MONEY retirement planning

Why You Should Think Twice Before Choosing a Roth IRA or Roth 401(k)

two gold eggs
GP Kidd—Getty Images

Sure, Roth plans let your savings grow tax free. But if you're nearing retirement, a traditional pre-tax account may be the best choice.

Even assuming a Republican Congress doesn’t go along with the tax hikes President Obama has proposed, the mere fact that talk of higher taxes is in the air could very well make Roth IRAs and Roth 401(k)s even more popular than they already are. But is that necessarily a good thing?

For years, the conventional wisdom held that you were better off saving for retirement in a Roth IRA or Roth 401(k) rather than the traditional versions, provided you expect to face a higher tax rate in retirement than when you make the contribution. This makes sense because you would be paying tax at a lower rate upfront and avoiding a higher tax bill down the road when you withdraw your contribution and earnings tax-free.

Lately, however, it seems more people are challenging this view, and suggesting that you may still be better off in a Roth even if you end up in a lower tax rate when you withdraw the money in retirement. For example, T. Rowe Price released research last year showing not only that a Roth IRA or Roth 401(k) could generate more income in retirement than a traditional account for people who drop to a lower tax rate; it also showed that even older savers—people in their 50s and early 60s—who fall into a lower marginal tax rate in retirement could come out ahead with a Roth.

But while this can be true—and there may also be other good reasons to fund a Roth—it’s hardly a given. So if you think you may end up dropping into a lower marginal tax rate in retirement, you should be aware of a few important caveats before doing a Roth, especially if you’re nearing retirement age.

The Drag of Taxes

For example, according to T. Rowe Price’s analysis a 55-year-old in the 33% tax bracket today who retires at age 65 would receive 9% more retirement income by making a contribution to a Roth 401(k) or Roth IRA instead of a traditional account, even if he slipped into the 28% tax bracket upon retiring.

How is that possible? Let’s assume this 55-year-old has the choice of contributing $24,000 (the 2015 maximum for someone 50 or older) to a Roth 401(k) or a traditional 401(k). If he does the Roth and the $24,000 grows in a diversified mix of stocks and bonds at 7% a year, he would have $47,212 tax-free after 10 years.

If, on the other hand, he puts the $24,000 into a traditional 401(k) that returns 7% annually, he also would have $47,212 after 10 years. But assuming he drops to a 28% tax rate at retirement, he would owe $13,219 in taxes at withdrawal, leaving him with $33,993 after tax.

But the $24,000 he puts into the traditional 401(k) also gets him a tax deduction, which at a 33% pre-retirement tax rate effectively frees up $7,920 he can invest in a separate taxable account. If that account also earns 7% a year, after 10 years the 55-year-old would end up with $2,361 more in the traditional 401(k) plus the taxable account than he would with the Roth.

But wait. He must also pay taxes on gains in the taxable side account. Assuming he pays tax each year at a 33% rate before retiring, that would effectively reduce his after-tax return in the taxable account from 7% to roughly 4.7%, giving him a total after-tax balance in the traditional 401(k) plus side account of $694 less than the Roth.

In short, it’s the drag of taxes on the money invested in the taxable side account that allows the Roth to come out ahead. Or, to put it another way, the Roth wins out in this scenario because it effectively shelters more of your money from taxes than a traditional 401(k) plus the separate taxable account.

Check Your Time Horizon

But anyone, young or old, hoping to capitalize on this advantage by choosing a Roth 401(k) or Roth IRA over a traditional account needs to be aware of two things.

First, as this example shows, the advantage the Roth gets from this tax-drag effect is relatively small. It can take many years for the Roth to build a meaningful edge in cases where someone slips into a lower marginal tax rate in retirement. In the example above, the Roth account is ahead by only 1.5% after 10 years. And if that 55-year-old were to drop from a 33% tax rate to a 25% rate in retirement, the Roth account would actually still be behind by about 1.5% after 10 years.

So for the 55-year-old to get that extra 9% of retirement income, the T. Rowe Price analysis assumes that the contribution made at age 55 not only stays invested until retirement at 65, but is withdrawn gradually over the course of 30 years (and earns a 6% annual return during that time). Which means at least some of the funds must remain invested in the Roth as long as 40 years.

The second caveat is that to take full advantage of the Roth’s tax-shelter benefits, you must contribute the maximum allowed or something close to it—specifically, enough so that you would be unable to match the aftertax Roth contribution by putting the pretax equivalent into a traditional account.

For example, had the 55-year-old in the scenario above been investing, say, $10,000 in the Roth instead of the maximum $24,000, he could have simply invested the entire pretax equivalent of his Roth contribution ($14,925 in the 33% tax bracket) in the traditional account instead of splitting his money between the traditional account and the separate taxable account. Doing so would eliminate the tax drag of the taxable account as well as the Roth’s 9% income advantage. Indeed the Roth account would provide 7% less after-tax income over 30 years than the traditional 401(k).

