The OverTaxed Investor: Slash Your Tax Bill & Be a Tax Alpha Dog

By Phil Demuth

Today, Taxes Come First

Every year, Congress used to paste together a mismash of temporary tax rules. Then the so-called American Taxpayer Relief Act of 2012 rocked this world, making long-range tax planning possible for the first time in a decade. Because tax rates skyrocketed, it also became necessary

• Language: English
• Publisher: CWM LLC
• Release date: Mar 18, 2016
• ISBN: 9780997059618

Book preview

Preface

Confessions of

a Tax Ignoramus

Suppose you were an idiot. And suppose you were a member of Congress. But then I repeat myself.

—MARK TWAIN

I was jawboning on a client call when it hit me like a Buick.

   ME: I see you sold a block of company stock last year. You must have paid a pretty penny to the IRS on that one.

   JOHN: Actually, no.

   ME: No?

   JOHN: Well, I just retired. I haven’t filed for Social Security. I’m not tapping my IRA.

   ME: Yeah . . . ?

   JOHN: The long-term capital gains were over $100,000, but since I’m in the 15% bracket, my tax was zero.

   ME: (scales falling from eyes): Great Caesar’s ghost!

I had no idea a wormhole existed inside the tax code so that someone could pay nothing on a six-figure capital gains distribution. I naively assumed that tax rates were continuous and connected to reality.

I needed to educate myself on this topic, but I could find no readable, up-to-date book on taxes for investors. This left me with no choice but to write the damn thing myself. Believe me, I didn’t want to. If you had bothered to write one, it would have saved me a lot of trouble.

My own relationship with the Internal Revenue Service had been one-sided. Every quarter, just as I hoped I might be getting a dollar ahead in this world, they would swoop down and Hoover out my bank account. Like Sisyphus, I resignedly watched the ball roll down Mulholland Drive once more.

My taxes took weeks to compile. I would overnight a steamer trunk to my CPA in early March, and then on April 15 a wooden crate containing my tax returns would arrive at my door via the Panama Canal, full of horrible surprises. In an agonizing annual ritual, I would feverishly write check after check and race to post them by midnight.

My experience was further clouded by having what we laughingly called a family business. Although it invariably failed to make any money, it did a terrific job of generating billable hours for accountants and attorneys. My tax return was the size of a phone book and had to be filed in four states. I struggled to make sense of it, only to be defeated by the debilitating K-1 partnership schedules. I was licked.

Then we offloaded the business. The impenetrable K-1 schedules disappeared. It was just me and my svelte little Form 1040. For once I could see how the gears worked, like looking into a child’s mechanical toy.

What instantly became clear was that my own taxes were far from optimal—especially the taxes on my investments, my supposed area of expertise. These had seemed like small change at the time because they were swamped by all the other charges, but now with the blinkers off, I saw how I was generating beaucoup de taxable income that I didn’t need or want. I also saw how this same problem was hitting people like my clients the hardest: high-net-worth types who lived in high-tax states like New York, California, New Jersey, Oregon, Minnesota, New Jersey, Vermont, Maryland, and so on. These are high–investment tax states, which are not necessarily the same as the high–income tax states. But I anticipate . . . The point is, a lot of people are paying far too much in taxes on their investments.

The solution came like a blinding beam of pure celestial white light. It wasn’t new—Warren Buffett had been practicing it for years. But it was new to me. I can assure you that it is scarcely practiced at all within the investment advisory community, but maybe it should be practiced by you.

The topic seemed especially relevant for retirees, present and future. The government has been attacking their savings with a two-pronged fork of late. First, in response to the Great Recession, a zero interest rate policy was implemented to pry seniors out of their savings accounts with a crow bar. Then, as seniors are forced to seek interest income more aggressively, it gets taxed heavily. In our low-return world, the impact of taxes is keenly felt. Retirees need to pare this tax bill down to the legal minimum requirement.

Along the way, I discovered that many investors could significantly increase their after-tax returns by following a few sensible rules: buying the right kinds of investments, putting them in the right kinds of accounts, and then following the right drawdown strategy during retirement. There are right and wrong answers to these questions that can raise your standard of living. The solutions are nonobvious. Most people are doing it wrong. This is just shoveling money to the Feds.

The Orwellian American Taxpayer Relief Act of 2012 provided this relief by scrapping the low Bush tax rates and installing the new high Obama tax rates. Any more relief and it would have killed us. Because it is here to stay, it makes comprehensive tax planning possible for the first time in a decade, and because the new rates are so high, it also makes tax planning necessary. It is time to take stock. Perhaps, like me, you have a vague sense that your taxes are not optimal, that you are spitballing and paying too much.

A few things before we dive in:

I am not a CPA or a tax attorney. Your situation is unique, and the tax code is a shapeshifting death eater. I am going to focus on fundamentals. It is amazing how often twenty journal articles of gobbledygook can be reduced to a few straightforward rules of thumb that cover 99% of the cases. While this book contains tactics and strategies, you will have to figure out how they apply to you. Be guided by your own counselors. If you only listen to me, you will probably get into a peck of trouble.

