How Bad Were Your Taxes?

Now that we have passed the tax filing deadline, I thought it important to address one of the concerns I often encountered when working with clients who were not high net worth individuals.  Wealthy or not, high income or low income, individuals frequently wanted to discuss the impact of income taxes on their finances and how to mitigate that impact. While a valid concern, I often learned that many individuals were not aware of their tax situation. Today I would like to urge you to understand your tax situation so that you can be more aware of the impact income taxes are having (OR NOT!) on your financial well-being.

According to The Tax Foundation, a non-profit tax research organization, for the most recent data available by the IRS (2007 Tax Year), the average income tax rate for all taxpayers was 12.68%. Drilling into the numbers deeper, however, shows that a great number of taxpayers pay taxes at a far lower rate. The bottom 50% of taxpayers paid an average income tax rate of only 2.99% and the next 25% of tax payers paid an average income tax rate of 7.01%. It is fair to say that 3/4 of all taxpayers in the United Stated had an average income tax rate of about 7% or less in 2007! What I would like you to consider is where do you fall in this range?

I often worked with clients who desired to reduce their income taxes and suggested strategies they read about to do so. What they did not realize and what I tried to make them aware of was that many of these strategies could cost far more in the long run than any small tax savings they may be able to obtain.

For example1, clients often wondered about using a variable annuity solely as a tax-sheltering vehicle to protect income in excess of IRA contributions they could make. Assuming a reasonable 1.65% total annual annuity expense (made up of several charges) and an investment of $100,000, the annual fees for owning that annuity would be approximately $1,650. If that money had been held in an account which did not offer tax-deferral, taxes would have to be paid on realized income. Assume the $100,000 were invested in an interest-bearing savings account paying 3% interest, total income would be $3,000. Even if taxed in the 25% tax bracket, the total income tax would be only $750…far less than the annuity charge. Plus the annuity income likely would be still be taxed in the future at time of withdrawal! Other tax-sheltering strategies can have similar costs.

My point is, know your income tax situation. If you are one of the 75% of taxpayers discussed above, many tax-sheltering strategies actually could harm you financially. You may have political reasons to feel strongly about reducing your taxes, in which case, these strategies could make sense to you even though there is a cost associated. I would then advise you to consider this a goal you have based on a value which can be planned for. But know the costs and potential benefits of pursuing this goal. I submit that you might find yourself surprised.

A point of note: I have in this piece only focused on income taxes. For the 75% of taxpayers discussed who receive employment income, the heavier tax burdens are frequently in the form of employment taxes and real estate taxes. Unfortunately, the tax strategies often employed to reduce taxes do not impact these tax burdens.

1This example has been greatly simplified including a simplification of the actual mechanics of a variable annuity which are far too complicated for this simple discussion.  Frankly, this complexity is a major criticism I have of variable annuity products. An annuity can offer other benefits in addition to tax-deferral which should be considered, however, which may satisfy some of your goals. 


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