U.S. Income Tax: A Brief History
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 part 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 we take a look at the history of U.S. income tax in the United States, deferring isn’t always the right strategy.
When we talk about the U.S. income tax we must examine “tax deferring,” we are talking about a strategy where you defer paying taxes on certain assets until a future date. A date where you would conceivably move from a higher tax bracket to a lower tax bracket. But as we take a look at the history of taxes, it is clear that the tax rate does not always move in a downward direction. Tax rates and tax brackets change over time. They sometimes go up, and sometimes they go 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. You will 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.
There are many sources of tax for the government. It includes payroll taxes such as Medicare, FICA, Social Security, and self-employment tax. And there is also income tax and corporate income tax. Historically, payroll taxes have consistently increased as a tax source. In contrast, income tax amounts have fluctuated, and corporate tax has gone down.
History of U.S. Income Tax
Taxes first showed up in the US in 1861, when Abraham Lincoln ordered any income over $800 to be taxed at 3%. The intent was to collect money to help pay the debt from the American Civil War. Conceivably, once the war debt was repaid, taxation would stop. 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 saw 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 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.
It’s important to understand the history of the U.S. income tax. Taxes are one of the foremost factors putting pressure on our wealth. Tax codes and rates are always changing.
- count on tax rates staying the same or going down
- count on the threshold in any tax bracket staying the same
- depend on those itemized deductions we all love so much
- rely on getting a break for medical expenses, state and local tax credit, real estate taxes, interest, or charitable donations
The government has the power to lower these amounts or phase them out completely. This is why deferral should not be a go-to strategy when it comes to wealth planning. Consider it carefully after examining all aspects and goals of your wealth plan.