Truly Taxing

Jonathan Clements  |  July 16, 2015

THE FEDERAL TAX system punishes the middle class, who have earned income and fund retirement accounts. Meanwhile, it favors the wealthy, who are more likely to have substantial sums in taxable accounts and then bequeath those assets.

Okay, now I need to explain myself.

First, there’s the question of earned versus unearned income. Tax rates on wages are higher than those on long-term capital gains and qualified dividends, plus workers also have to pay Social Security payroll taxes. The latter is especially rough on the self-employed, who have to pay the full 15.3% payroll tax, because they don’t have an employer to pay the other half.

Defenders of the current system will say that we need lower tax rates on investments to encourage folks to save and invest for the long haul, and that those who pay Social Security taxes are eventually rewarded with retirement benefits. But along the way, aren’t we discouraging people from working, a bad idea in an economy where the ratio of workers to retirees is shrinking? On $100,000 in income, a single self-employed individual might lose more than 30% of his or her income to federal income and payroll taxes, or quadruple the 8% paid by someone who lives off qualified dividends and long-term capital gains.

Second, there’s the issue of what gets taxed after your death. In 2015, if you die with less than $5.43 million ($10.86 million if a couple) in a taxable account, you’ll owe no federal taxes. But if you died with a comparable sum in a traditional retirement account, your heirs would owe a massive amount of income taxes. There’s even talk of forcing heirs to empty retirement accounts within five years of the original owner’s death, which would make the tax bill especially massive. (In 2019, this came to pass, though most beneficiaries were given 10 years to empty inherited retirement accounts.)

Again, defenders of the current system would argue that the traditional retirement-account dollars have never been taxed, so the federal government should still get its money. But arguably, that’s also true of the embedded capital gains in a taxable account, and yet those capital-gains tax bills disappear upon death, thanks to the step-up in cost basis that occurs.

As you can tell, I’m well aware of the rationale behind the current system. And while perhaps the current system shouldn’t be scrapped, it seems like we need to tweak the incentives somewhat—so that people have a greater incentive not only to work and to launch their own businesses, but also to save in retirement accounts both for their own benefit and with their heirs in mind.

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