Tax The Rich

What's up, Taxes? It's Graham here.

So normally, I don't talk about topics that could get politicized or taken out of context, but I gotta say there is so much confusion and misinformation surrounding some of the new proposals aimed at taxing the rich that I want to set the record straight. Coming from the perspective of someone who this directly impacts on almost every single level, in the last week, there have been multiple new announcements about eliminating retirement account contributions, increasing tax brackets, adding a surcharge on personal incomes, and taxing stock buybacks to help offset the cost of the three-and-a-half trillion-dollar infrastructure package.

And I have to say, there are several items on here that I think absolutely make sense, while others leave me scratching my head wondering how on Earth did anyone think that would be a good idea. And don't worry, even though I'm going to break down every single proposed change here and its impact on the entire economy, I do not go into politics. I don't take sides; I just look at the facts, analyze the data behind them in terms of how it impacts everybody, and then I let you come to your own conclusion.

Although, before we talk about the expectations for taxing the rich and how excited I am that Taco Bell is testing out a new subscription service, it would mean a lot to me if you could come to your own conclusion to tax that like button for the YouTube algorithm by paying it a gentle tap. Doing that helps me out tremendously, and if I see this video topic do well, I'm more likely to make others like it in the future. So thank you guys so much, and now with that said, let's begin.

Alright, so before we talk about the major shortcomings throughout the entire tax system and why it looks like a talking head, let's first talk about the wrench. Throughout most of these proposals, this is defined as an individual or a household earning more than four hundred thousand dollars a year, and they make up 1.8 percent of the US population. The central argument is that this group benefited the most throughout recent history, and because of that, they should pay a higher tax to help fund the programs that benefit the rest of the population.

From an objective point of view, they aren't exactly wrong. The Federal Reserve reported that since 1990, the top one percent of household wealth saw the largest increase across all brackets, and this group also experienced the highest wage growth across all incomes. However, before we dive into the new taxes being outlined and the potential impact for everybody, it's important to differentiate between the terms income and wealth because when it comes to taxes, the two are far from being treated equally.

When you hear the word income, this refers to money being earned from your labor, a job, dividend payments, rental income, or any other money that's actively deposited to your bank account. But wealth, on the other hand, is calculated by the value of the assets you own—like a house, stocks, artwork, collectibles, and anything else that might go up in value over time. In this case, it's just as possible to be high income and living paycheck to paycheck as it is to be totally jobless while sitting on a portfolio worth a hundred million dollars and growing.

I think that's really important to mention because when it comes to these tax policies, income is the main point of discussion. Even though a wealth tax has been floated around for these last few months, today we should focus on the most burning topics of discussion, and that would be the elimination of what's called the backdoor Roth IRA contribution.

And I hate to say I told you so, but two months ago I said this: the biggest risk right now to the Roth IRA is most likely going to be the elimination of the backdoor Roth IRA contribution, which allows high-income people to get around the income limitations. Congress, hey, if you're watching this, I would at least hope that you get your free stock down below in the description that's worth all the way up to a thousand dollars when you use the good gram.

Anyway, for those unaware, the Roth IRA is really just a retirement account that lets you contribute up to six thousand dollars a year of after-tax money, and then anything you make within that account is completely tax-free after the age of 59 and a half. But there's a bit of a problem. See, the Roth IRA was originally set up to help the middle class save for retirement, and because of that, there are income limitations as to who can and cannot get the tax-free benefits.

Well, here's where things get interesting: there's a loophole that allows you to get around those pesky income requirements by contributing to a traditional IRA first, which doesn't have an income limit, and then immediately converting that to a Roth. And voila! You can now contribute to a Roth IRA regardless of how much money you make.

However, this new proposal would close the loophole by disallowing Roth conversions after December 31st, 2031, and they would also disallow mega backdoor Roth IRA contributions regardless of how much money you make. Essentially, this would enforce the current limitations in place and make sure that no one is able to contribute to a Roth IRA if their income is above that threshold. You would be limited in terms of how much money you're able to contribute.

As far as my own thoughts on this, on the surface I get it. The Roth IRA income restrictions never made much sense to me given how simple it was to get around. It was basically the equivalent of locking the front door of a house but leaving the side door wide open for anybody to use. But calling for this loophole to be closed in ten years is essentially just an open invitation for as many people to use it and pack away as much money as possible until then, at which point there's plenty of time for future lawmakers to change it back.

I can only assume the reason for this is because they generate a significant amount of tax revenue upfront on Roth conversions, so they'd rather not miss out on immediate tax revenue and instead just push it off as a future event. To me, that doesn't make a lot of sense to do, but it is what it is.

