Most Hated Taxes in America
February 17, 2014
Written By SBAM Approved Partner AdvanceHR
Few people are fond of taxes, but some taxes are more despised than others. While Hollywood is holding various award ceremonies (Grammys, Golden Globes, Oscars, etc.), we’re conducting an awards event of our own. Here are six worthy candidates for the “most-hated taxes” award in America.
1. Forced Taxes on Retirement Account Withdrawals
Do you have money in an IRA or 401(k) account? Once you turn age 70 1/2, you must start taking annual required minimum distributions (RMDs) or face a steep penalty. Guess what? Those required withdrawals are taxable, which is why Congress dreamed up the rules in the first place. The government wants to get its hands on some of your retirement account money sooner rather than later.
What if you don’t want to take the distributions and pay the tax because you don’t need the money and would rather save it for later in your retirement? Sorry, you don’t have a choice.
2. The Alternative Minimum Tax
The original reason for the alternative minimum tax (AMT) was to ensure that the wealthiest individuals who take advantage of multiple tax breaks would still have to pay some federal income tax each year. The unfortunate reality today is that upper-middle-income individuals who pay relatively high state and local taxes and have spouses and kids are the most likely AMT victims.
AMT Basics: Think of the AMT as a separate tax system with a resemblance to the regular federal income tax system. One difference is the AMT system taxes certain types of income that are tax-free under the regular tax system and disallows some regular tax deductions.
Second, the AMT rate ranges from 26 percent to 28 percent. Regular tax rates range from 10 percent to 39.6 percent. Finally, you’re theoretically entitled to a relatively generous AMT exemption, which is equivalent to a deduction, but the exemption is phased out at upper-middle-income levels. If your AMT bill exceeds your regular tax bill, you must pay the higher AMT amount.
Interacting factors make it difficult to pinpoint precisely who will be hit by the AMT. But here are the biggest danger signs of AMT exposure:
- Your gross income is high enough (say $250,000 or higher) that a large part, or all, of your AMT exemption is phased-out.
- You have relatively large deductions for state and local income and property taxes under the regular tax rules (say $20,000 and up). These deductions are disallowed under AMT rules.
- You have a spouse and several children, which translates into four or more personal and dependent exemption deductions under the regular tax rules. These deductions ($3,950 each for 2014 and $3,900 for 2013) are disallowed under the AMT rules.
- You exercised one or more in-the-money incentive stock options (ISOs). The “bargain element” (the difference between the market value of the shares on the exercise date and the exercise price) does not count as income under the regular tax rules. But it does count as income under AMT rules and can throw you into the AMT zone.
Why Upper-Middle-Income Folks Are the Most Likely Victims
Under our current federal income tax system, the AMT is usually not a factor for individuals with really high incomes (say $750,000 or higher) for two main reasons.
First their marginal regular federal income rate will be 39.6 percent while the maximum AMT rate is “only” 28 percent. So folks with really high incomes are less likely to have an AMT bill that is higher than their regular federal income tax bill. In contrast, folks in the upper-middle-income zone may have enough regular tax deductions that their average regular tax rate is lower than the 28 percent maximum AMT rate. Those folks are likely to owe the AMT.
Second, many tax breaks for folks with really high incomes are already cut back under the regular tax rules before even getting to the AMT calculation. For example, if your income exceeds certain limits, you’ll run into regular tax phase-out rules that chip away or eliminate your personal exemptions, your biggest itemized deductions, and your tax credits. So you may have little or nothing left to lose under the AMT rules. High-powered executives are also less likely to receive incentive stock options (they usually get restricted stock grants or nonqualified options instead). In contrast, folks in the upper-middle-income zone often have lots to lose, such as significant deductions that are allowed for regular tax purposes but disallowed under the AMT rules. And they are more likely to receive incentive stock options. As a result, they are more likely to wind up owing the AMT.
3. The Social Security Tax
You may not hear that much griping about the Social Security tax. That’s strange because it’s just as expensive as the federal income tax for many folks, especially the self-employed. Plus, it has serious fairness issues.
