Income tax vs. capital gains "fairness" test

[Animorph]

I created a spreadsheet to look at the issue of "fairness" between income taxes and capital gains taxes. To do this, I compared what present value in an IRA would be required to match a sample take home pay stream, and what taxable account present value would be required to also match the take home pay stream. The IRA is equity based, but is taxed as income and avoids SS and Medicare taxes. The taxable account is equity based and is taxed as capital gains..

Assumptions:

The IRA starts with a present value that is all pre-tax and magically appears.

The starting tax basis in the taxable account is $0. This seemed fair since non of the IRA starting balance was taxed. Like a really good stock option grant.

I used the 2012 federal tax table, with brackets adjusted for inflation after the first year.

I used fixed 3% yearly inflation, inflation+2% salary increases, inflation+6% equity growth, 7.65% SS+Medicare taxes when calculating take home pay, 15% capital gains rate, a $60k starting salary, and a 35 year career. The initial take home pay was $47,280.

The results:
The IRA requires an initial balance of $1,078,462.
This was enough to make yearly withdrawals (start of year), pay the income tax, and net the target take home pay for 35 years. The IRA balance after 35 years is $0.

The taxable account requires an initial balance of $1,086,383.
This was enough to make yearly withdrawals (start of year), pay the capital gains tax, and net the target take home pay for 35 years. The taxable account balance after 35 years is $0.

(A Roth account requires $923,425)

Actually pretty close, I think.

The breakeven point (equal IRA and taxable account starting values) in this case is about 14.38% capital gains tax. Can't get much closer to even than that.

The comparative result did not change much with different investment gain assumptions. Probably because they are both equity based.

Here's the results for different starting salaries:

$20k IRA: $361,940
$20k Taxable: $377,972


$30k IRA: $542,911
$30k Taxable: $558,942



$40k IRA: $723,574
$40k Taxable: $739,605




$50k IRA: $901,877
$50k Taxable: $916,120





$60k IRA: $1,078,462
$60k Taxable: $1,086,383


$70k IRA: $1,253,044
$70k Taxable: $1,249,242

$80k IRA: $1,428,502
$80k Taxable: $1,406,750

$100k IRA: $1,783,840
$100k Taxable: $1,719,358

As expected, capital gains taxes look better than income taxes as you average income tax rate rises.

[LOL!]

I have a problem with your assumptions and I expect others will as well. The money in the taxable account was probably taxed at least once beforehand unless inherited from a dead person who had been in the 0% tax bracket for a long time or stolen.

[Animorph]

Quote:

Originally Posted by LOL! I have a problem with your assumptions and I expect others will as well. The money in the taxable account was probably taxed at least once beforehand unless inherited from a dead person who had been in the 0% tax bracket for a long time or stolen.

Yeah, I started out using a full tax basis for the taxable account, making the assumption that it was all previously taxed. But how is that fair against untaxed money in an IRA? I felt the $0 basis was a better match.

If the taxable account has a tax basis equal to its original balance, then a capital gains rate of just about 25% was required to equalize the IRA and the taxable starting balances.

[donheff]

Not sure I understand the argument about double taxing capital gains. Anamorph seems to have a sensible comparison (for a specific income level and set of taxe rates). If your point is that the gains were already taxed (corporate tax) per the common argument for not taxing CGs, the same would apply in the IRA in reverse. The CGs in that account were profits already subject to corporate taxes and then subject to income taxes when withdrawn.

[pb4uski]

Quote:

Originally Posted by donheff Not sure I understand the argument about double taxing capital gains. Anamorph seems to have a sensible comparison (for a specific income level and set of taxe rates). If you point that the gains were already taxed (corporate tax) per the commen argument for not taxing CGs, the same would apply in the IRA in reverse. The CGs in that account were profits already subject to corporate taxes and then subject to income taxes when withdrawn.

I don't think that many have suggested not taxing capital gains at all, but rather having preferential rates for capital gains to reduce the effect of double taxation.

