accounts (IRA) and annuities. This also includes 401K plans for those who work for private or public companies. If you’re a teacher, or work for certain non-profit organizations, you have the option of a 403B plan. Unfortunately many 403 B’s have very few options available and that will be the subject of a future article. A 457 plan is an option to defer income into retirement years when you might be in a lower bracket. With this flavor of tax, you don’t pay now, but you pay later when you take it out.

Now we’re starting to get into some of the better flavors, the first of which is “preferred tax” status. Many of you who are retired do have this preferred tax on your Social Security benefits. If you’re in a very low income tax bracket, you pay no tax on your Social Security benefits. If you have some additional income, you could pay tax on up to 85% of your benefits. Some of you might be old enough to remember the government’s previous promise never to tax Social Security benefits. What happened to that?

Another type of preferred flavor is that of long-term capital gains. If you invest in stocks or other types of investments and hold them for longer than one year, sell the item and reap a profit, you pay less than ordinary income tax rates. If you are in a low tax bracket, you would pay zero tax and in higher brackets, long-term tax rates are 15%, which is honestly preferred to the higher rate of full taxes.

Now we come to the best flavor of all… “Tax-free”. Municipal bonds are what most people think of when they think of tax-free income. There are, however, many other sources of tax-free money. When someone gives you a gift, there is no tax due (as long as it is under $13,000). If you receive an inheritance, there is generally no Federal tax due. Life insurance payouts are income tax-free except in extremely rare circumstances.  When you sell your home, you are exempt from income tax up to $500,000 as a couple. You do not have to pay income tax on child support. Roth IRA withdrawals require no taxes be paid either. Health Savings Account withdrawals are income tax free as long as you use it for a qualified expense.

The fifth flavor of tax is the Alternative Minimum Tax. The IRS, for the purpose of making sure the wealthy pay their fair share, invented this particular flavor. When Congress wrote this rule, they did not index the tax for inflation. As a result, years later, it is impacting many middle-income taxpayers. Unfortunately, our lawmakers don’t have the time to eliminate this flavor from our ice cream shop.  (Oh, I mean tax code.)

As a financial planner, as well as a taxpayer, my favorite flavor is tax-free, followed by tax preferred then tax-deferred. My least favorite flavor of tax is “fully taxable” and I personally have never had to taste the Alternative Minimum Tax. What are your favorites, if any?

Michael Chamberlain CFP®
CA Registered Investment Advisor

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This article is for informational purposes and should not be taken as legal, tax or investment advice.

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