Social Security tax basics. For employees, wages are hit with the 12.4 percent Social Security tax up to the annual wage ceiling. Half the Social Security tax (6.2 percent) is withheld from employees’ paychecks. The other half (also 6.2 percent) is paid by the employer, so employees never actually see it. Unless you understand how the tax works and closely examine your pay stubs, you may be blissfully unaware of how much the Social Security tax actually costs. The Social Security tax wage ceiling for 2014 is $117,000 (up from $113,700 for 2013). If your wages met or exceeded the 2013 ceiling, the Social Security tax hit on last year’s wages was a whopping $14,099 (12.4 percent times $113,700).
While many employees may be in the dark about the magnitude of the tax, because they only pay half the bill, self-employed folks (sole proprietors, partners, and LLC members) know the full story. That’s because self-employed people must pay the entire 12.4 percent Social Security tax out of their own pockets, based on their net self-employment income.
Reasons for Hate
Disconnect between the Tax and Benefits. While the Social Security tax ceiling increased by 2.9 percent from 2013 to 2014 (from $113,700 to $117,000), Social Security benefits only increased by 1.5 percent. This disconnect has occurred in quite a few recent years.
Below are the Social Security Administration’s latest projections (issued in June of 2013) for the Social Security tax ceilings for 2015 and beyond. However, the actual ceilings will probably be higher based on the estimate for 2014 compared with the actual amounts. Do you think Social Security benefits will rise at the same rate?
Insolvency Is Looming. Some people think the government has accounts with their names on them to hold money to pay for their future Social Security benefits. They believe that’s where the Social Security taxes on people’s wages and self-employment income goes. Sadly, this is not the case. There are no individual accounts. All you actually have is a non-binding promise from the government that you will receive benefits. Meanwhile, the Social Security Administration’s most recent report on the system’s financial condition (dated May 31, 2013) projects insolvency in 2033. In that year, the program is only expected to have enough revenue from the Social Security tax to pay about 77 percent of the promised benefits, according to a recent Congressional Research Service study.
4. The Tax on Social Security Benefits
When you start receiving Social Security benefits, you will discover the sad truth that between 50 and 85 percent of your payments might get hit with federal income tax (the taxable percentage goes up with your income). That’s a rip-off for two reasons.
As explained earlier, you already paid Social Security tax in the form of withholding from your salary or self-employment tax. So now you are paying income tax on benefits that are based on a tax you already paid years ago. Even worse, you already paid federal income tax on those Social Security taxes years ago, because they were included as part of your taxable salary or as part of your self-employment income.
To sum up:
- You already paid Social Security tax over the years.
- You already paid federal income tax on those Social Security tax bills, and
- Now you must pay federal income tax on a big chunk of your Social Security benefits.
That’s double taxation, or even triple taxation depending on how you look at it. Thankfully, retirees who are at very low income levels don’t have to pay any federal income tax on their Social Security benefits, but everybody else gets socked. Is this unfair? Of course! But the government wants the revenue stream.
5. Disguised Taxes in the Form of Phase-Out Rules
One of the tricks of politicians is to create a tax break, bask in the favorable publicity, and then take away the benefit from those whose income is deemed to be “too high” to claim it. For example, personal and dependent exemption deductions, the most popular itemized deductions, the child tax credit, the higher-education tax credits, and many other tax breaks are subject to phase-out rules that reduce or completely eliminate them as your income goes up. In effect, these phase-outs are disguised tax rate increases — although you won’t hear Congress describe them that way.
6. The Federal Estate Tax
Many people believe the estate tax is unfair because it amounts to double taxation on wealth that was already hit with income tax during the deceased person’s life. (However, some estates contain assets with unrealized capital gains that have not been taxed before death.)
How it works. Your taxable estate is your gross estate minus allowable deductions. Your gross estate includes cash and property (real estate, stocks, bonds, business ownership interests and other assets). Not all estates are liable for the federal estate tax. It is only levied on the part of an estate’s value that exceeds a certain exemption level, which for 2014 is $5.34 million per person ($10.68 million for a married couple). This exemption amount is indexed annually for inflation. In addition to the federal tax, an estate may be liable for state estate or inheritance taxes.
Bottom line: You may hate certain taxes during your lifetime but if you’re wealthy enough, you will be paying the federal government even after you die.