Sooner or later nearly everyone will be affected – infected, shall we say? – by “bracket creep.” Ryan L. Ellis, dubbed “the high priest of Republican tax-cutting,” by The New York Times, bemoans bracket creep.
In an interview with ThinkAdvisor, Ellis, a leading tax expert on the political scene and an IRS enrolled agent shed light on bracket creep and other matters germane to 2015 tax returns and beyond.
The senior advisor for tax policy to the Conservative Reform Network spends the bulk of his time trying to persuade companies to work better with conservative groups. He is also a Washington lobbyist on tax issues.
As an enrolled agent, Ellis’s federal license authorizes him to represent taxpayers of any state. During the first three-and-a-half months of each year, he runs a tax preparation service, Ryan Ellis LLC, based in Arlington, Virginia, specializing in small-business and retail property returns.
He was formerly lead federal tax policy director of Grover Norquist’s Americans for Tax Reform, an organization founded in the course of Ronald Reagan’s presidency. Author of the book “Tax Reform for Our Century” (Conservative Reform Network), Ellis makes the case for revamping the tax code as a way to generate economic growth and bring tax relief to working families with children.
ThinkAdvisor spoke with him about tax-efficient investments, this season’s taxpayer surprises, what’s upcoming for 2016 and why bracket creep is a damnable fact of life. Here are interview highlights:
THINKADVISOR: Is the U.S. tax system becoming increasingly progressive?
RYAN L. ELLIS: Yes. It has built into it things that make it more and more progressive every year. That increases the tax burden every year. So it’s already baked into the cake: If we keep current law in place, we’re going to have higher taxes and more progressive taxes. The Congressional Budget Office says that by the end of this century, the federal tax burden will go from the current 18% of GDP to 24% of GDP, which will be a record.
Two reasons: The first is bracket creep, which happens because the tax brackets are indexed to inflation. The CBO is projecting that more and more income will be taxed at higher bracket levels because people’s incomes grow faster than inflation, and that’s especially true at the top end.
What’s the second reason?
The 3.8% surtax on savings and investments – a result of Obamacare – is not indexed to inflation: It kicks in with households that have adjusted gross income of $250,000 or more. Over time, more people will be making $250,000. In a hundred years, that will be what you earn if you work at McDonald’s during the week! So almost everybody is going to be paying that 3.8%. Any surprises for taxpayers this year?
A few. One is how high capital gains rates have become. People still have 15% in their heads because that was the rate for about 10 years. But if you’re a high net worth individual, you can easily have the regular capital gains rate of 20% and on top of that the 3.8% surtax. With itemized deductions being clawed back, this has the mathematical effect of increasing the capital gains rate. And then, state income taxes have been on the rise for the last 10 to 15 years.
What might be the grand total?
When you calculate the entire amount, you could find yourself with a 30% to 35% capital gains rate. That’s much higher than it was even five or six years ago.
Any other surprises?
If you’re making $150,000 to about $600,000, you’re likely an Alternative Minimum Tax household. AMT is a certain set of [complex] tax calculations that you have to live under. Everyone thinks this has been repealed. It’s not gone.
Any more surprises?
Because the 3.8% surtax isn’t indexed to inflation, every year more and more households will find themselves in that surtax area. They’ll have a capital gains rate and [surtax] of 23.8%, and for the most part, ordinary income tax rates in the 40%’s, if they’re at the high end.
The Bush tax cuts expired at the end of 2012. So is that issue no longer relevant?
All the Bush tax cuts went away permanently for about 12 to 18 hours. But then Congress passed a piece of legislation, the American Tax Relief Act, or ATRA. What that did was to permanently put in place Bush tax-cut levels for households making less than $250,000 a year. For those making more than that, the Bush tax-cut provisions mostly expired.
Any notable exceptions?
Under ATRA, qualified dividends are permanently taxed at the same rate as long-term capital gains – the way they have been since 2003. Before 2003, they were taxed as ordinary income.
What’s another exception?
The 39.6% tax bracket was restored but in a way that there’s only a $2,000 income differential between it and the 35% bracket. This is a very odd situation: the top two brackets – 35% and 39.6% – are almost exactly the same. This was done artificially as a result of political compromise. So you have a couple of little odd cats and dogs at the higher end.
What’s important to know for investors who own company stock?
This is something that advisors should keep in mind: If you’re a high-net-worth individual living in a higher-tax state and keep [company stock] in a brokerage account, when it throws off dividends, you could very easily find yourself paying a 30% or 35% combined annual tax. [Hence], by putting that stock in a brokerage account, over time, taxes will eat away the ability to grow those assets. [Meanwhile], dividends could have grown tax deferred – and maybe get reinvested – if the [stock] were inside a qualified plan or an IRA. What impact do low oil prices have on the taxes of master limited partnership (MLP) investors?