The upshot: Unless you’re willing to make the maximum contribution to a Roth IRA or 401(k) or an amount approaching that limit, dropping into a lower tax bracket in retirement could do away with much, if not all, of the expected advantage of going with a Roth. (The Roth might still come out ahead over a very long time since you can avoid required minimum distributions).

Diversify, Tax-wise

There are plenty of compelling reasons to choose a Roth IRA or Roth 401(k), even if you’re unsure what tax rate you’ll face in retirement. For example, I’ve long been an advocate of “tax diversification.” By having money in both Roth and traditional accounts you can diversify your tax exposure, so not every cent of your retirement savings is taxed at whatever tax rate some future Congress sets on ordinary income.

And since (under current law, at least) there are no required distributions from a Roth IRA starting after age 70 ½, money in a Roth IRA can compound tax-free the rest of your life, after which you can pass it on as a tax-free legacy to your heirs. Roth IRA distributions also won’t trigger taxes on your Social Security benefits, as can sometimes happen with withdrawals from a regular IRA or 401(k).

Bottom line: Before doing a Roth IRA or Roth 401(k), take the time run a few scenarios on a calculator like those in RDR’s Retirement Toolbox using different pre- and post-retirement tax rates. Such an exercise is even more important if you think you might face a lower marginal tax rate in retirement, and absolutely crucial if you’re nearing retirement age.

But above all, don’t assume that just because Roth withdrawals can be tax-free that Roths are automatically the better deal.

[Note: This version has been revised to make it clear that the scenario with the hypothetical 55-year-old compares a Roth 401(k) vs. a traditional 401(k), not a traditional IRA.]

Walter Updegrave is the editor of If you have a question on retirement or investing that you would like Walter to answer online, send it to him at

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The 4 Tax Forms You Should Be Getting Soon

Jeffrey Coolidge—Getty Images

To get ready for tax season, here are the important envelopes to look out for.

You may have already started receiving tax forms in the mail. You know what I’m talking about — the envelopes are marked in big block letters, “IMPORTANT TAX DOCUMENTS ENCLOSED.”

If you haven’t received any yet, you should soon, and for some people, you’ll be getting many pieces of mail like that over the next few weeks. Getting your taxes done quickly and accurately requires you to organize your necessary documents and know when something’s missing, and looking at last year’s tax return is a good way to help you do that.

“Unless things change dramatically, if it was on last year’s tax returns it will be on this year’s,” said Howard Rosen, a CPA with Conner Ash Certified Public Accountants & Business Consultants in St. Louis. Rosen said that approach helps most people, but even if you’ve opened a new bank account or switched jobs, knowing how things changed from last year will help you put together a checklist of documents to expect.

When you’re getting everything together you need to file your taxes, you’ll want to watch your mailbox (physical and electronic) for these items.

1. Your W-2

You can expect Form W-2, Wage and Tax Statement, from your employer by the end of January, Rosen said. He recommends reaching out to your employer if you haven’t received it by the of the month.

Paul Herman, who owns Herman & Co. CPAs in White Plains, N.Y., said to give employers a little more time.

“It’s not unusual for them to be received in early or mid-February,” Herman said. “Some people send them out later.”

If you’re trying to file your taxes as soon as possible and you’re waiting on your W-2, ask about it in February, but know there may not be much you can do to speed up the process.

2. Any 1099s

There are many kinds of 1099s, but some of the most common ones consumers get are 1099-MISC, for miscellaneous income; 1099-INT, for interest income; 1099-S, if you sold real estate in the past year; and 1099-R, if you received distributions from a retirement plan. There are dozens more, including the dreaded 1099-C, which means you have to pay taxes on canceled debt. Basically, you’ll get a 1099 if money considered untaxed income has been reported to the Internal Revenue Service.

1099s usually come out by the end of February, Rosen said.

3. 1098s

These are more welcome forms than 1099s, because 1098s usually means you get a tax credit. Common forms are 1098 for mortgage interest, 1098-E for student loan interest and 1098-T for tuition paid during the tax year. Banks and loan servicers tend to make these forms available quickly, particularly because many people manage paying these accounts online. If you haven’t received your form by the end of January, contact your loan servicer.

4. Charitable Receipts

You should receive letters from charitable organizations to which you donated in 2014 documenting how much you gave.

Those are just a few, typical examples of the many forms you might receive. As you get these things, either in an envelope or to your email inbox, gather them in a common place. Perhaps that’s a folder on your computer and a physical folder in your filing cabinet, including a checklist of what you’re waiting on before you can file your taxes. Mark your calendar for when you anticipate receiving tax documents so you can inquire about them if they haven’t arrived as expected.

