Take a couple who has made a decent income, $150K-$200K, and after selling their home, decides to take their retirement fund, and rent. They have exactly $4M. They don’t trust the stock market to go back to annual returns of 8-10%, and therefore they only withdraw $120K per year. (Remember, this is a retired couple, whatever their profession, let’s just agree they lived well beneath their means to save this money. They paid their taxes, but invested for the long term, much of it pretax.) The seemingly ‘fair’ 3% is $30K of the excess $1M they have. And it’s 25% of their annual budget. If the entire $120K withdrawal is a 401(k) or pretax IRA distribution, they are already planning to pay about $17K in tax, living off the $103K net. This tax would leave them with $73K.

At $5M, the numbers look even worse for this couple. Planning to withdraw $150K gross, and pay closer to $25K in tax, for a net $125K. Now take off $60K for the wealth tax, and they are left with $65K. Uh, right, they socked away an extra million dollars, but this wealth tax leaves them with a lower annual income. “But Joe, the wealth tax can come off the top, not from the withdrawals.” Agreed. but in the 25% bracket, it would take an extra $80,000 withdrawal to net the $60,000 for the $5M couple. They went from a pretty conservative 3% withdrawal target to $230K, a 4.6% rate. Something about this doesn’t seem right. Yet, when you paint a different picture, the 30 year old Wall Street Exec who has already built a $10M retirement account, the tax doesn’t seem so bad.

When it comes to the tax code, it’s very difficult to have a tax that doesn’t hurt those who are not the intended target. It’s easy to make judgments about who has really earned their money. I for one think there are hundreds of bankers involved in the Mortgage Collapse who deserve long jail sentences. The same folk at S&P who decided when you take enough C rated paper and put together, you can get AAA investments are the ones who pulled Uncle Sam’s AAA rating. These are the people who made us all poorer, along with our children who will inherit the national debt. Why these people are still on the streets (I mean employed and not serving time) I don’t know.

What do you think of the wealth tax? Have you seen any articles on it yet?

When Steve Forbes ran for office he was an advocate of a flat tax. A 17% flat tax if I recall correctly. Now, Mr. Cain’s 9-9-9 plan takes the flat tax a step further, a very low 9% income tax along with a 9% sales tax.

At first blush, it looks like most of those who currently pay no federal tax at all will see an increase, but Cain points out that this covers the payroll tax as well, so even if you have no federal tax, you are paying 7.65% for social security and medicare. I think the idea of a tax like this might be appealing, after all, the simplicity alone is elegant, but the transition would be a tough hurdle.

What becomes of those who converted their IRAs to Roth IRAs to avoid higher future taxes? They paid 15,25, even 33%, and now would find that their rate is now 9%. Obama and others are currently on a “tax the rich” crusade, looking to bump their marginal rates further and remove their favorable cap gains rates. Cain’s plan has no cap gain at all.  I can only wonder what the reaction would be from Main Street if the fat cats managed to keep their income treated at capital gains and reduced their tax burden even further. I know, this can be legislated, and treated as ordinary income. Still, it goes counter to the concept of the Buffet plan, that the fairest tax system is a progressive one and higher earners should pay a higher rate.

The interesting thing to me is that Cain has calculated that compliance, enforcement, and collection of taxes cost the US $430 billion per year more than his plan would. Sounds like the IRS would have to plan a large downsizing if this plan goes through. On the other hand it would sure make planning easier, removing all the variables that change every year, that patches, fixes, extensions, et cetera. Unintended consequences aside (and you know there will be some big ones) I’d like to see if Cain’s plan gains any traction.

What do you think? Would a 9% flat tax appeal to you? No itemizing, no deductions at all?

• A personal exemption is now $3,800, up $100 from 2011
• The standard deduction is now $5,950 for singles, $11,900 for married filing joint. Up $150/$300 respectively.
• Tax bracket thresholds have been adjusted, so, for instance, the 15% bracket for married filing joint now ends at $70,700 up from $69,000.
• The gift tax exclusion remains at $13,000 but the estate tax amount has increased to $5,120,000.

For greater details on 2012 tax brackets I recommend taking a peek at Revenue Procedure 2011-52. When these numbers appear at Fairmark.com, I’ll update here to advise.

That’s just the tax side, on the retirement side we have some changes as well:

• Participant in 401(k), 403(b), 457 plans, and the Government TSP is increased to $17,000 from $16,500
• No change in the catch-up contribution of $5,500 for those 50 or older.
• For those covered by a retirement plan at work, the IRA deductibility is phased out over the range of $58,000 – $68,000 for singles or $92,000 – $112,000 for married filing joint.
• The Roth IRA phase-out occurs from $110,000 – $125,000 for single and $173,000 – $183,000 for married filing joint.

My last two posts were published just over a week ago, and are good reading.

First, a look at Tax Withholdings and Your W-4. If in April you got (or owed) more than $1000, this article will help you understand how to adjust the money withheld each paycheck. I know a big refund feels good, but it also means you lent Uncle Sam money interest free.