While your observation on CGs in an IRA is true, for tax efficiency most people hold bonds rather than stocks in taxable IRAs so your thinking would not apply to the extent that the growth in the IRA is from compounded interest which is taxed at ordinary rates.

The argument for double taxation is fairly easy. Let's say you have an investment in Company A and Company A has 100 of pre-tax profit for the year. Company A would typically pay 20 in corporate income tax, though it could be as low as nothing or as high as 35 depending on their specific tax situation, but I'll use 20 for the rest of this example. If Company A decides to distribute that 80 of after-tax profit as a dividend, and it is tax as ordinary income then the recipient would pay another say 28%, so of the original 100 of profit, 58 ends up in the investors pocket and 42 gets paid to the federal treasury (20 from the company and 28% of the 80 dividend) so there is a 42% effective federal tax rate on that 100 of profit. Plus, in many cases you have state income taxes as well. The tax preference (lower rate) on dividends reduces the 42% to 32% (at 15% tax rate on qualified dividends, lower, but still higher than the 28% the federal government collects from the taxpayer on 100 of wages.

The same idea applies if the 80 of corporate after-tax income is retained rather than distributed in that the retained profit increases the value of Company A.

In a sense, the government receives less on 100 of wages in that it receives 28 from the wage earner but gets 20 less from the corporate employer for a net receipt of 8 since the employer gets to deduct the wages for tax purposes (wouldn't apply to non-corporate employers like government or not-for-profit entities). Similar for interest too.

[donheff]

I understand the double tax argument. I was just pointing out that it applies to both taxable and IRAs. As you point out IRAs often hold more bonds that taxable but for many people. especially the young, IRAs still hold a lot of equities. DW and I (already retired) have all of our bonds in tax advantaged but still have substantial equities in them because they outweigh our taxable accounts by a large margin. As we burn up our taxable we will re-balance the tax advantaged to even more equities. Still, I agree the accounts are not equal from a double taxation perspective.

[pb4uski]

Quote:

Originally Posted by donheff I understand the double tax argument. I was just pointing out that it applies to both taxable and IRAs. As you point out IRAs often hold more bonds that taxable but for many people. especially the young, IRAs still hold a lot of equities. DW and I (already retired) have all of our bonds in tax advantaged but still have substantial equities in them because they outweigh our taxable accounts by a large margin. As we burn up our taxable we will re-balance the tax advantaged to even more equities. Still, I agree the accounts are not equal from a double taxation perspective.

Totally agree - we are doing exactly what you are - all bonds in tax-deferred plus some equities and taxable account are all equities - using taxable accounts to live on until pension and SS come on line and rebalance within the tax-deferred accounts.

Imperfect system, but it is what it is and I'll take the tax deferral and not worry too much about any theoretical inconsistencies.

[samclem]

The "double taxation" argument WRT dividends doesn't seem very strong to me. The corporation is an entity for tax purposes, and pays tax on it's earnings (profits). Then there is a transfer of funds (dividends) to individuals. We tax many kinds of transfers between entities (e.g. when a bank pays interest to depositors, when a corporation pays employees for their labor, etc), I'm not clear on why this transfer of assets between corporations and individuals should be treated differently.

Cap Gains are different. I'd favor treating them as individual income after adjusting for inflation. It's easy to do with today's tools.

[Hamlet]

You appear to be neglecting FICA in this comparison. That's another 12+% that the government is receiving on most wage income.

That concerns me more than the double taxation of dividends, especially with the recent trend towards plummeting real corporate tax rates.

Quote:

Originally Posted by pb4uski In a sense, the government receives less on 100 of wages in that it receives 28 from the wage earner but gets 20 less from the corporate employer for a net receipt of 8 since the employer gets to deduct the wages for tax purposes (wouldn't apply to non-corporate employers like government or not-for-profit entities). Similar for interest too.