Admit it, we like the taxes paid by others. Unlike the horrendous taxes we pay, the taxes others pay are fair and equitable. Everyone knows this. That's why we love to defer taxes whenever possible. The only thing better is avoiding them altogether.
Until this year, that is.
The passage of the "Jobs & Growth Tax Relief Reconciliation Act of 2003" changed it all. While most media attention focused on tax cuts for "the rich", my personal bet is these reductions won't change the gigantic proportion of all income taxes paid by top earners. In 2000, for instance, the top ten percent of all earners--- households with adjusted gross incomes of $92,144 or more--- paid a whopping 67.33 percent of all income taxes, up from 54.69 percent in 1986.
(Readers who compete beyond the golf course take note: the threshold for the top 5 percent was $128,336. The top 1 percent requires at least $313,469.)
The real action will be changes in where people invest:
- With most stock dividends taxed at only 15 percent and capital gains taxes also 15 percent, investing in dividend stocks will be more attractive than investing in long-term tax-free bonds. The interest rate risk (not to mention credit risk for places like California) on long-term municipals gives them mostly downside. Dividend paying stocks, on the other hand, have the potential for growth.
- Stock dividends will also be more attractive than bank certificates of deposit and short-term taxable bonds. A bank CD with a yield of 2.67percent, for instance, only yields 1.74 percent for investors in the 35 percent tax bracket. A stock with a yield of 2.04 percent will provide the same after-tax yield--- the tax burden is only 15 percent. That 2.04 percent yield is high but common--- nearly a third of the stocks in the S&P 500 Index qualify.
- With both dividends and capital gains taxed at only 15 percent, investors can now be indifferent to whether their return comes in dividends or capital gains. This is a gigantic shift. For decades, high-income investors have fueled the market for growth stocks, hoping to score a major capital gain. Now, there is no tax difference between income stocks and growth stocks. Think about that.
- Most tax-deferred annuities now look silly. You'll do a lot better paying 15 percent taxes today than paying 35 percent taxes tomorrow. Add the fact that most equity mutual funds still have capital loss carry forwards and taxable investments are the most tax efficient.
- Finally, there will be a shift from tax-deferred contributions in 401(k) plans to Roth-IRAs and taxable accounts. Joint returns with incomes under the $160,000 cut off for Roth-IRAs ($110,000 for single filers) may elect to pay income taxes at today's lower rates, gambling that tax rates will be higher in the future. Similarly, savers who are ineligible for a Roth-IRA can shift some money to taxable investments--- simply to increase the money they can access without paying taxes.
Bottom line: traditional tax phobia is likely to be hazardous to your financial health. ‘Pay -As-You-Go' taxes are an opportunity.