And my last post of the season, The IRS Increases Standard Mileage Rates to 55.5 Cents Per Mile. In a rare mid-year move, the IRS updates the standard rates for those who take a tax write-off for miles driven, whether for business, medical, moving, or charity. Check out the full article and let my friends and TurboTax know Joe sent you!

Now, our friends in the Senate (when they are trying to get a bill I like passed, they are ‘friends,’ and I am their fair-weather friend) have introduced the Medical Flexible Spending Account Improvement Act, S. 1404 which would allow plan participants to withdraw their unused money at year end and pay the tax on it.

I like the idea of getting rid of the “lose it” part of the FSA, but the text of this bill leaves me a bit concerned. When an employee leaves, either voluntarily or is fired, and he had spent more from his FSA than he deposited, he is not liable to pay back the difference. My understanding was that the employers weren’t seeing a windfall from leftover money as their were those who spent more than they deposited before leaving. Note, you tell your employer in October/November how much you want to put in during the upcoming year, and are eligible for the entire annual amount as soon as you incur the medical bills regardless of how little you deposited by then.

Unless the bill addresses this feature of reimbursing before collecting, I can see a crazy “unintended consequence” brewing. Employers who decide to lower the FSA limits even lower than the upcoming $2500 limit congress has authorized.

How will this impact you? Do you have access to an FSA, and take advantage of it? Will this bill help you use it more than you did before?

This graph, clipped from the image drawn on a napkin (you can click the image to see the full sized one, including Mr. Laffer’s signing it “To Don Rumsfeld.”) illustrates a centuries-old concept. At a zero tax rate, revenue will be zero. This of course stands to reason. But, at a 100% tax rate, why would anyone work? So again, the tax revenue generated is also zero. So what’s left is two concepts, first, that there’s a rate that provides maximum tax revenue raised. Second, that if we are operating at the wrong point on the curve, at a rate higher than the maximum revenue rate, to raise revenue from there, the rate must actually be lowered, not raised.

The concept is intriguing, yet pretty simple. The question, however, is can we ever know where we are on the curve? Of course, as a thought experiment, not every individual may have the same shaped curve, so it’s the aggregate that needs to be optimized. This all goes to the point that as our government tries to get spending under control (they’re doing that, right?) they had best be very careful when tinkering with out tax rates.

• Don’t Panic – you may just have a minor adjustment to your return. Better yet, they may owe you money.

• The letter will have specific details telling you what you need to do to respond.
• If it’s a correction notice, compare their details to your records and see what you missed.
• If you don’t agree, send a written explanation including copies of any documents you want them to consider.
• You should be able to handle most issues via mail, no visit required.
• Keep copies of all corresponding.
• Most important – Don’t Panic!

Find Person-to-Person Help

The IRS has teamed up with nonprofit and community organizations at more than 12,000 locations throughout the nation to offer free tax preparation services. Those most likely to benefit from these government-partnered services include tax filers who fall within low to middle income brackets, and elderly taxpayers. Here are some volunteer programs that run until April 18, 2011 (depending on location; some may close earlier) that provide free tax filing assistance:

• Individuals Who Have an AGI of $49K or Less: The most common volunteer program used by individuals who have an AGI of $49,000 or less (or are unable prepare their taxes on their own) is the Volunteer Income Tax Assistance (VITA) program. The individuals working at VITA locations are IRS-certified volunteers who have been trained to prepare basic tax returns. To find one of the many locations where this program is offered call 800-906-9887.
• Individuals 60 or Older: The Tax Counseling for the Elderly (TCE) program offers free help for individuals age 60 or older who have basic tax returns. Like VITA, TCE offers in-person assistance in communities across the U.S. The AARP has the largest IRS-sponsored TCE program. They have over 6,000 located around the country. You can find the locations by using the Tax-Aide Locator or by calling 888-227-7669.
• Military and Military Families: The military has a large VITA program, with the Armed Forces Tax Council (AFTC) overseeing the military tax programs worldwide. The AFTC coordinates with the U.S. Air Force, U.S. Marine Corps, U.S. Coast Guard, U.S. Army and U.S. Navy. These VITA programs utilize volunteers trained to understand military-specific tax issues to help military members and their families, and are typically located within military installations.

Keep in mind that since scams increase during tax season, it is very important for you to confirm that you are working with a legitimate program. The IRS provides information about these and other income tax filing assistance programs on their website, www.IRS.gov.

Do-it-Yourself Tax Preparation

• Individuals With an AGI of $58K or Less: The IRS has partnered with many well-known tax software companies that offer free federal filings to individuals who meet their basic qualifications. In order to qualify, your AGI must be no greater than $58K and you cannot itemize your deductions. To find the best tax software program for you, visit the IRS-operated Free File site to get all of the information needed for you to begin the tax filing process.
• Individuals With an AGI of $58K+: If you have an AGI over $58K and/or plan to itemize your deductions, your options for free tax filing are limited. If you are knowledgeable about filing taxes then you can use the free fillable forms available on the IRS website. These forms are only slightly easier than preparing by hand because they do perform some basic math functions for you. If you do not have a strong understanding of filing tax returns, then this is probably not a good option for you.

