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Am I A Financial Hypocrite?
| December 3, 2010 | Posted by Roshawn Watson under Uncategorized |
By: Roshawn Watson
There are many types of income, but most income can be classified into three broad classes. While the distinction may be trivial to some, especially if they are personally struggling, the type of income can have tremendous implications to your bottom line and your quality of life. Understanding some basic caveats between the types of income can help you focus on obtaining more tax-advantaged income. Additionally, some recent recommendations by the White House-appointed deficit-reduction commission threaten a well-known tax haven used by both the wealthy and non-wealthy alike, which makes me ask “am I a hypocrite?” Find out why.
Types of Income
The three broad types of income are “earned” income, portfolio income, and passive income.
Earned Income
The income that most are probably familiar with is earned income. This is the money we receive from jobs or our businesses in the form of a paycheck. We have to work for it, typically there is no residual value for it, and it is often the highest taxed. Since we’re taxed when we earn, spend, invest, save, and die, taxes are a big deal financially. I do take issue with this being called “earned income” because it indirectly suggests that other types of income, such as income from assets, is not earned.
Portfolio Income
This income includes money received from paper assets, such as stocks, mutual funds, ETFs, bonds, etc. This income is most commonly received in the form of capital gains and dividends. Presently, this is taxed lower rates than earned income, provided that you meet certain requirements. For example, in the US, income from dividend-producing equities in non-retirement accounts held long-term is taxed at the same rate as long-term capital gains presently (according to the Jobs and Growth Tax Relief Reconciliation Act of 2003). Otherwise, dividend income is taxed at the ordinary income level, which is higher than the capital gains tax rate. Most of us have been forced to become investors because of the shift from Defined Benefit pension plans to Defined Contribution pension plans. Consequently, many of us intend to retire on portfolio income since we are now individually financially responsible for ourselves. Thus, understanding this income distinction is important, so that we won’t be ill-equipped.
Passive income
Passive income can take the form of royalties from patents or use of intellectual property, rental income, etc. It is also more tax-advantaged and in my opinion is the most leveraged of these three types of income.
Idle Rich Are Idle No More
Many of the wealthiest individuals have strong streams of passive and portfolio income. Think Carlos Slim and Warren Buffett. However, don’t think of the golf course or sailing necessarily. There’s been a recent shift in the type of income received by the wealthy during the most recent wealth boom. Wealth has interestingly been fueled more by the working wealthy–entrepreneurs and executives–than by passive capitalists who earn a living off their investment. Berkeley researcher Emmanuel Saez found that wages from paychecks accounted for 56% of the income for the top 1% of earners in 2008 compared to only 40% in 1960. Again, there are tax consequences of getting one’s income from wages instead of assets, so it is important to understand how to transform that income into more tax-advantaged income.
Tax-advantaged Income
Moreover, you certainly don’t have to be rich to acquire tax-advantaged investments. For example, you could become a landlord or increase your portfolio income. Also, there are risks inherent with each type of investment. There is principal risk, market risk, inflation risk, etc. Putting all of your money in fixed-rate CDs seems safe until you factor in you may not earn enough to keep up with inflation and meet your future financial needs. Investing in bonds is risky because the company or government entity could default on the payments. Investing in stocks is risky because the value of the shares could drop or the company could even close up and leave you with worthless stock. There is no such thing as a risk-free investment, but the key is to minimize risk to an acceptable level for you.
For those who like tax-free income and have a moderate risk-tolerance, many own municipal bonds.1 Typically, you are loaning a state or local government entity money in exchange for a reasonable and tax-free rate of return. The larger your portfolio, the more pronounced this benefit is, but this is also huge for income investors with modest portfolios. Municipal bonds represent a nice reprieve from taxes and penalties for tapping earnings from IRAs, Roth IRAs, 401Ks, Roth 401Ks, etc., taxes on capital gains, and taxes on dividend income. I don’t mean to represent them as being safe. Despite their historic relatively low default rates, defaults on municipal bonds are certainly possible. Struggling local and state economies are a reality (i.e. look no further than California and New Jersey), so caveat emptor.
Anyway, this is relevant because a recent proposal threatens their existence.
Am I Being Hypocritical?