“I do think people struggle with it if they have more than just a couple of forms because it’s tough to keep track of all these things,” Herman said. He gives his clients tax organizers (folders, really) to help them manage the paperwork, and he repeatedly emphasized the importance of looking at the previous year’s return to help plan for this year’s.

Rosen said the same.

“I think most people worry than they need to, to be honest with you. They’re thinking, ‘Do I have everything? Do I have everything?’” Rosen said, mimicking a stressed consumer. “For most folks, just using last year as your guideline is a great way to start.”

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7 Ways to Keep Your Tax Refund Safe From Thieves

black glove holding US Treasury check
Sarina Finkelstein (photo illustration)—Getty Images (glove); Dan Sullivan/Alamy (check)

To make sure your hard-earned money doesn't fall into the wrong hands, protect your identity this tax season.

The tax season officially opened on January 20, meaning it’s time for that dreaded (but inescapable) annual job: filing your tax return.

One group isn’t putting off that task. Identity thieves may have already filed a return in your name—and made off with your refund check.

In 2013, the IRS mistakenly paid out more than $5 billion worth of refunds to identity thieves, according to the Government Accountability Office. The agency estimates it stopped another $24.4 billion in attempted fraud, and the problem may be even bigger than that. Considering that most refunds are for a few hundred to a thousand dollars, that’s a staggeringly large number of false returns.

And despite the IRS’s efforts to fight fraud, tax-and-wage-related identity theft still made up a third of ID-theft complaints to the Federal Trade Commission last year.

One reason this kind of fraud can happen is that the IRS processes refunds as quickly as possible, typically within 21 days, and matches up the verifying information later. That way you don’t have to wait six to nine months for a refund.

When you file early, the IRS might not even have everything it needs to verify your information. Your employer must send you your W-2 income statement by the end of January, but it doesn’t have to file that information with the government until March. The IRS often doesn’t even begin checking returns against W-2s until July, meaning it can take a year or longer for the IRS to spot the theft, the GAO report found.

You can reduce you odds of becoming a victim by making these seven smart moves.

1. Be the First to File

“You’ve got to beat the crooks to the punch,” says CPA Troy Lewis, chairman of the American Institute of CPAs’ tax executive committee. “Since January 20, it’s been open season, and they know that the first filer wins.”

Once the IRS receives a return with your Social Security number, the agency will reject any duplicate filings. So even though your return is the legitimate one, if it is second you will have to go through a verification process with the IRS.

If you owe money and want to delay paying as long as possible, file early anyway. You have until the April 15 filing deadline to mail you check regardless of when you submitted your return.

2. Eliminate the Paper Trial

Elect to have all tax documents delivered electronically, including your W-2 and 1099s. If e-delivery isn’t for you, opt for a P.O. Box or locked mailbox. “Toward the end of January is prime time for this,” says Lewis. “Thieves know that’s when W-2s are sent out.” Be sure to destroy extra copies or old tax paperwork as well. All thieves need is your date of birth and Social Security number to file in your name.

3. Put A PIN On It

The IRS is piloting an initiative, available to taxpayers in the tax fraud hotbeds of Florida, Georgia, and D.C., for a single-use, identity protection personal identification number.

To get the six-digit number, you need to register and verify your identity online. This PIN must be on all tax forms for your return to be processed, giving you an extra layer of security. Anyone who has had their identity stolen and reported it to the IRS will automatically receive a PIN annually.

The downsides: It’s another piece of information to remember and guard, and once you’ve opted into the service you can’t opt out.

You can sign up for a PIN on the IRS website.

4. Secure Your Network

This step is easy: Never file electronically over public wi-fi or a network that’s not password protected. Keep your antivirus software up to date and use a firewall.

5. Hang Up

Be wary of email or phone calls claiming to be from the IRS. An unexpected email from the IRS, notifying you about an outstanding refund or a pending investigation, say, is always a scam. The IRS will never initiate contact via email to request sensitive information.

If you do receive an email that appears to be from the IRS or the Electronic Federal Tax Payment System, forward the message to Don’t click any links within the email, even if the URL appears to be connected to the IRS website.

You should be equally suspicious of out-of-the-blue phone calls purporting to be from the IRS. Scammers typically say you’re entitled to a huge refund, or they may threaten you with arrest to get you to reveal personal information.

More sophisticated scammers may know the last four digits of your Social Security number and use that to win your trust, warns the IRS. Other scammers imitate the IRS toll-free number on your caller ID.

The best thing to do if you get a call: hang up. If you think the IRS may have a legitimate reason for contacting you, call them back (800-829-1040).