Contact the IRS Directly

The IRS will help taxpayers who have frequently asked questions on both on their website and via telephone. To order forms, instructions or publications, go to www.IRS.gov or call 800-829-3676. When visiting the website, be sure to type in IRS.gov, not .com, .net or .org, as any website that has an address ending in anything other than .gov is not a legitimate government site.

For questions regarding taxes, individuals may phone 800-829-1040 and businesses may call 800-829-4933.

Importance of Filing On Time

It is very important for all wage earners who are required to file income tax returns do so by the April 18, 2011 deadline in order to avoid losing their refund, incurring possible failure-to-file penalties and being charged with other unnecessary interest and fees. With all of the resources offered by the IRS and partnering community groups, even those taxpayers with limited financial resources have the means and opportunity to get help filing their tax returns. Take advantage of these offers to ensure that you are not paying more in fees and penalties than you would have paid for tax preparation.

This guest post was provided by Matt Robinson, a tax professional and tax writer who provides valuable tax tips, news, guidance and more on his tax blog. His website also gives detailed do-it-yourself information on resolving various IRS problems.

There’s quite a list of things can can be accumulated for itemizing, but remember, the standard deduction is $5,700 if single or $11,400 married, so many don’t exceed these numbers. But, here, I’d like to offer a different spin to those who just miss by a bit. The concept is to bunch your deduction in a way that will put you over the standard deduction every other year. Say your deductions (assuming married) add to $10,000 and you are just missing being able to itemize.

There are three items that you can shift a bit, First, your mortgage payment. In odd years (we’re going to try to make the odd year the one where we itemize, got that?) make the next January payment in December, then in the next year, the even one, be sure not to do this. If your interest is averaging $500 per month, you’ve managed to shift an extra $500 into the itemizing year. Next, the property tax bill. It’s usually not calendar, ours is July-June. So in odd years we can just make the Q1 payment from the next year a month or so early. While the median annual property tax is barely $2000, this strategy will still help you add another $500 to the odd year. If you aren’t afraid of being a bit late, paying the 4th quarter payment on Jan 2nd will help more. You may have a small late fee, ours is 1.5% per month, but if it makes this deductible, it may be worth it. (Careful, if you have a mortgage, the bank won’t like to see a late tax payment, just stick with the pay early.)

Last, and easiest to manipulate is the charitable deductions. For the generous among us, you can put some money in your pocket and keep up your kind philanthropy. Just keep 100% of your donations in the odd years. If you are donating $4000 per year, this strategy would have you make the same $4000 donation in both January and December of the odd year. Now, instead of just $10,000 in the odd year, you have $15,000 in itemized deductions. $3600 over the current standard deduction and a resulting tax savings of $900 if you are in the 25% bracket. Even the $540 you’ll save if 15% is still worth this slight effort. Really, it’s no effort, just a bit of change to the dates you’ll write these checks.

Joe

First Winner – msf – a comprehensive plan:
1. Move back toward Reagan’s 1986 Tax Reform Act concept of treating all income the same – no favoritism for capital gains. This would have a side benefit of getting rid of the issue of how to deal with “carried interest” (the loophole by which hedge fund managers pay 15% tax on their compensation).
2. Gradually phase out the mortgage deduction – it has already been capped, removal of the deduction would reduce distortions in the real estate market, and other countries do fine without it.
3. Simplify pass throughs of expenses and exemptions of mutual funds
a) in some states, your bond fund has to have over 50% in treasuries to get pro-rated state tax exemption. Make this consistent – all states pro-rate.
b) foreign tax passthrough. Just get rid of it, and have the funds deduct the taxes themselves. This is what global funds must do (if funds don’t meet a certain threshold, they are not allowed to pass through the taxes, but deduct them directly), and will have no impact on funds held in tax sheltered accounts. This simplifies matters, since the funds then treat taxes paid the same way they treat any other cost – as a reduction of income.
4. Restructure the AMT form – the AMT is nearly a flat tax – how much did you make, multiply by 26% (or 28%), and compare with your ordinary income tax. Pay the higher. By restructuring the form, it will be clearer that these are two parallel systems (not an AMT “surcharge”), and it will be clearer that the taxpayer’s goal is to minimize taxes (keep the amount owed in both systems low), not to eliminate AMT (even at the expense of paying higher taxes). It will also help show what a flat tax could look like in practice.

Second Winner – Augustine – simple, but powerful:
Flat, 15% rate with no deductions. It’s been done in other countries, including Russia after it ditched Marx’s progressive income tax, and its revenues increased. I’d even add it to the constitution, along with a mandate for a balanced federal budget, so that government would be bound by the same rules as every American: unless you live within your means, you go bankrupt.
PS: no way I’ll win this.

WildCard Winner – Janet – no loopholes:
I’d get rid of all tax loopholes. No overseas tax shelters or anything like that. You make money, you pay tax.

Judging these contests is tough. It got tougher as more comments came in. I chose the top two ideas I thought were well reasoned and then did a random drawing for the third card. Winners will be notified by day’s end and I’ll send the card or PIN for them to access the TurboTax software.

FTC disclaimer – I received no compensation for this giveaway. I’ve used TurboTax for 27 years now, and am proud to offer my readers this opportunity.
Joe