Over the past several weeks, we’ve been discussing everyone’s favorite subject to hate, taxes. One thing of particular interest to me is how federal government revenue is close to an all-time high and yet all we hear about is how they need more taxes! More taxes? How much more? That’s a question no one has really answered. Come to think of it, I don’t recall anyone asking the question. If I may translate, government needs new taxes to pay for all this stimulus spending. In other words, the Fed is buying $85 billion in government and mortgage backed securities each month. I believe if it doesn’t stop soon, we won’t be able to tax individuals and businesses enough to pay for it. Interestingly, some of the recent tax hikes have been a little more clandestine. Let me explain.
Other than raising the highest bracket to 39.6%, marginal tax rates stayed the same. However, several new taxes were implemented and old ones were taken off the shelf. For example, the phaseout of the personal and dependent exemption along with the phaseout of itemized deductions, which had been suspended, were brought back. Also, the temporary 2.0% payroll tax cut was allowed to expire. In addition, the Medicare payroll tax was increased by 0.9% and the top long-term capital gains rate was increased to 20%. Finally, a new 3.8% Medicare Surtax was introduced. What do all these tax hikes have in common? They all target high-income earners! Each of these tax hikes are aimed squarely at the heart of those individuals whom we, as advisors, serve. Therefore, we need to stay abreast of these changes and plan accordingly. Here’s one thing I’m doing to help clients plan for potentially higher taxes in the future.
Typically, when a financial plan is created, it is done using a set of reasonable assumptions. However reasonable they may be, they will not mimic reality. Because of this, Monte Carlo simulation has become a widely used and useful tool. But how you use MCS is key. To digress for moment, in a typical MCS analysis, investment returns are simulated using the mean and standard deviation. However, when you have multiple portfolios, if each portfolio isn’t properly correlated with every other portfolio, the simulation will understate the risk. This is because during the simulation, there will be trials when one portfolio zigs and the other zags. However, in reality, even conservative and aggressive portfolio sare more highly correlated than one might think. Hence, they move more together than the “zig” and “zag” would indicate. But that’s a topic for another time. Let’s get back to taxes.
Due to the extent of debt our government is accumulating, in the financial plan, I am simulating higher taxes in the future. Here’s how. Using the “effective tax rate” (ETR), I am setting a parameter around this assumption. At the lower bound is the current ETR and at the high end is an arbitrary ETR percentage above the current ETR. Moreover, I’m using a Uniform distribution for this because there is no preference for any number in between the lower bound and the upper. In other words, it is equally probable that the future ETR will be anywhere between the lower and upper bound.
Even though actual tax increases may stem from sources other than marginal tax rates, by simulating higher tax rates, I can effectively stress test the client’s plan. With the massive debt accumulation we are witnessing, it’s important to protect our clients against a government which continues to spend nearly $1 trillion more than it collects. Therefore, when Uncle Sam comes knocking, don’t forget, “The tax man cometh…and the tax man taketh away!” Let’s help our client prepare for his arrival.