6. Pick a Preparer Carefully

Three in five taxpayers will get help preparing their taxes this year, the IRS reports, but not all help is equal. Some shady preparers set up shop to snag your personal information or make off with your refund. And no matter who prepares your return, you’re responsible for what is on it.

First, check that the pro has a preparer tax identification number. All paid tax preparers must have one. That’s just a start. “Some people may try to pass their tax preparer identification number off as a license, but it’s just an ID from the IRS. It’s not a sign of authenticity or knowledge,” says Valrie Chambers, a CPA and Stetson University accounting professor.

Ask what professional organizations the pro belongs to. Check with the Better Business Bureau to see if complaints have been lodged against him or her. Make sure licenses are up to date and whether any disciplinary actions have been taken—this IRS guide lists which agencies supervise different kinds of pros.

“You want someone with a license, a reputation, a permanent shop,” says Chambers. “You’re giving this person all your information: your Social Security number, your bank routing number.”

7. Have Less to Lose

If you’re expecting a big refund this year, you have a lot of money at stake. By adjusting your tax withholding so that you get a small refund or even owe a small sum, any fraud-related delay won’t cause you as much financial hardship. “You don’t want to be dependent on this money,” says Lewis.


TurboTax Offers $25 Rebate to Angry Customers

Paul Sakuma—AP

The company apologizes after alienating customers with a price increase on its tax-prep software. But is it enough?

In response to accusations of a “sneaky” price hike, TurboTax is offering rebates to customers who feel they were misled by the company’s recent pricing changes to its desktop tax preparation software.

The consumer outrage stemmed from a change to the TurboTax Deluxe edition, which now requires users to upgrade to the more expensive TurboTax Premier or TurboTax Home & Business to prepare certain forms, including Schedules C and D, that had been available in previous versions of the software. The response was swift and furious, with customers posting more than 1,500 one-star reviews on Amazon, and competitor H&R Block offering tax preparation software for free to consumers who felt duped.

On Friday, in an open letter to customers, Intuit TurboTax general manager Sasan Goodarzi acknowledged that the company “messed up” by not doing enough to communicate the pricing change to customers:

“I deeply regret the anger and distress we have caused those of you affected by this change. Our customers are the heartbeat of every TurboTax employee. Our hope is that we can regain your trust and demonstrate that our commitment to you has never been stronger.”

After filing their 2014 returns, customers who used the software to electronically file their 2013 taxes but had to upgrade to do so this year can go online to request a $25 rebate. But as Edgar Dworsky of points out, the rebate is less than the $30 charge to upgrade to Premier and the $40 charge to upgrade to Home & Business.

“Intuit should be offering free automatic upgrades this year and not requiring users to remember to send in for a rebate possibly months from now after they file their taxes,” Dworsky said of the apology.

For customers looking to avoid paying for tax preparation software, TaxAct offers free access to all federal tax forms, though fees do apply if you want to import information from previous years.

TIME Davos

The Coming Crisis Making the World’s Most Powerful People Blanch stock photos Money Dollar Bills
Elizabeth Renstrom for TIME

If global growth slows, as some predict it will, the globe is in for a lot of very big problems

The past 50 years have been the most exceptional period of growth in global history. The world economy expanded sixfold, average per capita income tripled, and hundreds of millions of people were lifted out of poverty. That’s the good news. But according to a new McKinsey report on the next 50 years of global growth revealed today at the World Economic Forum in Davos, it’s very unlikely that we’ll be able to equal that in the future. There are two main reasons for this gloomy conclusion: the global birthrate is falling dramatically and productivity is slowing. Economic growth is basically productivity plus demographics. The result? McKinsey is forecasting that if current trends continue, global growth will fall by 40% over the next half century, to around 2.1% year.

A while back, I wrote a column about what a 2% economy would mean for the U.S. Imagine if the whole world, including emerging markets that need much higher rates just to keep social unrest under control, were growing that slowly too. Not good.

McKinsey got a bunch of big brains—Larry Summers, Martin Sorrel, Martin Wolf, Laura Tyson, Michael Spence, and others—together to discuss all this and figure out some possible solutions. A few interesting points that came out: while we are in the middle of a digital revolution that seems to be disrupting nearly every aspect of business and the economy, not to mention our personal lives and culture, the revolution isn’t showing up in productivity numbers yet. Part of that could be that the way we measure productivity isn’t capturing everything that individuals are doing on their smartphones, tablets, and other gadgets. (It’s also worth noting that a lot of what is being created by individuals on those devices is free, which is an economic problem all its own, in the sense that only a few big companies like Facebook and Google and Twitter capture those creative gains, and they don’t create enough jobs to sustain what’s being lost in the economy.) There’s also the possibility that this “revolution,” simply isn’t as transformative, at least in terms of broadly shared economic growth, as those of the past—the Industrial Revolution or even the 1970s computer revolution. (For more on this, check out research by Northwestern University academic Robert Gordon, who is all over this topic.)