The first issue with energy-derived MLPs is that plummeting oil prices means there will probably be less of a profit-share allocation to you as a partner. The other is that the permanent tax bill that was passed [stipulates] scrutiny of partnership returns. So there’s an increased audit risk at the partnership level to make sure the tax liability that’s implied on the partnership tax return actually finds its way down to the [Schedule] K1.
What does that mean to MLP partners?
You’re likely to have a higher degree of uncertainty that the K1 you get in March or April is ultimately going to be a reliable one for [filing] your 1040. You could find yourself getting a delayed K1, which will delay the ability to file your return because you can’t file your 1040 without a K1. Or you could end up getting a corrected K1. Or the MLP files their partnership tax return and then gets audited by the IRS.
What happens then?
They’ll have to file an amended 1055, which means amended K1’s for all the partners.
Turning to ETFs, are they as tax efficient as they’re touted to be?
Compared to mutual funds, they might be. The biggest consideration between an ETF and a mutual fund is tax efficiency. If the mutual fund you desire is very tax inefficient, you should probably look at an ETF, all things being equal.
What’s the primary difference between the two tax-wise?
Mutual funds throw off capital gains distributions. ETFs are individual securities that, like stocks, trade throughout the course of the day and don’t have internally generated capital gains. If you can find an ETF that has the same basic investment philosophy as the mutual fund [you’re considering], you’re probably better off owning the ETF. But if the only mutual funds that you’ll ever purchase in a brokerage account would be very efficient low-cost stock index funds, they’ll be competitive with the equivalent ETFs.
When does ETFs versus mutual funds matter most?
When you have a desire to buy an actively managed type of investment. [For tax efficiency], you’re probably better off getting the ETF version than the mutual fund version.
Donor-advised funds seem to be popular these days. How tax-efficient are they?
This is a way to get an immediate tax deduction for a charitable contribution and let somebody else figure out how to best allocate it. The donor-advised fund allows an investor who, say, doesn’t have the means to establish their own foundation, to do so in a more accessible way by setting up a fund to give $100,000, for example, to certain charities. Though you get that immediate tax deduction, you surrender the actual direction of the fund to the advisor. However, you can direct the advisor in a general way as to the fund’s mission. What should FAs keep in mind tax-wise about tax-deferred annuities?
They’re more attractive now than they were 10 years ago because tax rates are higher. But you have to factor in costs. Deferred annuities are very high-cost investment vehicles compared to brokerage costs. So, No. 1, [investors] have to figure the cost of the annuity, the commission and the interest rate at the time the annuity is constructed. With this very low interest rate environment, you end up with a pretty paltry annuity formula – and all you’re getting is the security of a monthly payment from the annuity.
So buying a tax-deferred annuity mainly for tax efficiency isn’t a great idea?
It kind of lets the tail wag the dog.
Are long-term care insurance policies tax deductible? Many people don’t buy them because they’re expensive.
Long-term care is tax advantaged federally, though it’s a little difficult to qualify. You can deduct the premiums up to certain limits; but you have to do it as a medical itemized deduction. That’s fairly hard to do because you need to have [high] out-of-pocket medical expenses in a given year in order to deduct anything. However, if your employer is willing to purchase a policy for you, that could be a tax-free fringe benefit.
Any other way to deduct these premiums?
If you use pretax Health Savings Account (HSA) dollars to purchase long-term care insurance, it becomes tax advantaged.
Are there any major tax changes upcoming that will impact 2016 returns?
At the end of last year, the bill called Protecting Americans From Tax Hikes Act (PATH) was passed, which made permanent the lion’s share of [what had been temporary] tax extenders. That takes a lot of uncertainty off the table. There were about 55 temporary tax-code provisions that Congress would reauthorize every couple of years that were driving tax extenders. Now there’s a higher degree of certainty that rates won’t change, or at least, won’t change to the upside, as a result of that bill’s passing. It means you can plan with a little more confidence than you could in the past.
So are there no new deductions or other changes for year 2016?
We’ve had a lot of permanence put into the tax code in the last couple of years – both for good and for ill. We know what the rates for capital gains and dividends are going to be, the surtax level, IRA and 401(k) contribution levels and what qualified plan limits will be. We know what people can take in itemized deductions. All that is set in stone. So there aren’t a lot of new credits or twists on tax law [upcoming].
“Set in stone” for how long?
If we move into a period where there’s a serious discussion of fundamental tax reform, then that’s something people need to be looking at.
Are you a CPA?
No. I have no interest in accounting. I’m a tax guy. I just like taxes.
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