I try to be reasonable, and sometimes you just have to own your biases. For example, I am a huge fan of deficit reduction. Like many others, I think that the recently announced two-year pay freeze for federal workers represents a necessary evil. I am aware that I have readers who work for the Federal government, and please know that this isn’t an attack against you but rather the lesser of four evils.When surveyed, if faced between a choice of rising costs that choke the entire system, losing a job, taking a salary decrease, or taking a temporary salary freeze, repeatedly most people opt for the latter. While there are typically not mass-layoffs with the federal government, it is certainly not implausible. Consider the post office layoffs. Anyway, while the pay freeze is largely symbolic (small dent in the national deficit), it is a step towards fiscal restraint, which is important given the economy.
However, there is another proposal to reduce our national debt that I was not in favor of: the White House-appointed deficit-reduction commission’s recent proposal to eliminate the tax-free status of municipal bonds.
The rates of returns on municipal bonds aren’t exorbitant, so eliminating their tax-free status will only shift money elsewhere (in my opinion). The problem is I’m biased on this one, so my opinion is far from objective. It seems a little bit hypocritical for me to be a fan of deficit reduction except when it impacts my bottom line. Is this a case of trying to have my cake and eat it too or is this proposal an attempt to increase taxes on wealthy individuals (i.e. those with a net worth of over $20 million and get sizable chunks of “unearned” income), and individual income investors are just getting caught in the cross-fire? As indicated, now over half of the rich get their income from wages, but suppose the deficit-reduction commission didn’t get the memo.
Read my mail and let me know your thoughts, am I a hypocrite for not supporting this austerity measure or a consumer advocate for individual income investors?
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1Please note I am not giving tax or investing advice, nor am I a tax or investing professional. While the information given is intended to be authoritative, please consult with your local tax and investment advisers for your own unique situation.
I have many friends who work for the Feds, and boy do they have sweet deals compared to the private sector in terms of salaries, benefits, hours worked, job stress, etc. Over the past 30 years their salaries have grown far faster than their counterparts in the private sector. This is unsustainable since government employees produce no wealth, but only consume the wealth of others. Salary freezes in this area are long overdue.
Deficit commissions and politicians in general are such cowardly lions– they make a lot of noise but have no teeth. I think a 10% across the board cut in federal spending is in order like so many businesses have done over the past 2 years. But don't hold your breath over that one.
I work for the private sector and the cost cutting we've done was quick and deep. For god's sake, they even got rid of our coffee makers at work.
10% should be doable without majorly affecting quality of services. The private sector does it all the time and not only do they do it once, but they do it over and over. I would love to be a cost cutter in one of these places.
I don't see why we can't have high efficiency standards in the public sector like it is in the private sector.
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No I definitely won't hold my breath. You make some fabulous points. I forgot that wage increases in the public sector and far-outpaced the private.
Also you are right that the recommendations aren't binding and may not even become a formal recommendation to Congress and the White House. However, the report is expected to help define debate about possible solutions.
With respect to the cut, there definitely are some very difficult decisions ahead. Working for a state-funded institution, I have also seen several friends' salaries and budgets slashed recently. It's a tough reality.
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I think it would practically kill the muni-market unless they increase their returns substantially. You can certainly find higher paying bonds and preferred stock, so the muni play for many people is primarily about relativelystable tax free income.
I keep on harping on the spending problem too. It's quite sickening how out of control we can be financially.
It is definitely an increase in taxes, and like normal people will just move their income to places where it is treated more favorably.
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That's interesting but true. There's bound to be fat in some of these organizations. I'm sure not everyone is overcompensated but even some of the perks, for example, could be slashed in the name of efficiency.
At the end of the day, I would rather have a job/business/organization than the organization breaking its budget to keep some perks.
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I never did work for Federal Government, but I spent a career working at the local and state levels of government. (I have since retired). I will agree that these government jobs are good ones and that cuts need to be made, particularly in the pension plans. Now…would I be hypocritical if I didn't want MY pension cut? I don't think so, because I paid into it out of my income for all of those years and it was the arrangement I agreed to when I went to work.
In Illinois, the broke state I live in, some changes in pensions for newly hired workers are in the works. They need to be.
