Friday, May 30, 2008

Tycoons, taxes, and the time-value-of-money

It is in your interest to pay the IRS as little as possible, as late as possible, while still avoiding penalties for underpayment -- unless you enjoy loaning Uncle Sam money for free.

The overenthusiastic taxpayer might decide to have his or her employer withhold nothing from his/her paycheck, and then make a big tax payment on April 15th. Unfortunately, the IRS is on to you – it penalizes taxpayers who paid too little in taxes over the course of the year. In fact, very roughly speaking, the IRS cares whether you've paid enough tax on a quarterly basis to cover your income that quarter.

However, the IRS has created various safe harbor provisions, under which one pays no penalty at all, so long as one has withheld some minimum amount of taxes over the course of the year.

Making use of these provisions is an additional, and entirely distinct strategy from minimizing your actual total tax burden.

Optimize by satisfying one of the safe harbor criteria stated below – pick the option that generates the smallest tax payment, and you’ll be able to avoid any penalty:

Safe harbor 1:If you have remarkable foresight, and can thus predict what your total tax burden will be for this year, pay exactly 90% of that amount and no more.

Safe harbor 2:If your prior year adjusted gross income (AGI) was less than $150,000, pay your prior year tax amount.

Safe harbor 3:If your prior year adjusted gross income (AGI) was greater than $150,000, pay 110% of your prior year tax amount.

Enhancements to this strategy, rapidly increasing in impracticality:

Enhancement 1: W-2 withholding is automatically smoothed over the entire year and avoids the quarterly check mentioned above. Thus, one could satisfy one's safe harbor contribution amount by having nothing withheld from one's paycheck until the last possible few pay periods, then have massive amounts of money withheld -- and not have to pay a penalty for making uneven quarterly tax payments. N.B.: This was certainly true in 2003, and to the best of my knowledge, is still true today.

Enhancement 2: Safe harbor #2 creates some interesting, but not-very-real-world-ish opportunities, where you have your employer pay you very chunkily on an every-other-year basis – eg, pay you minimum wage in year 1, then huge gobs of money in year 2, and then minimum wage again in year 3, huge gobs in year 4, etc.

Obviously, some wild-assed assumptions need to be made -- for starters:

-assume that you have sufficient savings to not worry about lean years.

-assume that there’s no risk that your employer will go under, or cheat you.

-assume that your employer’s tax rate and investment options for excess cash are no worse than yours (or at least are sufficiently close to your own) – this assumption is primarily intended to offset for the fact that your employer wants to deduct your salary to reduce its taxes as soon as possible, and to deal with your delayed receipt of funds that you could have otherwise spent or reinvested in year 1.


Year 1: You owe virtually no tax

Year 2: During the year, you only pay what you owed in year 1. Then, on April 15th of the next year, you pay the rest of your humongous tax burden. You got yourself a huge free loan from the IRS!

Year 3: You owe virtually no tax

…and so on

There’s a huge additional assumption embedded in this fanciful example – after all, we live in a world of graduated taxation. There’s a high opportunity cost to having chunky income.

In your years of famine, you lose the benefit of a lower marginal tax rate – that is, you could reduce your total taxes by getting paid more in a famine year, and reducing your income in a feast year. One needs to make a great deal of money, or have some really awesome investments, or else really excellent uses for that money to surmount this problem.

Enhancement 3:One more obviously win-win scenario (from a tax perspective) for the feast/famine strategy, is if the employee works for an offshore hedge fund/private equity fund, and gets paid mainly in deferred compensation (which, unless Representative Chuck Rangel has his way, grows tax-deferred until actually received). Deferred compensation in this context basically means that your money grows tax-free in the fund until actually doled out.

Ignore issues such as:

A.The downsides to having a huge chunk of your wealth effectively invested in your employer (a la Enron), so that your wealth and income end up highly correlated due to mutual dependency upon your employer’s financial health

B.Whether you work for Paulson Capital circa 2007, or Bear Stearns’ subprime hedge funds circa 2008 – that is, whether investing in your own fund is worth it.

C.Whether your personal discount rate is higher than tax-adjusted expected returns, and so on (basically, whether you’d rather have $1 to spend today, or have $1 + returns on your fund in the future)

One objection might be that this set of assumptions is self-contradictory -- a person with such a long view would probably prefer to defer as much compensation as possible for as long as possible, period – lots of famine years, followed by a single feast year.

However, if someone is willing to defer most of his or her compensation, but does want to make sizeable withdrawals from time to time, it may make sense to do so in off years.


At 6/15/2008 11:01 AM, Anonymous Pamela Grundy said...

This post reminded me of the whole "death and taxes" bit. For most of us, its a lot better to just pay up and keep the IRS out of our lives to the highest degree possible. Start looking for 'safe harbors' and you'll end up in a harbor--unless you happen to be Dick Cheney. That's just my opinion, worth not all that much. Thanks for the post though.


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