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Old 11-17-2012, 04:19 PM   #21
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Because tax brackets are already adjusted for inflation every year. If inflation doubles in those 5 years, the tax brackets will adjust to it.

In other words, someone earning $40K per year today and $80K in five years in your scenario will be in the exact same place in terms of tax brackets. Before tax reform addressed "bracket creep" in the 1980s, your example was a very real and serious one.

Cost bases, unlike tax brackets, are not adjusted for inflation. I understand your concern -- passive income should not be favored over earned income -- but I don't see that happening in my suggestions.
I'm still not convinced.

Let's say I am currently in the 25% marginal bracket. If I work for one hour for $10 (i.e - sell my "asset" of one hour labor), I'll pay $2.50 in taxes. Because the brackets are indexed for inflation, in five years, even if my pay rate doubles, I'll still be in the 25% bracket. Now, however, I'll pay $5.00 in tax (25% x $20.00)

Now let's assume a world where capital gains are taxed as ordinary income. Let's also assume that my doppelganger has income from selling shares of stock such that he is also in the 25% bracket. Instead of an hour of labor, he has a share of GLW as his asset. He can sell it (his asset) for $10.00 and pay $2.50 in taxes. In five years, if prices have doubled solely due to inflation, he sells his share for $20.00 and pays $5 in tax, because he is still in the 25% bracket due to inflation adjusted brackets.

Finally, let's assume a world with inflation indexed capital gains. In five years, when I sell my asset (my hour of labor), I pay $5 in tax. But when my doppelganger sells his asset (his share of GLW) in five years, he pays only $2.50 in tax. And yet those two things (an hour of time and a share of GLW) are equal in real value today and equal in real value in five years.
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Old 11-17-2012, 04:22 PM   #22
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Originally Posted by Gumby View Post
Let's say I am currently in the 25% marginal bracket...

Now let's assume a world where capital gains are taxed as ordinary income. Let's also assume that my doppelganger has income from selling shares of stock such that he is also in the 25% bracket. Instead of an hour of labor, he has a share of GLW as his asset. He can sell it (his asset) for $10.00 and pay $2.50 in taxes. In five years, if prices have doubled solely due to inflation, he sells his share for $20.00 and pays $5 in tax, because he is still in the 25% bracket due to inflation adjusted brackets.

Finally, let's assume a world with inflation indexed capital gains. In five years, when I sell my asset (my hour of labor), I pay $5 in tax. But when my doppelganger sells his asset (his share of GLW) in five years, he pays only $2.50 in tax. And yet those two things (an hour of time and a share of GLW) are equal in real value today and equal in real value in five years.
The $10 the stock owner paid T-5 years ago was taxed T-5 years ago. If prices double over 5 years, a worker that earns twice as much as he/she did in year T-5 has not had their effective tax rate changed because brackets are indexed.

The owner of stock, however, has no such indexing. The tax code protects earned income from inflation by adjusting the brackets annually. The tax code has NO accounting for "phantom" capital gains due only to inflation.

If I buy a share of stock with $10 (one hour of my time in your example), and inflation now makes one hour of time worth $20 in five years... if I sell it for $20, what have I gained? To suggest I should pay ordinary income tax on half of the purchase price, when I have gained ZERO in real terms, seems really unfair. And it would devastate the incentives to long-term investing.
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Old 11-17-2012, 04:47 PM   #23
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In the case of the stock, you haven't said what you paid for it, so we don't know your gain. Let's say you bought it yesterday for 1 cent and today it is worth $10.01. Now we have a situation that is analogous to your case with the labor: If you realized the gain (by selling it) you'd owe 15% tax on your $10 gain (just like with your labor if you earned $10 in that hour, a $10 gain) and in five years (when the stock is worth $20.01 in inflated dollars) you'd owe $3 in taxes. Just like with the labor.
The basis issue may indeed be the answer to my dilemma. In my hypothetical, I assumed that all of the $10 value of the stock was taxable if sold today. That almost certainly is not true. You likely already paid taxes on the labor you expended to get the money to buy the stock in the first place. Whereas the laborer has not paid any taxes yet on the hour of time he has in his pocket.

Let's assume you worked yesterday for an hour and ten minutes, paid ten minutes worth of tax ($1.50) and used the remaining $10 to buy stock, which today is still selling for $10.00. If you sold, you would have no cap gains and hence no tax. So now, you and the laborer have an asset of equal value, but you have already paid $1.50 in tax. In five years, if prices double for both you and laborer, but your cap gains are inflation indexed, you will not pay any more tax. The laborer will pay $3 in tax on the hour he sells then. But the tax paid will have the same real value as the $1.50 you paid yesterday.

I'm glad we had this discussion. It has helped to clarify my thinking on this issue.
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Old 11-17-2012, 04:47 PM   #24
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Pension income is taxed at ordinary income rates. Dividend income is modest at best. So, very little impact to us, except when selling real estate (paper gains, more than offset by carrying costs).

