Count Up Your Blessings – Most Retirees Can Dodge a Capital Gains Tax Boost

Count Up Your Blessings – Most Retirees Can Dodge a Capital Gains Tax Boost

Is extreme income inequality a bad sign for society?

I think it is, and most would agree with this simplest of statements. Yet start a discussion on how it occurs and what should be done about it, and tempers are sure to flare.

Jake’s a good friend of mine, works in IT. Nothing grand, yet he and his wife live in a swell old, red-painted New England frame house by a lake in Maynard, Massachusetts. Jake’s brother drives him nuts. He doesn’t live in a trailer park, exactly, but only because most towns in MA don’t allow them.

One day, he went to see this brother, whom we’ll call Jed, because we like a good chuckle, and raccoons had gotten into his trash: très chic. “The trash was blown all over his yard: Marlboro cartons, scratch tickets, lite beer cans and fast-food wrappers. He’s a Yankee bubba,” said Jake, about his best bud in the world.

Misunderstand-me-not: I drink my share of beer, smoke a ciggy or two when no one is looking, and I’m part of a Powerball syndicate with two pals – our day is coming, we know it. I’m no lifestyle bigot.

And yet – Jake’s brother is ever in trouble: can’t pay the electric, his cable and Wi-Fi get cut off, he moves regularly, and landlords forgive his arrears to be rid of him. Jake, who earns a moderate income, mind you, is well placed for retirement. Five years ago, his RN wife was hit by health problems; that’s a high-stress career, caring for others. She took early retirement with no real hit to their lifestyle or retirement plans – Jake had them covered. We always talk investments when I’m home, but while Jake does the asking, I learn more from him than he does from me.

Jake’s squared away, his brother’s a puddle. This disparity between brothers will clearly carry over into retirement: one will live comfy, the other will scramble. But where is the injustice?

Jake’s the rare bird who took investment and retirement planning by the horns, early on. Why they don’t teach money management and such in school – don’t get me started. The problem, boiled down, is this: when Jake’s brother gets sick in old age, someone will need to pay for his treatment. He can’t do it. Jake may try, but he’s got a wife. I guess we’re on the spot, you and me.

Let’s face it, though: Jake and I should live a lot better, travel a bit, see the Sox now and then, hit a clam bake on the Cape, all the sweet stuff. Why not? If brother’s left out – well… grasshopper and ant, baby. We choose our paths. I don’t want to see bro suffer, so I’ll help pay the bill for scraping those coffin nails and brews out of his arteries. Yes, we are someone else’s brother’s keeper.

Let’s shift to politics. President Joe Biden has lots of plans, but let’s restrict ourselves to just two of them. I’m old now, I get winded.

One proposal calls for changing the tax treatment of a lofty form of executive compensation – carried interest. Partners in private equity or hedge funds are typically paid under the 2-and-20 scheme – they get two percent of assets under management, plus twenty percent of profit beyond a certain performance threshold. It’s good to be the partner.

Tax rules consider the ‘20’ a return on investment, so it’s treated as capital gains and taxed at 20% maximum, versus the top income tax rate – currently 37%; 39.6% if President Biden gets lucky. Democrats consider this a classic ‘inequality’ issue – every other profession pays the income tax rate, why not hedge fund managers?

This loophole looks ready for plugging and Joe Biden says the tax funds will go to help Jake’s brother, to say nothing of his uninspiring kids. There’s nothing fundamentally wrong with them, and a few federal bucks might be well spent if they drag the boys through community college by the scruff of their necks. But will those dollars really come straight from the millionaires and into the hands of the needy? This is the question of the doubters; in whose ranks you’ll usually find me. I reckon we’ll get to see, shortly.

An item of more general interest is Biden’s plan to remodel the capital gains tax regime. A $1 million income barrier would be set; those earning beyond this threshold would pay 39.6% on capital gains. The 3.8% net investment income tax would apply, too, so the tax bill would reach 43.4%. I won’t even tell you what state income taxes could add. In the worst cases, however, your capital gains bill would look positively Scandinavian.

This worries some who are planning for retirement, although most specialists seem unconcerned, noting that few of their customers will ever have retirement incomes exceeding $1 million. In any case, they have venerable tools at hand, equally effective whatever the tax regime or rates.

Funded with after-tax money, Roth IRA accounts support tax-free disbursements after your last day in the office – no capital gains rates apply. Health Savings Accounts (HSAs) are just as efficient. Permanent life insurance policies feature cash value accounts that can be tapped tax-free in retirement, avoiding the capital gains trap entirely. The death benefit is a wondrous boon: you can leave it to heirs, tax free to them. Even from the Great Beyond, you can call yourself Ahab and stab at those IRS whales.

No matter which way the wind swirls between White House and Capitol Hill, these investments can protect clients from capital gains taxes, however high they climb. I should know; when I called Jake to banter about Biden and company, he told me all about them.

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