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That's a very interesting point. If that was the deal that you signed up for, then you have every right to protest any changing of terms. With respect to the municipal bonds, I believe the proposal doesn't existing affect the taxes on existing bonds but rather newly issued bonds. Thus, the hypocrisy would be why would I protest this if it decreases the deficit: is it because I doubt this will work (I do) or is it me being upset about having to change investment strategy/tax planning (could be as well).
I completely understand your point about the local and state government jobs that need to be revamped given the current economic climate. Just like with GM packages, changes have to be made in order to prevent the collapse of the entire system. This meant agreeing to lower benefits and wages. It's not fun or celebrated but a necessary evil sometimes.
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I agree with what she said (Everyday Tips and Thoughts)…
I remember reading (I think Robert Kiyosaki's Rich Dad Poor Dad) that the author said: success for business is getting more done with less, while with government, success is measured by how large your organization is and how much you spend…
I don't think they will take the tax benefit way from the municipal bonds, surely they must realize that such bonds would become a practically dead security if they did so?…
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Yes, Kris analyzed the situation so well.
I have worked for the federal government 3 times directly. Only once was I overpaid by private sector standards. Business, especially private companies, are primarily about profit and don't necessarily need growth. As you point out, the government is a different beast.
I doubt they will take the tax away either, as it would affect a lot of retirees, and they vote!!!! However, I brought this up for two reasons 1) it is something that could invest income investors (i.e. you and I) and 2) I want to own my biases.
A third benefit is I get all of your opinions 🙂 For example, Joe's comment made me smile (vindicated)!
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2 points here:
1) They should have done even more than freeze federal wages, because they have recently risen much faster than the private sector wages and inflation. A reduction would not have been out of line.
2) You are correct. The local governments stand to lose big if the muni tax free status is revoked. Capital will flow elsewhere, and the cities and towns will be the worse for it.
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The Muni market will still be there, just at higher interest rates, much like corporate bonds. Build America bonds are taxable muni bonds that are being issued today.
Sure, if they increase they increased the interest rate to be competitive with corporate bonds or referred stock; however, that tremendously increases the cost of borrowing for municipalities, which kind of defeats their purpose. I think it would be a major blow, and with so many local government hemorrhaging I do wonder if they will all survive.
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yes, I had completely forgot about the rise in public versus private sector wages until Biz brought it up.
Yes, I believe this would be a major blow to municipalities issuing bonds. Several of them have already criticized this proposal, even though it is virtually brand new.
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Love to have more passive income and portfolio income. This means that the money is working hard for me instead of me working hard for the money.
You're right on the spot that people that if employees can make a choice between losing their job or taking a salary reduction or freeze, majority would opt for the salary reduction. It is better to have income than not at all.
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I'm sorry, but i don't get it. Are you saying most/alot of your income is from tax free munis bonds hence why you are opposed? If so, yes of course it's not fair for you to want to raise taxes but exempt everything that hurts your bottom line don't you think? Pretty logical. Or, am I misunderstanding?
It's like a person who makes less than $200,000 as a single wanting for more tax increases on the rich, while getting a tax break themselves. That's just nonsense.
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I'm not really for raising taxes at all. The potential hypocrisy is that I'm for budget reduction, so the salary freeze seem reasonable to me given the circumstances. However, eliminating the tax-exemption status could potentially (although I doubt it) aid in budget reduction as well, yet I'm not for it. I am questioning my own motives for my opposition that's all. Do I genuinely believe it is bad policy based on the merits of the idea, or am I against any proposal which affects my bottom line, as I do own muni's in my portfolio.
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Thanks so much for sharing your thoughts about the scenario I proposed. Who wants to be unemployed? I would argue very few.
Also, I'm right with you with respect to passive and portfolio income.
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"Don't tax you, don't tax me, tax the fellow behind the tree". I think your reaction is normal. What's not usual is your reflection on what it means. Some or most folks don't go that far, including alleged fiscal conservatives with pet programs or policies.
For me, I was a big fan of the "free" services provided by our city's green waste site (free firewood, mulch and waste drop-off), until I stopped to consider about the pluses, minuses and unintended consequences. Now I'm a little more conflicted, but still get my mulch from there. I guess that makes a small-h hypocrite. 🙂
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Thanks so much. I was beginning to feel that my point was completely misunderstood. I also appreciate your story, as it just goes to show the complexity with taking a stance. Are we purists or something other? It's okay to be something other IMHO, but at least we should acknowledge where the appearance of hypocrisy begins, especially if we go on diatribes with our talking points.