There are things we can do to boost productivity, like getting the private sector more involved in areas like education (for more, see The School That Will Get You a Job), and by allowing the gains from the internet of things (meaning the connection of all digital devices to each other) to filter through over the next few years. It’s not yet clear that will create more jobs though. Indeed, it may create jobless productivity which is a whole new challenge to cope with, one that might require bigger wealth transfers from the small number of wealthy people who do have jobs to the larger number of people who don’t. (Paging Thomas Piketty!)

There are some other ideas on the demographic side. Women are still dramatically underrepresented in the workforce in many countries. (One WEF study estimates it will take 81 more years for global gender parity at the current rate of change—argh!) Putting more of them to work could help a lot with growth; indeed, Warren Buffet once suggested to be that the federal government should provide inexpensive, partly federally funded child care to allow other women to take jobs higher up the food chain, this boosting economic growth. A win win.

Of course, this requires governments to take the lead on what can be politically contentious policy decisions, not easy when most politicians spend much of their terms trying to get reelected. Unfortunately short-termism is rife in the private sector too. CEO tenures are now five years on average and CFOs only last 3. All of which tends to lead to decision-making that benefits corporate compensation more than real economic growth.

Depressing, I know. But I saw one ray of hope when I ran into an emerging market CEO outside the panel, one who runs a family business that does planning in 10- to 20-year cycles rather than quarterly, investing quite a lot in areas like training and education. McKinsey research shows these types of firms will make up the biggest chunk of new global multinationals. Perhaps they can take the long view and come up with some better ideas about how to ensure global growth for the future.

MONEY 529 plans

Why Obama Wants to Tax College Savings

U.S. President Barack Obama delivers his State of the Union address to a joint session of Congress on Capitol Hill in Washington, January 20, 2015.
Mandel Ngan—Reuters

In this week's State of the Union address, the president proposed ending a popular tax break on 529 plans. Here's what's behind that pitch.

In his State of the Union address Tuesday, President Obama promised to make college more affordable for low- and middle-income families. But one way he would pay for that would be to make college more expensive for millions of upper-income Americans.

The president proposed ending a key tax break on state 529 college savings plans. Today, the money you invest in a 529 plan isn’t deductible on your federal taxes (34 states and the District of Columbia give you a break on state taxes), but your savings grow tax-deferred, and you won’t owe any taxes on your earnings when you withdraw that money to pay for higher education expenses, including tuition, room and board, and books. Under Obama’s plan, those investment profits would be taxable, even if the money went toward college.

President Obama says he’d use the estimated $2 billion in additional tax revenues to raise the American Opportunity tax credit, which is a $2,500 write-off targeted at low- and middle-income families paying tuition bills. The administration points out that 529 plans disproportionately benefit higher-income households.

In essence, Obama is proposing making college more expensive for an estimated 2 million mostly upper-income families to ease the tuition burden for more than 8.5 million low- and middle-income families.

A Question of Fairness

This proposal—which is already facing Republican opposition in Congress—is based on concerns about the fairness of the 529 tax breaks that have been widely discussed among education-related think tanks and experts of all political leanings for years.

In all, federal taxpayers spend more on educational tax breaks than they do on popular financial aid programs such as Pell grants, noted a 2013 report by the Reimagining Aid Design and Delivery (RADD) Consortium for Higher Education Tax Reform. Not only are all the education tax breaks confusing and hard to collect, “students from families with the least financial need receive the most tax-based aid,” the report noted.

In theory, 529 plans aren’t just for the rich. Anybody can open one of these tax-protected colleges savings account for a child or for themselves. You can choose either a prepaid tuition plan, which lets you buy tuition credits ahead of time, or a college savings plan, which lets you set money aside for a future college student.

That tax break that the president wants to eliminate has been a key to 529 plans’ popularity. Since President George W. Bush signed the 529 tax exemption into law in 2001, families have opened nearly 12 million new 529 accounts and have socked away almost $250 billion for college.

And states have been marketing the savings programs. In 2012, the GAO found that 14 states offered matching grants to encourage low-income families to save. Some states even offered 529 brochures to new parents leaving the hospital.

Despite these efforts, very few low- or middle-income families have managed to save very much in 529s. In 2012, more than 97% of families had no special college savings account, according to a Government Accountability Office report. (The large number of accounts may be due to some families opening separate accounts for each child and parent.)

One reason for the low participation: Many still don’t know about 529s. Of parents who say they’re planning to send their kids to college, 49% don’t even know what a 529 plan is, Sallie Mae found in its annual “How America Pays For College” report.

