Am I A Financial Hypocrite?
|December 3, 2010||Posted by Roshawn Watson under Uncategorized|
By: Roshawn Watson
There are many types of income, but most income can be classified into three broad classes. While the distinction may be trivial to some, especially if they are personally struggling, the type of income can have tremendous implications to your bottom line and your quality of life. Understanding some basic caveats between the types of income can help you focus on obtaining more tax-advantaged income. Additionally, some recent recommendations by the White House-appointed deficit-reduction commission threaten a well-known tax haven used by both the wealthy and non-wealthy alike, which makes me ask “am I a hypocrite?” Find out why.
Types of Income
The three broad types of income are “earned” income, portfolio income, and passive income.
The income that most are probably familiar with is earned income. This is the money we receive from jobs or our businesses in the form of a paycheck. We have to work for it, typically there is no residual value for it, and it is often the highest taxed. Since we’re taxed when we earn, spend, invest, save, and die, taxes are a big deal financially. I do take issue with this being called “earned income” because it indirectly suggests that other types of income, such as income from assets, is not earned.
This income includes money received from paper assets, such as stocks, mutual funds, ETFs, bonds, etc. This income is most commonly received in the form of capital gains and dividends. Presently, this is taxed lower rates than earned income, provided that you meet certain requirements. For example, in the US, income from dividend-producing equities in non-retirement accounts held long-term is taxed at the same rate as long-term capital gains presently (according to the Jobs and Growth Tax Relief Reconciliation Act of 2003). Otherwise, dividend income is taxed at the ordinary income level, which is higher than the capital gains tax rate. Most of us have been forced to become investors because of the shift from Defined Benefit pension plans to Defined Contribution pension plans. Consequently, many of us intend to retire on portfolio income since we are now individually financially responsible for ourselves. Thus, understanding this income distinction is important, so that we won’t be ill-equipped.
Passive income can take the form of royalties from patents or use of intellectual property, rental income, etc. It is also more tax-advantaged and in my opinion is the most leveraged of these three types of income.
Idle Rich Are Idle No More
Many of the wealthiest individuals have strong streams of passive and portfolio income. Think Carlos Slim and Warren Buffett. However, don’t think of the golf course or sailing necessarily. There’s been a recent shift in the type of income received by the wealthy during the most recent wealth boom. Wealth has interestingly been fueled more by the working wealthy–entrepreneurs and executives–than by passive capitalists who earn a living off their investment. Berkeley researcher Emmanuel Saez found that wages from paychecks accounted for 56% of the income for the top 1% of earners in 2008 compared to only 40% in 1960. Again, there are tax consequences of getting one’s income from wages instead of assets, so it is important to understand how to transform that income into more tax-advantaged income.
Moreover, you certainly don’t have to be rich to acquire tax-advantaged investments. For example, you could become a landlord or increase your portfolio income. Also, there are risks inherent with each type of investment. There is principal risk, market risk, inflation risk, etc. Putting all of your money in fixed-rate CDs seems safe until you factor in you may not earn enough to keep up with inflation and meet your future financial needs. Investing in bonds is risky because the company or government entity could default on the payments. Investing in stocks is risky because the value of the shares could drop or the company could even close up and leave you with worthless stock. There is no such thing as a risk-free investment, but the key is to minimize risk to an acceptable level for you.
For those who like tax-free income and have a moderate risk-tolerance, many own municipal bonds.1 Typically, you are loaning a state or local government entity money in exchange for a reasonable and tax-free rate of return. The larger your portfolio, the more pronounced this benefit is, but this is also huge for income investors with modest portfolios. Municipal bonds represent a nice reprieve from taxes and penalties for tapping earnings from IRAs, Roth IRAs, 401Ks, Roth 401Ks, etc., taxes on capital gains, and taxes on dividend income. I don’t mean to represent them as being safe. Despite their historic relatively low default rates, defaults on municipal bonds are certainly possible. Struggling local and state economies are a reality (i.e. look no further than California and New Jersey), so caveat emptor.
Anyway, this is relevant because a recent proposal threatens their existence.
Am I Being Hypocritical?
I try to be reasonable, and sometimes you just have to own your biases. For example, I am a huge fan of deficit reduction. Like many others, I think that the recently announced two-year pay freeze for federal workers represents a necessary evil. I am aware that I have readers who work for the Federal government, and please know that this isn’t an attack against you but rather the lesser of four evils.When surveyed, if faced between a choice of rising costs that choke the entire system, losing a job, taking a salary decrease, or taking a temporary salary freeze, repeatedly most people opt for the latter. While there are typically not mass-layoffs with the federal government, it is certainly not implausible. Consider the post office layoffs. Anyway, while the pay freeze is largely symbolic (small dent in the national deficit), it is a step towards fiscal restraint, which is important given the economy.
However, there is another proposal to reduce our national debt that I was not in favor of: the White House-appointed deficit-reduction commission’s recent proposal to eliminate the tax-free status of municipal bonds.
The rates of returns on municipal bonds aren’t exorbitant, so eliminating their tax-free status will only shift money elsewhere (in my opinion). The problem is I’m biased on this one, so my opinion is far from objective. It seems a little bit hypocritical for me to be a fan of deficit reduction except when it impacts my bottom line. Is this a case of trying to have my cake and eat it too or is this proposal an attempt to increase taxes on wealthy individuals (i.e. those with a net worth of over $20 million and get sizable chunks of “unearned” income), and individual income investors are just getting caught in the cross-fire? As indicated, now over half of the rich get their income from wages, but suppose the deficit-reduction commission didn’t get the memo.
Read my mail and let me know your thoughts, am I a hypocrite for not supporting this austerity measure or a consumer advocate for individual income investors?
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1Please note I am not giving tax or investing advice, nor am I a tax or investing professional. While the information given is intended to be authoritative, please consult with your local tax and investment advisers for your own unique situation.
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Copyright 2012, Roshawn Watson, Pharm.D., Ph.D. All Rights Reserved.