Because I am an investment advisor, and people are needlessly paying high taxes on their investment accounts, I am going to focus on taxes as they relate to investing. If you are wondering whether you can deduct your Porsche as a business office, ask somebody else. I will refrain from commenting on investing in general, except as it relates to taxes. In the unlikely event that you care about my views on investing (to judge from recent sales), please read my book The Affluent Investor (Barron’s, 2013).

One pronounced bias: I am not a fan of financial products spawned by insurance companies, such as variable annuities and whole life insurance. I mention this because these products are often touted as having psychedelic tax benefits. In my experience, they baffle analysis and come booby trapped with high fees. If you think you understand one, all that means is that you haven’t read the prospectus carefully.

This book will not be recommending goofball ideas like offshore trusts or other dubious schemes to help you evade taxation. In my experience, these structures create tax problems rather than solve them. Remember that jack-booted G-Men have guns and can lock you in a cage. They can confiscate your money if they even suspect you’ve done something wrong—no warning, no hearing, poof! They seized $242 million through civil forfeiture between 2005 and 2012. If you want your money back, the burden of proof is on you. Fighting the IRS is not a fair fight. It will take years and grind you to a nub, and they’ll bring you home in a body bag.

In an act of self-restraint that would impress Marcus Aurelius, I will eschew polemics and stick to taxes. But since you asked, here is how the sausage gets made. The code is intended to stimulate perpetual lobbying by interest groups who either seek exemptions from taxes themselves or want more taxes imposed on their competitors. This is what greases congressional reelection campaigns. Roughly 70% of our budget consists of transfer payments from one group to another, which is another way of saying that it is money used by politicians to buy votes. A fairer and more efficient system could be designed in fifteen minutes if Congress really wanted one, which they don’t.

As reading material, the tax code and its supporting documentation are an acquired taste. Some feel that the 73,954 pages err on the side of being technical and dry. Nobody understands it all. But taxes can be fun! (Just kidding.) At any rate, I hereby pledge to avoid long passages that make your eyeballs glaze over. If your eyes glaze over anyway, it is probably because you are reading something that doesn’t apply to you. Skip it and go on to something more personally relevant.

I hate books that say, Here is my gee-whiz approach, but to get the real juju, you have to hire me. Not here. You can do all the investment stuff yourself.

If you are a renowned tax expert and wonder how I came up with some revolutionary idea you find herein, the answer is that I probably lifted it from you. I am not going to weigh down the text with footnotes and citations but will acknowledge my betters in a section at the end that no one has to read.

Phil DeMuth, PhD

Conservative Wealth Management LLC

Chapter One

The Tail of the

Tax Alpha Dog

In the beginning, all the world was America.

—JOHN LOCKE

I want to teach you how to become a Tax Alpha Dog.

Alpha, in investing, means getting excess returns.

Tax Alpha is the extra returns you get by making sure you are not paying a dime more in taxes on your investments than is legally required.

The Alpha Dog is the leader of the pack. In other words, you.

With that understood, let us begin by surveying the forces arrayed against us.

Back in 1776, when our taxes were between 1% and 2%, American colonists started a revolution rather than pay more.

Louis XVI got his head chopped off when he tried to levy a 10% tax on France. He cut it back to 5%, but too late.

That was then. Today, for high earners,

At the federal level, the Internal Revenue Service charges 39.6%.

Most states have a state income tax; California is king, at 13.3%.

City taxes are sometimes called assessments or fees, but these are a rose by another name. You don’t even have to be a resident of the cities that levy them to be required to pay. New York City charges a top rate of 3.876% on a person’s income.

You and/or your employer pay FICA taxes to support Social Security (6.2% from both you and your employer) and Medicare (1.45% from both you and your employer), for a grand total of 15.3% subtracted from your paycheck. Are you self-employed? Then you pay the whole tab yourself.

Medicare charges an additional tax on earned income at 0.9% above a threshold.

Obamacare charges a net investment incometax on unearned income at 3.8%.

Your employer pays into the federal unemployment (FUTA) tax (typically 6%) and state unemployment tax (in Massachusetts, an additional 12.27%).

If you fall into the arms of the Alternative Minimum Tax system, you are charged 28%, but don’t worry—if you are a high earner, you pay far more than this in your regular taxes.

You are taxed at your marginal (higher) income rate on short-term capital gains on stocks and bonds you have traded within the year, including taxes on the short-term gains accrued inside mutual funds, even if you never bought or sold a single share that year.

Dividend and long-term capital gains taxes clock in at 20% (plus an additional 3.8% net investment surtax). In California, for example, the top combined state and federal rate on capital gains is 33%. Only in Denmark will you pay more.

You are taxed on the interest on your savings at ordinary income rates.

You pay state and local sales taxes where you shop, even if the goods are shipped to your home in a different state. Tennessee charges the highest rate, at 9.45%.

Own a home? Then you pay property tax. New Jersey charges the most: 1.89% of your home’s value every year. After thirty-seven years, you have paid New Jersey more in taxes than you paid for your house.

