Taxes-picture

It’s the $64 Trillion question: how much of an impact will the Obama tax measures really have on wealthy individuals?   There are few straightforward answers because at least three variables will impact the effective tax rate a wealthy individual is liable to pay.

The following commentary will showcase the key variables impacted by the new tax measures in order to illuminate the income profiles of those who will be impacted the most.  It will conclude with an analysis of effective tax rate variance among four sample profiles to further crystallize the impacts of the measures.

The Obama Tax Measures Demystified

Broad-swathing changes will impact citizens with annual income greater than $200,000 and married couples with income greater than $250,000.  The new laws will levy a 3.8% Medicaid Tax, raise the Long-Term Capital Gains Tax from 15% to 20%, and raise the Qualified Dividends Tax rate from 15% to that of the Ordinary Dividends Tax Rate (which is individually determined, but usually hovers in the 30%-35% range).

Effective tax rate impacts are difficult to predict based on tax hike figures alone because each of these new taxes or rate increases impacts a different area of individual income.  Therefore, it matters very much whether the primary source of income is salary vs. investments, to what order of magnitude, and, for income from investments, what kinds.  Other individual factors (such as charitable giving, special deductions, and other low-order-of-magnitude math) further individualize impacts.

The Three Variables That Predict Impacts To Wealthy Individuals

Salary is the first variable to impact the degree to which effective tax rates will change.  A wealthy individual receiving most of her income from a salary can expect to see the brunt of the impact come from the 3.8% Medicaid Tax.  Conversely, an independently wealthy individual who does not receive salary income but rather takes all income from investments will be minimally impacted by the 3.8% Medicaid Tax, instead seeing his effective tax rate variances driven by changes to the tax rates of investments.

That brings us to the second variable—Long-Term Gains.  Wealthy individuals with income profiles weighted heavily in this category will see a 5% tax increase for that portion of income.  Therefore, an individual who receives 100% of income from Long-Term Gains would see a greater rise in effective tax rate than an individual who receives 100% of income from salary.

The third variable—Qualified Dividend Income—will see the largest swing.  Wealthy individuals with income profiles weighted heavily in this category will see tax increases in the neighborhood of 15-20%.  Though this group stands to see the largest swing in effective tax rate, it is unlikely that most wealthy individuals have income heavily weighted to any of these three categories to the exclusion of others.  Additional investment categories (the Short Term Capital Gains Tax, for one) won’t see a tax rate change and most wealthy individuals’ income hails from multiple sources.

Assumptions: Income Profiles and Tax Scenarios of Wealthy Americans

For the purposes of analyzing possible effective tax rate variances, we’ve profiled three investment scenarios for each of two income profiles. The first scenario profiles “Married High Earners,” assuming annual income of $500k and broadly representing a plausible salary vs. investment distribution for a highly-paid worker.  The analysis assumes that 90% of High Earner income ($450k) originates from salary and that only $50k is earned through investments.

The “Married & Independently Wealthy” profiles assumes an annual income of $1M, and posits that only 25% of income ($250k) comes from salary while 75% ($750k) is earned through investments.

Beyond the earning profiles, three scenarios are run for each profile: one in which most investments come from Short-Term Capital Gains (the rate for which will remaining flat), a second in which most investment income comes from Long-Term Capital Gains, and a third in which most investment income comes from Qualified Dividends.  These scenarios will illustrate how individual portfolio weighting will have the most bearing on an effective tax rate change.

Finally, other assumptions were made to complete each of the four profiles after benchmarking certain variables for each demographic (e.g., charitable giving, etc.)  Adjustments were also made for marital status (as the names indicate) and reflect other areas of the tax code that differentiate rates for single and married filers.

Though most wealthy Americans report paying effective tax rates in the mid-to high teens, this analysis does not account for the scores of specialized deductions that lower effective tax rates to those levels.  However, the scenarios below remain good indicators of projected tax variance given the order of magnitude of the measured tax rate changes.

The Math

For high earners in the $500k income range with 90% of income attributable to salary, effective tax rates are likely to rise only by 3-4% under the new laws.  For these couples, the dollar increase would amount to between $15k and $20k, depending on what portion of investment income originates from Qualified Dividends.

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For independently wealthy couples with $1M in aggregated income and 75% of income from investments, effective tax rates could rise anywhere from 3-9%, with the majority of increases impacting those with significant holdings of stocks with Qualified Dividends.  For these couples, the dollar increase would amount to between $30k and $90k.

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From this we can conclude that most wealthy Americans will see at least a 3% increase in effective tax rate, with much higher bumps seen by those who receive most income from investments and a significant portion of that from Qualified Dividend income.

The Impacts of the Obama Law

Perhaps more relevant than effective tax rate variances are events that will occur as a result of the changes themselves.  The laws will alter investor incentives, causing individuals to re-weight their portfolios and optimize their tax-adjusted return when they file with TurboTax online.

Consider an individual who was highly invested in securities with a Qualified Dividend.  Without such a significant tax shelter, the same individual has fewer incentives to remain invested in the stock of those particular firms.  Consequently, some selloff of stocks with Qualified Dividends is likely to be seen as investors open themselves to other options.

Some might also argue that a lower overall investment return profile diminishes incentives to save and causes wealthy individuals to spend more of their money in lieu of awaiting a return.  Less favorable tax treatment of investment income may also motivate wealthy individuals to devote more to charitable giving.  Both behaviors, if pursued en masse, would materially improve the health of the economy.

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