Truth in taxation: Taxing an illusion
By Ken Davis
So, tax time is fresh in our memory and we all dutifully reported our form 1099 income on our 2012 tax return to the federal government. We might have been one of the lucky people to make one half of 1 percent on our bank CD last year. On $100,000, we would have made about $500.
According to www.usinflationcalculator.com, the inflation rate was reported to be 2.1 percent in 2012. So, 2.1 percent of $100,000 is a true economic loss of $2,100. Take $2,100 loss minus our gain of $500 and we derive a $1,500 pre-tax real economic loss. Pay taxes of, say, $100 on that “income” and your real economic loss is $1,600.
The tax machine does not stop there. Inflation slowly chips away at our tax deductions, credits and exemptions. Many of these tax benefits, contained in our Internal Revenue Code, are subject to being reduced if our adjusted gross income exceeds certain thresholds or exemptions. The efficacy of those exemptions, used in the phase-out formulas, erodes with inflation. True, some of them are inflation adjusted, but some aren’t.
For example, the new 3.8 percent Obamacare surtax is not inflation adjusted. And the formula which determines inclusion of Social Security in income is not either. The latter used to have a very significant threshold that only applied to affluent taxpayers back in the early 1980s. Over time, inflation has made the taxation of Social Security common to the lower middle class taxpayer and above. It all happened so slowly, nobody raised the alarm.
Even more concerning is where inflation goes in the future. Many commentators believe that the government will have to monetize the debt by printing money, thereby causing a lot more inflation in the future. If that turns out to be true, then we may repeat the experiences of the 1970s and early 1980s, when inflation was in the low teens. I believe the compound inflation rate for the 1970s was around 7 percent or more.
We, as insurance professionals, can help protect against much of this bad news. While our interest rates on annuities and life insurance are also at historical lows, they are higher than many other safe assets paying interest. If you believe in indexed products, your clients’ may be able to squeeze out even better rates.
And remember, our earnings compound at pre-tax rates. In the case of life insurance, the client may even take their income out tax free if they use the policy correctly. In the case of annuities with LTC-type benefits, they may also distribute tax free to pay for qualified LTC costs.
Traditional LTC policies are deductible within limits and the benefits are paid tax free. Where else in the Internal Revenue Code do you find a deduction up front and tax-free income when distributed?
So, while the tax misery grows on a daily basis, we have the products to help defend against increasing taxation and to provide reasonable returns safely to our clients.