Another factor: Low and middle-income families pay comparatively low taxes, so the tax break is not much of a lure to lock up money for one purpose. Families can take money out of 529s to spend on non-college expenses, but they’ll have to pay regular income taxes, plus an extra 10% penalty, on any earnings.

As a result, 529 investors tend to be wealthy. Families with 529s earned a median annual income of $142,400 and reported a median of $413,500 in financial assets, according to the GAO. About half of families with 529s (or similar Coverdell accounts) had an income above $150,000 in 2010.

And, in part because high earners typically owe higher taxes, the wealthy reaped large tax breaks from using 529s. In 2012, the GAO found that Americans who made less than $100,000 withdrew a median $7,491 from their 529s, saving just $561 on their taxes. But Americans who earned more than $150,000 withdrew a median $18,039, saving $3,132 in taxes.

In place of the tax break at withdrawal, Obama wants to expand the American Opportunity Tax Credit, which is currently phased out for families earning more than $180,000 a year.

The administration would like to expand the write-off to more students, such as those who attend college part-time. “It’s targeted in such a way that it will be most impactful to the students who need the assistance the most,” says Cecilia Muñoz, White House domestic policy director.

What Changes You’ll Really See

What does this all mean for you: Not much, at least for the near term.

If you’ve already got money in a 529, don’t worry. The president’s plan wouldn’t be retroactive. It would repeal the tax break on earnings only for future contributions.

And if you’re planning to start saving for college, there’s probably not much to worry about either. Republicans, who control both houses of Congress, have come out in opposition to the proposal. “You don’t produce a healthy economy and an educated workforce by raising taxes on college savings,” Brendan Buck, a spokesman for Rep. Paul Ryan, R-Wis., told the Wall Street Journal.

That means there probably won’t be extra money in the budget for much additional financial aid for low- and middle-income families. So you may as well start saving for tuition bills. Here’s how to find the best 529 plan for you.

Correction: An earlier version of this story misstated the proportion of new tax revenues that would come from families earning above $250,000 if Obama’s proposal was enacted. The reference has been removed.


MONEY The Economy

The 2015 State of the Union Address In Under 2 Minutes

President Barack Obama highlighted the recovering economy as well as proposals for free community college, increasing trade with Cuba, and building more infrastructure.

TIME Davos

What Obama and Davos Plutocrats Have in Common

A logo sits on a glass panel inside the venue of the World Economic Forum (WEF) in Davos, Switzerland on Jan. 19, 2015.
A logo sits on a glass panel inside the venue of the World Economic Forum (WEF) in Davos, Switzerland on Jan. 19, 2015. Chris Ratcliffe/Bloomberg—Getty Images

Global wealth has changed dramatically. It's time our tax code should, too

If President Obama’s State of the Union speech Tuesday night and the chatter at the World Economic Forum in Davos, which opened Wednesday, are any indication, inequality will be the hot economic topic for another year running.

The president’s proposals for changes to parts of the US tax code that mainly benefit the wealthy revives the conversation Warren Buffett started a few years back with his op-ed about why his secretary pays a higher tax rate than he does. (Answer: She works for wages, whereas the Oracle of Omaha earns money on money itself, in the form of capital gains, interest income, etc.) At the WEF in Davos, where world leaders meet every year to hash out the big geopolitical and economic issues of the day, one of the most talked about reports is Oxfam’s new brief looking at how the 85 richest people on the planet have the same amount of wealth as the poorest 50%, a huge jump from last year when it took a full 388 plutocrats to equal that wealth. Some 20% of the billionaires come from the world of finance and insurance, a group whose wealth increased by 11 % in the last twelve months. And $550 million of it was spent lobbying policy makers in places like Washington, something Oxfam believes has been a major barrier to tax and intellectual property reform that creates a fairer economic system.

Plenty of those plutocrats are here on the Magic Mountain, and some are undoubtedly checking in with their tax planners. I expect that we’ll hear lots more in Davos this week about how to restructure tax codes for the 21st century, mainly because the nature of wealth and how it gets created has changed so dramatically. Today, more than ever since the Gilded Age, money begets money; income earned from wages has been stagnating for years, or decades even, depending on which type of workers you tally. Meanwhile, changes in the tax code and corporate compensation over the last 30 years or so has concentrated more financial resources at the very top of the socio-economic food chain. Indeed, financial assets (stocks, bonds, and such) are the dominant form of wealth for the top 0.1 %, which actually creates a snowball effect of inequality.

As French economist Thomas Piketty explained so thoroughly in his now famous 693 page tome on wealth inequality, Capital in the 21st Century, the returns on financial assets greatly out-weigh those from income earned the old-fashioned way—by working for wages. Even when you consider the salaries of the modern economy’s super-managers—the CEOs, bankers, accountants, agents, consultants and lawyers that groups like Occupy Wall Street railed against—it’s important to remember that somewhere between 30% to 80 % of their incomes are awarded not in cash but in stock options and stock equity. This type of income is taxed at a much lower rate than what most of us pay on the money we receive in our regular checks. That means the composition of super-manager pay has the booster-rocket effect of lowering taxes (and thus governments’ ability to provide support for the poor and middle classes) while increasing inequality in the economy as a whole.