Do you perhaps drive a car? There are licensing fees (taxes) on automobiles as well as personal property taxes. Also on boats, planes, and so on. There is a surcharge on rental cars (37% in Minneapolis). And, of course, there are federal and state gasoline taxes. In California we currently pay 68.1 cents per gallon, but this is expected to rise significantly with Governor Jerry Brown’s exciting new carbon surtax.

There are federalexcise taxes on trucks, trailers, tires, firearms, sporting equipment, and coal. There is a gas-guzzling tax. A tax on wagering. Excise taxes are also added at the state and local levels. You will find them on amusement facilities and on a deck of playing cards.

Discover oil in your backyard? Then you pay severance taxes to pull it out of the ground.

If you plan to escape paying property tax by living in a hotel, think again. The hotel accommodations tax adds 17% to your nightly tariff if you visit Houston (but only 15% in Connecticut).

Importing from abroad? Don’t forget to pay customs duties on whatever you bring in, which can add 20% to your cost.

Want to open a business in your state? Don’t forget to pay a franchise tax. In California, dog groomers are among the many professions required to get an occupational license from the state.

Do all these taxes make you think you’d be better off just giving your money away? Not so fast: if you give away more than $14,000 a year per person or exceed your lifetime gift limit, you will pay the gift tax at 40% to punish your good deed.

There’s more:

My natural gas bill shows three different natural gas taxes amounting to over 15%, and this does not count taxes levied earlier on the gas in the distribution pipeline.

Los Angeles charges a 9.2% electricity tax on my use of electricity.

Our phone bills are like Christmas trees lit up with taxes. Congress has abnegated its taxing responsibilities by offloading them to bureaucrats, who can set whatever taxes they please (taxation without representation). Look over your statement, and you will find such goodies as a federal landline phone tax, state landline phone tax, federal cell phone tax, state cell phone tax, city utility tax, 911 tax, regulatory cost recovery charge, and state public utility surcharge, among other taxes. Taken together, these amount to about 10.94% of the total bill. Taxes on your wireless phone bill come to 16.87%, on average.

The cable TV tax is 11.69%, on average.

The broadband Internet tax has a small effective tax rate of 0.71%. Watch this one go up.

If this drives you to drink, the state of Washington will charge you $35.22 per gallon tax on spirits, Tennessee will charge a $1.29 per gallon tax on beer, and New York City will charge a cigarette tax of $4.35 for a pack of smokes (the federal taxes are $1.01).

If this drinking and smoking kills you, you face an estate tax (death tax) of 40%. Declare the pennies on your eyes. A number of states have estate taxes as well—for example, Washington charges 20%. Additionally, some states also tack on an inheritance tax for the people receiving your property (Nebraska wants 18% for nonrelatives).

There are many other taxes as well. Here’s a big one: according to the Tax Foundation, taxpayers spend 6.1 billion hours and $168 billion complying with the tax code. That is a tax on a tax.

The Certified Public Accountants of America have a snappy website that lets you enter a few numbers and calculate how much in taxes you are paying. Point your browser to http:/​/​www.totaltaxinsights.com to give it a spin. You will get a chillingly accurate description of your tax situation. Because many of these taxes are buried or invisible, this helps brings your total tax picture into stark relief. It also tells your average tax rate, that is, out of every dollar in your wallet, what percentage of the money ends up being spent on taxes. That is a sum you will want to decrease.

The numbers will shock you. How has this happened? Has America become a zombie nation of Francophilic, tax-loving sheeple? No. Over the decades we have simply gotten used to higher taxes by degrees, like the complacent frog sitting idly in a pan of water as it slowly heats on the stove. What we are left with is America, the boiled frog.

Whither Our CPAs?

You might ask, Where is my accountant in all of this? Why isn’t he or she squeezing my tax returns like a lemon, extracting every pip of credit and deduction, and keeping more jack in my box?

Sadly, my clients rarely have a good word to say about their accountants. As one succinctly put it, I point out his mistakes, and then he charges me $350 an hour to fix them.

To be fair, I think we may be expecting too much from these beleaguered chaps. We dump shoeboxes of receipts in their laps on April 14 and expect them to work miracles. This is not a recipe for success. In the course of writing this epic, I have met a number of CPAs and invariably found them to be bright and hardworking cowboys of information.

If your taxes are complicated, make an appointment with your tax preparer in November. Tell him you want to review your overall tax situation and see where you might make changes for the better. E-mail him any specific questions you want to discuss in advance. Read over your tax forms before you arrive and, like a Boy Scout, be prepared. You might not leave with any grand strategy to save Western civilization, but at least you will know that you are doing everything in your power to save a dollar.

Here is another novel thought: try doing your own taxes, at least once. I don’t mean fire your accountant—are you crazy? No, you need him. I mean get TurboTax or H&R Block tax software and actually enter the information yourself and see how the whole thing works. You will lose your tax virginity. This will let you collaborate more intelligently with your tax planner going forward.

The Tail and the Dog

Enough with the preliminaries. You already knew taxes were a problem or you wouldn’t be reading the book. Let’s jump in.

As a college grad, you may