BTW, just discussing this issue in comments has given me so much additional insights. Thank you (and everyone else for that matter) for participating in a rich discussion.
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Actually, I'm very glad you brought it up! I had no idea that their was such a proposal on the table!
Once I get to a certain level of wealth, such muni bonds were part of my strategy! I would hate for those to be missing in the equation!
Kris always beats me to the punch in the comments area :(, She truly is great!
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I like the default titles assigned to the income types. First we have "earned income", as if all other types of income are unearned and undeserved. I agree with you on that. 🙂
Food for thought: Aren't all taxes on "unearned income" actually a form of double tax, since someone, somewhere, had to 'earn" that income in order to invest it? Even though I currently make about 95% of my income from "earned" income, I find it quite unfair that the government expects us to eat 100% of the loss when we invest, but only lets us keep 50%-75% of the gains. I only keep about 50-60% of my income, and on that, I have to pay further taxes when I invest.
Am I a hypocrite because I take advantage of government services, yet I prefer to pay less (no) tax? What if we had true competition in the government sphere so there was actual choice? Although it's hard to open up natural monopolies, I would argue that many functions currently handled by government are nowhere near being natural monopolies, especially with the ongoing advance of technology. So, am I a hypocrite, too? 😉
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As far as GM goes, I'm not sure why other companies couldn't have picked up some of the slack. Somehow the whole thing seems like a big FU to the other companies as well as the creditors, and a nice pay off for those who supported Obama during his campaign. I might be a little cynical, but the whole thing seems like little more than back-patting to me.
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Agree. My girlfriend's company is currently undergoing some severe cost-cutting measures and their company recently laid off 33% of staff and instituted 10% pay cuts on the rest. Nobody gets a pension or RRSP match, and no bonuses. If this was a government-run unionized shop, like a daycare or something, blood would be running on the streets now… it is difficult to go through that, but it is a reality of business. Profit & loss is a basic economic law that holds true everywhere, including with the government : the difference is that with the government (and those private entities well-connected to them), it's everyone else that covers the losses.
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Yes, we're in sync. It's an ugly truth, but ballooning deficits are just as ugly in my opinion and worst threaten the longevity and integrity of the organization. At some point, you have to pay the piper (deal with consequences of a down economy). Just because few would like this doesn't mean that it shouldn't happen.
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I think other companies (especially in that area) were trying to stay afloat as well. Yes, some had some fat in their budgets, but it was earmarked for solvency in an unpredictable market. If there wasn't an anti-business sentiment (regardless of whether it's justified), companies would possibly have felt more comfortable hiring.
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Don,
You are more than welcome. I think this proposal will not be seriously considered but will serve as part of the framework for future legislation. I thought it was interesting and gave me a chance to be introspective. I deliberately stay somewhat apolitical for multiple reasons. However, there are some intersections between fiscal policy and our own wealth-building plans that are way too juicy to pass up.
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To answer your question briefly….yes. It is double taxation. However, the counter-argument is that it is new income to you, so what does it matter that taxes have already been paid on it.
Choice is a very interesting addition to the conversation. I don't have a good answer, as I need to think about it more. I will say this though. There are clearly some services where choice has eliminated the monopoly such as mail (fed ex, DHL, UPS, vs USPS) – I know you are in Canada, but you get the point. These non-gov't institutions are thriving (to the best of my knowledge), so choice can certainly level the playing field.
No I don't think you are hypocritcal just because you take advantage of government services and pay less taxes unless you: 1) have the option of opting out of those taxes and services and 2) choose to pay no taxes AND recieve those services.
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LOL, I wish I had the option of paying no taxes and receiving those services. I suppose I could always go on welfare… but I prefer making income and paying taxes on it to that lifestyle, even if the taxes hit 40% and up. 😉
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Kevin,
That's the very rationale most people use. I think there are plenty who additionally wish we (our countries) would stop providing so many services thereby diminishing the need for so many taxes.