MORE How 7 ideas in the State of the Union would affect you

It’s a cycle that spins faster and faster as executives paid in stock make short-term business decisions that might undermine long-term growth in their companies even as they raise the value of their own options in the near. It’s no accident that corporate stock buybacks, which tend to bolster share prices but not underlying growth (you know, the kind that creates jobs for you and me), and corporate pay have gone up concurrently over the last four decades. There are any number of studies that illustrate the intersection between the markets, our tax system, and wealth gap; one of the most striking was done by economists James Galbraith and Travis Hale, who showed how during the late 1990s, changing income inequality tracked the go-go NASDAQ stock index to a remarkable degree.

As Piketty’s work shows, in the absence of some change-making event, like a war or a Great Depression that destroys financial asset value, the rich really do get richer–a lot richer–while the rest of us become relatively worse off. One of the few levers that governments have to combat this trend is the tax code. While Piketty argues for a global wealth tax, something that will likely never happen, President Obama’s stab at capital gains taxes and trust taxes is probably just the opening round in a tax debate that will go on throughout this year, and into the 2016 presidential race.

I say, bring it on—given that the nature of wealth has changed, it’s high time the tax system should too.


Now You Can Pick Up Your Tax Refund at Walmart

Walmart exterior
Cash for tax refunds is the latest financial service from the big box retailer. Saul Loeb—AFP/Getty Images

But should you take the retailer up on its new service?

This tax season, some shoppers could be walking out of Walmart with thousands in cash. On Tuesday, the company announced a new service that will let taxpayers “skip the check” and collect their tax refunds at Walmart stores across the country.

Here’s how it works: You have your taxes done at one of 25,000 outside tax preparers that offer Walmart’s “Direct2Cash” option and choose the service, which will cost you another $7 at most. Once you get a confirmation code, you go to Walmart and pick up your refund, in cash.

This is the latest in a growing list of financial services Walmart offers. You can also open a checking account and shop for health insurance at Walmart.

Walmart says its cash refund service is the first of its kind. The Internal Revenue Service lets you collect your refund a couple of ways. The simplest and fastest is to route your refund to your checking or savings account via direct deposit. If you don’t have a bank account or don’t want to use direct deposit, you can get your refund by check.

However, without a bank account, cashing a check can be expensive. Walmart reports that tax preparers charge clients a $20 fee to receive a refund by check. Then, Walmart says, you sometimes have to pay 1% to 2% of the check amount to a check cashing service to get your money. Last year, the average tax refund was $3,096, according to the IRS—which means you could pay more than $80 to get your refund.

Many Americans could face such a steep fee: About 9.6 million households had no bank account in 2013, according to a survey by the Federal Deposit Insurance Corporation.

But if customers pay only $7 at the time of filing, and Walmart doesn’t collect its own fee when customers pick up their checks, what’s in it for Walmart?

“It’s always a good thing to have customers in our stores who have jingles in their wallets and their pockets,” says Daniel Eckard, senior vice president for services for Walmart.

For customers, however, there’s a catch: Because you have to do your taxes at one of the 25,000 participating tax prep locations, you can’t take advantage of the IRS’s online tax-filing service, which gives you access to free online software if you earn less than $60,000. And if you make less than $53,000, you usually qualify for free in-person assistance from an IRS-certified volunteer (search for a site near you).

So while you will pay no more than $7 to get your refund in cash, you may have to pay someone for the actual tax prep. Eckard says the costs will vary “on a preparer by preparer basis.”

The average cost for tax preparation is $246, according to a survey from the National Society of Accountants. Simple returns can be cheaper: The average cost of filing a Form 1040 and state return without itemizing deductions is $143.

“It’s not just how much it costs you to cash the check. It’s the sum total cost of what it costs you to get your money,” says Brett Theodos, senior research associate at the Urban Institute. “The costs of tax prep are going to outstrip the costs of check cashing, but they still add up.”

Your cheapest option is to file your taxes for free and open a bank account where you can deposit your refund.

While banking fees have been on the rise, making it hard to maintain an account when you’re financially squeezed, MONEY has surveyed the 70 biggest banks in the country to uncover the ones with the most generous terms. Use our Bank Selector tool to find the best one for you. Or see if you’re eligible to open an account at a local credit union, which usually offers lower fees and higher savings yields. Here’s how to find the credit union for you.