Although, it doesn't just stop there. In fact, this is the very beginning, and there are some other restrictions we gotta talk about as well. In addition to closing out the Roth IRA backdoor contributions, Congress also wants to eliminate accredited investments from being placed within an IRA. If you're confused, here's what this means and why this could be such a big deal.

Like I mentioned earlier, the Roth IRA was originally set up to help the low and middle class save for retirement, so it would make sense that investments held within this account would be available for anybody, right? Well, not quite. Some private, non-publicly traded companies could raise capital by issuing stock to accredited investors who either have a net worth above a million dollars or make more than two hundred thousand dollars a year.

Why? Well, the SEC determines that private companies who are not openly registered and regulated are riskier investments than those available in the open market. Because of that, they have a high potential of one day being worth absolutely nothing. So, by placing a net worth and income limitation on these investments, the SEC is ensuring that average, everyday people don't buy into investments where they have a high chance of losing it all.

But given the high-risk, high-reward nature of these companies, accredited investors are able to buy them in and place them within their Roth IRA so that if they eventually go public, bam! They're worth a mini fortune, and all of that is tax-free. This is exactly how Peter Thiel was able to accumulate a five billion dollar fortune within a Roth IRA; it all started from a two thousand dollar investment in PayPal when the company was first founded.

So under these new rules, if an investment requires you to be accredited in order to participate, it's no longer going to be allowed within a Roth IRA. In addition to that, Roth IRA accounts who currently hold these investments would lose their tax-free status, meaning they would have to get them out of the Roth IRA over the next two years.

At the end of the day, I do think it's a reasonable request, but it might be tricky to retroactively apply this to past investments without grandfathering them in. After all, imagine you spent the last 25 years holding on to an investment growing tax-free, and then all of a sudden you owe taxes based on a brand new rule, even though you followed everything to a T in the past.

And finally, if the total value of your IRA accounts are above 10 million dollars, you would be required to withdraw 50 percent of anything above that amount if your income is higher than four hundred thousand dollars a year. In addition to that, if the total value of your IRA is more than 20 million dollars, you would be required to set up a distribution plan to bring the total back down to 20 million dollars.

So they're basically suggesting that you need to withdraw 50 percent of anything above 10 million dollars each year and 100 percent of anything above 20 million dollars each year in an effort to put a hard maximum on the amount of money that could be sheltered from taxes. They also aim to eliminate what's called self-dealing, which means you invest in a company that you own a portion of. As of now, it's legal to invest company shares in a Roth IRA that you own 50 percent or less of, but under this new provision, that would be adjusted down to 10 percent for investments that are not tradable on an established securities market, regardless of whether or not the IRA owner has a direct interest or not.

So overall, if this were to pass, they would aim to keep the Roth IRA only available for the people it was intended for, with broad investments only available to the general public. I would say for the vast majority of the population this is not going to make any difference to you whatsoever, but it certainly does set the precedent that if these changes could be retroactively applied, at what point could these thresholds be lowered to the point where eventually it impacts you?

Although, in terms of other potential changes, there's more. Right now, there's a proposal to increase the top tax bracket from 37 percent where it is now back to the previous 39.6 for incomes above 523,000 dollars a year. According to the Tax Foundation, this aspect of Biden's proposal would raise about 110 billion dollars over the next decade.

In addition to that, the top capital gains tax rate would be increased from 20 to 25 percent, which would likely apply to incomes above 445,000 dollars a year. This would also include a 3.8 percent investment surtax for incomes above a million dollars a year, which would put the total capital gains tax rate at 28.8 percent.

Now, what I actually found really interesting was that previously the Tax Foundation conducted a study, and they found the optimal capital gains tax rate to be 28. They found that this was the point to maximize cooperation and tax revenues without just causing people not to sell or try to find loopholes. This new rate is set to generate an additional 123 billion dollars over the next 10 years.

And finally, incomes about five million dollars a year would be subject to an additional three percent surtax bringing the total top federal tax rate to more like 42.6 percent, plus any state or local taxes which would push that even higher.

On a broader scale, part of this tax aims to implement a two percent tax on stock buybacks, which is generally used to boost the price of a company's stock. For those not aware, if a company has excess profit, they could usually do one of three things: they could invest that money back into the business, they could issue a dividend to all their shareholders, or they could buy back their stock, which incrementally increases the price of each share.