One thing I can't understand: Since real estate capital gains are taxed, why can't real estate capital losses be used to offset capital gains?

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Old 11-17-2012, 04:55 PM   #25
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The $10 the stock owner paid T-5 years ago was taxed T-5 years ago.
That's exactly what I was not seeing properly. Thanks for helping me think through this.
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Old 11-17-2012, 05:06 PM   #26
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In the ideal world, income tax brackets, dividends, and stock gains should all be adjusted for inflation. Tough luck if that is going to happen. No way!

Look at the AMT. Everybody knew about this problem with it not being inflation-indexed, but did Congress ever do anything about it? As I have worked part-time the last few years, plus my wife retired 5 years ago, our income has not been up there for me to know if there has been any change.

And think of the folks who are leery of stocks and buy CDs. They lost money because the interest is below the inflation rate. The tax on that interest adds insult to injury!
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Old 11-17-2012, 05:26 PM   #27
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Hi all

Read that the new tax overhaul proposal taxes dividends at 43% and capital gains at 23.8% (from the current 15% for both). Since many retirees depend on these types of investment vehicles for income, seems to me this is potentially a huge consideration for ER. The rates quoted are for the "top" tax rates implying that rates are tiered. Nonetheless, still a significant hit.

Opinions on how realistic this is (will it happen?)?
Strategies on dealing with it if it does?
Note that these rates in 2013 would start at a gross income of about 390k a year. The 36% bracket would extend down to 250 or 200k depending on if married or single, below 217k it would be 31% and below 142 it would be 28%. Note that the last 2 assume the bush tax cuts are not extended beyond 2012. The Obama proposal would not touch folks below 250/200 k neither on dividends/capital gains or overall rates. Note that the 39.6% rates is a rate that only 1% of taxpayers pay so it is truly a 1% rate.
Below 142k the rate would be 25 or if no law change 28% and below 70 k for married 15% so at that level it would not make any difference.
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Old 11-17-2012, 05:28 PM   #28
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Pension income is taxed at ordinary income rates. Dividend income is modest at best. So, very little impact to us, except when selling real estate (paper gains, more than offset by carrying costs).

One thing I can't understand: Since real estate capital gains are taxed, why can't real estate capital losses be used to offset capital gains?

Amethyst
They can except for personal residences. Of course on a primary residence you do get a 250/500k capital gain exemption. So today unless you have held a place for a very long time you should not have much taxable gain.
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Old 11-17-2012, 06:01 PM   #29
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On the face of it, this seems like a good idea. If I own one share of stock today that trades at $10.00 a share, I could sell it and buy 4 loaves of bread. If, due to inflation, in five years my share of stock is worth $20.00, but I can still only buy four loaves of bread with it, why should I be taxed on the $10 increase?

But then lets look at labor. Today, I have one hour of my time that I can sell for $10.00, with which I can buy 4 loaves of bread. If, again due to inflation, I am selling my hour for $20.00 in five years, but still can only buy four loaves of bread, why shouldn't I get the same inflation indexing for my tax bill?

A conundrum for which I do not have a good answer.
I think the difference has to do with the fact that you can take the $10 you earned today and immediately buy those 4 loaves of bread. But, the $10 in capital gains one earns over 5 years can't be used to buy bread until the stock is sold. And at that time you can only buy 2 loaves of bread.

Never mind, the tax rates are indexed for inflation so in real dollars it's the same thing.
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Old 11-17-2012, 06:03 PM   #30
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They can except for personal residences. Of course on a primary residence you do get a 250/500k capital gain exemption. So today unless you have held a place for a very long time you should not have much taxable gain.
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Old 11-17-2012, 06:05 PM   #31
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In the ideal world, income tax brackets, dividends, and stock gains should all be adjusted for inflation. Tough luck if that is going to happen. No way!

Look at the AMT. Everybody knew about this problem with it not being inflation-indexed, but did Congress ever do anything about it? As I have worked part-time the last few years, plus my wife retired 5 years ago, our income has not been up there for me to know if there has been any change.

And think of the folks who are leery of stocks and buy CDs. They lost money because the interest is below the inflation rate. The tax on that interest adds insult to injury!
Agreed!
And AMT ain't the only thing about US Tax Code that's NOT indexed for inflation.
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Old 11-17-2012, 06:11 PM   #32
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“The art of taxation consists in so plucking the goose as to get the most feathers with the least hissing.” - Jean Baptiste Colbert (French Economist and Minister of Finance under King Louis XIV of France. 1619-1683)
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Old 11-21-2012, 10:38 AM   #33
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I don't see double taxation of profits - corp tax + dividend tax - as right. Seems there ought to be one total tax rate for corporate profits whether paid by the corp or as dividends. Say that's 35%. So if the corp's marginal rate is 25% in a year, the personal tax rate on that corp's dividends ought to be 10% & so on.
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