A Brief History of U.S. Income Tax

Often times as a financial planner I hear people giving the advice to “defer, defer, defer.” Upon examining clients’ portfolios, I see it a lot where there is a large portion of it in tax-deferred assets. There is no doubt that some of the time, deferring can be a sound decision when it comes to wealth planning. But as you will see as we take a look at the history of income taxes in the United States, deferring isn’t always the right strategy.

When we talk about “tax deferring,” we are talking about the strategy where you would defer paying taxes on certain assets until a future date where you would conceivably move from a higher tax bracket to a lower tax bracket. But as we take a look back at the history of taxes in this country, it is clear that the tax rate does not always move in the downward direction. Tax rates and tax brackets have changed over time, sometimes going up, and sometimes going down. This is why deferral is a risk – if you defer tax and the rates go down, it’s a win and you pay less tax. But if you defer and find yourself with a higher tax rate in the future, you lose, and pay more than you would have had you not deferred.

The tax rate is divided into two categories – effective and marginal. The effective tax rate is the bracket in which your income falls. The marginal rate is tax paid on any amount of income that is above the largest tax bracket, i.e. tax rates go up to $450,000 income. Any amount you make more than that would be taxed at the marginal rate. Currently, any money taxed at the marginal rate is taxed at 39.6%, with an additional 3.8% Medicare taxes added. Any deductions you make occur in the marginal tax bracket. Sources of tax for the government include payroll taxes (Medicare, FICA, Social Security and self-employment tax), income tax, and corporate income tax. Historically, payroll taxes have consistently increased as a tax source, income tax amounts have fluctuated, and corporate tax has gone down.

Taxes first showed up in the US in 1861, when Abraham Lincoln ordered any income over $800 to be taxed at 3% as a means to collect money to help pay the debt from the American Civil War. Conceivably, once the war debt was repaid, taxes would cease. But we all know that did not happen. In 1916, the 16th Amendment was written, giving Congress the power to tax any and all income they see fit. The tax rate in that year was 7%. By 1919, the marginal tax rate was up to 78%, and in 1946, it went all the way to 94%, where it stayed for the next 25 or so years. In the Reagan era, the marginal rate was lowered to 28%, and it now rests at 39.6%. As you can see, the marginal rate has had its ups and downs. When it comes to deferral, timing is everything.

Taxes are one of the foremost factors putting pressure on our wealth. Tax codes and rates are always changing. The government has the ability to manipulate the following three areas of our tax code: tax rates, tax thresholds and itemized deductions. We can’t count on tax rates staying the same or going down, nor can we count on the threshold in any tax bracket staying the same. We can’t count on those itemized deductions we all love so much (i.e. medical expenses, state and local tax credit, real estate taxes, interest, charitable donations, etc.) to be there in the future as the government has the ability to bring the amount down or phase them out completely. This is why deferral should not be a go-to strategy when it comes to wealth planning. It should be considered carefully after examining all aspects and goals of your wealth plan.

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