It would be no different than a one hundred dollar stock paying a one dollar dividend or not paying a dividend and using that money to buy back their shares and increase the price of the stock to a hundred and one dollars. In both cases, you're still gaining that exact same one dollar worth of growth, but in the case of stock buybacks, you're not taxed up front on that one dollar worth of growth until you sell. And that is what's coming under fire.

Over the last 10 years, companies have engaged in a record amount of buybacks as a way to increase the price of their shares and generate a tax-efficient return to investors. But a new proposal would charge a two percent tax on stock buybacks in an effort to encourage companies to reinvest that money back into their workforce instead. However, the Tax Foundation analysis argues that anytime a company has more cash on hand than they reasonably know what to do with, they either hold on to it or return that value to shareholders.

In this case, companies make investments within themselves and their workforce first, and when no other options are available, they then use that cash to buy back their shares, helping out investors—not the other way around. Not to mention, if the capital gains taxes were increased to 25 percent, stock buybacks would actually lead to more tax revenues. Share prices rise, so you would almost want to encourage more stock buybacks because that leads to more taxes.

Or if you tax stock buybacks, then companies would be more inclined to issue a dividend instead, and that kind of just defeats the purpose. So either way, it's probably not the best attempt to increase taxes if that's the main objective.

As far as my own perspective, for whatever that's worth, I find most of these policies reasonable. Now, I'll be honest, as an investor, the 25 capital gains tax seems to be a little bit aggressive because just like an onion, there are layers to rich people. I don't really think people understand the varying levels of magnitude when it comes to wealth.

Just consider this: when most politicians and headlines lump everyone together in the “top one percent tax the rich” person category, they're doing a massive disservice by placing a very diverse group of people together that, when you zoom in, have very little in common with each other. For example, in most of these policies, the person earning four hundred thousand dollars a year is treated the exact same as somebody else earning 500 million dollars a year.

But just for reference, if each of these dots represents a hundred thousand dollars a year, this is a person who the media calls rich, but there are several hundred people who make more than 50 million dollars a year in wages alone. And when you put that side by side, you realize just how big of a number that really is.

Now, don't get me wrong, I'm not dismissing the significance of four hundred thousand dollars a year, but the difference between that and 50 million dollars a year is the exact same difference between someone earning a thousand dollars and 125 thousand dollars. Let that sink in.

The most difficult part of mine is that we very much have a growing disparity between the rich and the poor that was exacerbated by a K-shaped recovery that brought to light a lot of issues. Unfortunately, as a result of that, it seems like there's this narrative that rich people are greedy, that they're extracting as much value as possible from everybody else, and they're otherwise deemed for taking something that could have belonged to somebody else.

Although I have to say, with money, it's never a zero-sum game. One person making a dollar is not always at the expense of somebody else losing a dollar. For the vast majority of transactions, you're either paying or getting paid for providing a skill or service, not taking at the expense of somebody else. This applies whether you're earning thirty thousand dollars or thirty million dollars, unless, of course, you're running a Ponzi scheme, in which case, that's bad.

But really, I think a lot of the stress towards the rich is a totally separate topic from whether or not each tax bracket pays their fair share. I've seen some people mention the fact that sixty percent of U.S. households paid no federal income tax in 2020 while the top 10 percent pay seventy percent. And I've also seen articles about how rich people pay a lower tax rate than their secretary, but much of that comes down to wealth being treated differently than income.

And when your net worth is tied to unrealized company stock that fluctuates in price by the minute, that makes it impossible to tax. The same also applies to capital gains as an investment. Even though it seems odd that this tax rate would be lower than earned income, when you break it down even further, you're investing money that you've already been taxed on into a volatile investment without any guarantee of a return on your money while inflation eats away at the higher value while you pay tax again when you sell.

So even though I'm in favor of higher taxes, I do think that two things need to happen: one, let's separate the people earning four hundred thousand dollars a year from the other people making 40 million dollars a year; two, there should be a higher progressive tax policy that raises these percentage points over time depending on how much money you make. Not to mention, the reality is no matter how much we tax the rich, we spend so much money as a nation that it's barely going to make a difference.

Now, that's not to say what's the point, why even bother? But until we more efficiently spend our resources, it'll be like filling up a leaky bucket with water that'll constantly need to be replenished even more and more and more. And that's why I don't think we're going to be able to fix our problems with just taxes alone.

I really believe that financial education is probably the best weapon against poverty, and the more people know about personal finance, the better. Or at least, that's just my take on things. But you know what? We've gotten too serious here; let's lighten up the mood because Taco Bell is now testing out a new 30-day taco subscription across Arizona to gauge customer interest.

If you're local and want to try it out, let me know how it is because I would hope one day they bring this to Las Vegas.