If you can’t or don’t want to open a bank account, you might be able to get your refund on a prepaid debit card. New York, Georgia, Louisiana, Oklahoma, Connecticut, and South Carolina let you receive your tax refund on a state-issued debit card, Bankrate reports. Some paid tax preparers will also load your refund onto their own prepaid cards. But prepaid cards may carry fees that cut into your refund, and if your prepaid card is lost or stolen, you could be out the money.

“Some of these account cards that are attached to institutions can actually be not-great deals,” Theodos says.

And if you do need to cash a check? At least one big retailer is now vying for your business. “It’s interesting—Walmart has emerged as the lower-cost place to cash your check,” Theodos says. “They must be viewing this as a successful business model.”

Correction: This story was updated to correct Daniel Eckard’s quote. He said “jingles,” not “jiggles.” We regret the error.


Obama Calls for Raising Taxes on Investment Profits

stack of coins with the top one levitating above
When investments are inherited, how big a cut should government get? Phil Ashley—Getty Images

You pay less tax on capital gains than you do on regular income from a job. Why is that?

In Tuesday night’s State of the Union address, President Obama will be calling for a number of new tax credits for the middle class, along with a plan to make community college tuition free. And to help pay for all that, he’s proposing raising the taxes on some investors’ capital gains.

Most debate about taxes tends to focus on the income tax. But that’s not Uncle Sam’s only source of receipts. Another big item is capital gains—essentially, the profit you earn when you buy something and then sell it at a higher price. You may have to pay capital gains taxes if you trade stocks or bonds or when you sell real estate. The tax code provides lots of ways for middle-income taxpayers to avoid capital gains levies, such as Individual Retirement Accounts, 401(k)s, and an exclusion on profits when you sell a primary residence. So the new taxes Obama is talking about are aimed at the affluent.

The president is arguing for two changes to the capital gains tax:

1. Raise the top rate from 23.8% to 28%. The highest possible rate on investment profits today is far lower than the top rate on wage income, which is 42.4%. Obama’s plan would narrow the gap.

2. Make more capital gains subject to taxes. When you sell an asset, you don’t owe capital gains tax on the whole sale price, only on the amount above what you paid—that is, your profit. But there is an important exception. If you sell an asset you inherited, the gain isn’t based on what your benefactor originally paid. It’s based on the value the day you inherited it. This “step-up in basis,” to use the tax jargon, can be very valuable.

For instance, imagine inheriting a $2 million stock portfolio for which your uncle had originally paid $1 million. If you sold it a year later for $2.5 million, you would owe capital gains on the $500,000 in appreciation since it came into your hands, but not the $1 million in value it gained before your uncle passed it down to you.

Simply get rid of the step-up, and you’d be on the hook for taxes on $1.5 million in profits. But Obama’s proposal includes some provisions to protect middle-class heirs. The first $100,000 in profits is off the table. Other exemptions target homes and “small, family-owned and operated businesses.”

And even Obama, who is arguing that the wealthy are getting too a sweet deal, isn’t proposing taxing capital gains exactly the same as wage income. Which raises a question: Why not?

This has actually been the case for the most of the roughly 100 years that the country has levied an income tax. One exception: Top rates for both income and capital gains were briefly both set at 28% after Ronald Reagan’s 1986 tax overhaul. Reagan agreed to hike the capital gains rate from 20%, in exchange for the Democrats slashing the top income tax bracket from 50%.

Inflation is one reason for capital gains’ special tax status. Partly because of record-keeping difficulties, the tax code doesn’t let taxpayers factor in inflation when calculating profits. So lower tax rates are a kind of rough compromise for investors who otherwise might owe tax bills on nominal gains simply because today’s dollar doesn’t have the same value it did in, say, 1970 or 1980.

The other big argument has to do with economic growth. Many economists argue that lower capital-gains tax rates are justified because they encourage people to save, invest, or start businesses. Ultimately, they argue, giving capital gains a break will spur growth that ripples through the economy.

Does it work? The evidence is mixed. Both Clinton and Bush cut capital gains tax rates. Under Clinton the economy boomed, while under Bush it tanked. But given everything else that happened in between—from the Internet revolution to the financial crisis—it’s difficult to tell what effect, if any, these policy changes had.

Low capital gains taxes also raise questions of fairness. They are a big reason some the wealthiest Americans pay a surprisingly light tax bill, at least in terms of percentage of earnings. The U.S.’s 400 top earners, all making more than $99 million, paid average tax rates of just 18% in 2010, according to recently released data. That compares with 11.8% for all taxpayers, but that broader figure also includes the 40% of households that pay no income taxes.

In any case, don’t hold your breath for a radical change to capital gains taxes in the next two years. With Republicans in control of Congress, “it’s a non-starter,” says Roberton Williams, a fellow at the Tax Policy Center.

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