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Ten Tax Loopholes

Here are some counterintuitive tax loopholes to ponder:

  1. Savers can separate high and low income securities. Pre-tax savings instruments such as 401k, 403b and 529 plans are taxed at ordinary income tax rates when the money is withdrawn. This is great because it avoids double taxation of both income tax and capital gains tax. It is worth considering where it is most beneficial to put different types of securities from a broad portfolio. Even though the accounts are tax advantaged, the tax advantage all comes at the head end when money is put into the account. Once it is in the account, it is tax disadvantaged due to the high rate when it is withdrawn. (529s only avoid this for a few years while the beneficiary has a lower tax rate than the maximum). Thus if a portfolio has some securities with high expected return (like high beta risky securities), they incur lower taxes in a post-tax account so that upon withdrawal only capital gains of 20% are paid. Bonds and low risk securities belong in the 401k, 403b or other pre-tax account because they will pay out 35% (or higher if taxes go up) when they are withdrawn.

  2. Savers can back load non-matched 401k deposits. The tax benefit accrues if contributions to a 401k occur at whatever time during a year. If that all occurs on December 31, then the growth occurring at ordinary income tax rates has on average a half a year less to accumulate. Here is a strategy that compares favorably with contributing to a 401k all through the year. If money is placed in S&P 500 depository receipts (SPDRs) during the year, if it goes up a saver can borrow against it and put that money into a 401k and sell the SPDRs after a year and book the long term capital gain, holding cash in the 401k, then buying SPDRs in the 401k when it is sold in the cash account. If SPDR prices go down, they can be sold, the capital loss booked and the SPDRs rebought in the 401k. The reduction from 35% to 20% tax on the gains can make up for a lot of margin interest.

    There are some disadvantages to this loophole. Note that there are maximums to 401k contributions so the saver probably needs to start earlier. If the saver's job security is in doubt, it would be wise to start even earlier because some jobs have a waiting period before contributions may start. Finally, the saver may need the help with the will power that contributing every month brings.

    (Note: for matched deposits, the doubling of the principle earning income offsets any savings in taxation so those contributions are not subject to this loophole.)

  3. Savers can actively convert ordinary income into capital gains. If securities prices rise and fall together, then they can be used to induce "spooky action at a distance". Einstein coined the phrase to talked about quantum entanglement of particles. Suppose instead we have two entangled investments. If a cash (post-tax) account holds a short position in a risky security and the 401k or 403b holds a long position in the same security, one account will rise and the other will fall as an exact mirror image.

    To mix another metaphor from physics, the custodian of the accounts can behave like Maxwell's Demon who lets energetic particles through a door and sends slow particles back the other way. Dinkin's Demon is going to close both positions after one year if the price of the risky security falls and keep positions where the risky security rises. There entropy in thermodynamics that makes Maxwell's Demon expensive. Dinkin's Demon only costs commissions. The risky security is held both long and short so all the security has to do is oscillate to generate the opportunity for money to flow from the pre-tax account to the post tax account.

  4. Saver's can actively convert capital gains and ordinary income into Roth IRA appreciation. The previous loophole would be even wider if the post tax account was a Roth IRA, an account where growth is not taxed. Then no tax would be due on the gains. It would also be quicker because the trade could take one day because there would be no waiting period for the long term capital gains. Not everyone qualifies, however, for a Roth IRA.

  5. Earners can take income in alternate years to avoid estimated taxes. The IRS requires that payments be made to the US Treasury that are the minimum of 90% of current year's tax due or 100-110% of last year's tax. If money is earned in alternate years, the minimum will always be zero. Since payments are due annually instead of quarterly, six months interest can be earned on taxes.

  6. Earners can backload regular withholding. There are high penalties associated with the following loophole if it is not executed correctly. By changing the W-4 to have lots of extra withholding in December, it is possible to keep and earn interest on most of the earner's money that would otherwise be withheld about a half a year extra. Having the high month be November is a little safer because it gives time to correct an accounting error (or find a new job) for December.

  7. Earners can form a partnership to earn dividends instead of wages. Dividends are taxed at ordinary income rates. Wages also require Medicare. The economic incidence of Medicare taxes is twice the employee share of 1.45%. That is, by converting wages to dividends, marginal taxes can be cut by 2.9%. Many states have taxes on partnership and corporate earnings that offset this, but not all. IRS does not look kindly on exclusively paying dividends and not wages so they are on to the loophole. But the loophole is still open for a typical division of profits and salary.

  8. Owners can pay out capital gains instead of cash. One of the biggest drivers of the technology economy was the differential taxation between capital gains and ordinary income. By paying very little cash and making it up with stock or stock option compensation, firms could reduce the tax load of their employees. If the money that was being used for salary and benefits was instead put into a share buyback to reduce the number of shares outstanding, the price of the shares would steadily rise even if the value of the firm stays constant or falls.

    For example, suppose a firm is worth $100 million and stays exactly the same total value. Suppose there are 100 million shares outstanding at $1.00 each. Suppose the firm pays $100 million/year in compensation. If employees and management agreed, 25 million options could be issued, cash compensation reduced, and $50 million (and a $49 million loan) could be used to buy up 99% of the outstanding stock at $1.01, then 8.33 million shares resold. (A synthetic 1 for 3 reverse split). The price per share after the buyback would be $3. The employees would have $50 million in capital gains that they would pay $10 million in taxes on if they exercise the options and hold them for a year so they have $40 million in gains post tax. Compare that to the $50 million they receive in cash. The $50 million would be taxed at ordinary income tax rates so the employees would have only $32.5 million if they are in the 35% bracket. If they are in the 25% bracket, they and their employers have to pay social security so take home pay is roughly the same with cash, but lower brackets do even better with capital gains.

  9. Taxpayers can start a schedule C business. There is a 2% limitation on miscellaneous tax deductions. There is no minimum on schedule C deductions which can be deducted from the first dollar.

  10. High tax payers can renounce citizenship before making too much money. The United States has a mean streak. It has evolved beyond 'love it or leave it' to 'if you leave it we want your money'. If taxpayers pay more than $122,000 in taxes, they may be liable for 10 years of additional taxes if they decide to renounce their citizenship. This way of avoiding taxes will probably become less popular if estate taxes are reduced or eliminated.

Posted by Sam Dinkin at April 16, 2005 09:33 AM
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Comments

Is this now an H&R Block website?

What's next, a discussion of insurance actuarial tables?

Posted by Bobby Kline at April 16, 2005 03:48 PM

Note, by the way, that the funtion Maxwell attributed to a demon is actually performed by a device called the Hilsch vortex tube.

Posted by triticale at April 16, 2005 05:43 PM

In space, no one can audit your taxes.

Posted by McGehee at April 17, 2005 07:04 AM


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