NOBODY EVER SAID TAXES WERE FAIR

Tax reform discussions rarely touch on the many inequities and basic “unfairness” in the US Tax Code.

Here are three examples of “unfairness” that still remain in the US Tax Code.  They were not addressed in the GOP Tax Act but should be in future tax reform legislation.  I have posted separately about these in the past – but here they are together in one post.

As an aside, many of the inequities in the pre-TCJA code involved or were made worse by the dreaded Alternative Minimum Tax.  But the Act makes the AMT no longer an issue in most cases.

(1) Taxation of Social Security and Railroad Retirement Benefits

As I am often telling clients each filing season, because of the way Social Security and Railroad Retirement benefits are taxed it is very possible that for every additional $1.00 of income you pay tax on $1.85.  So, income that falls within the new 22% bracket can be effectively taxed at 40.7% - almost 4% above the current top tax rate.

Social Security and Railroad Retirement benefits are taxed based on the extent of your other taxable income and tax-exempt interest.  You could pay tax on up to 50% or 85% of the gross benefits.  So, an additional $100 of dividends, or interest or capital gains or W-2 income can cause an additional $85 of your benefits to be taxed, so the $100 increase causes your AGI to increase by $185.

Because taxable Social Security and Railroad Retirement benefits increase AGI, increases could also reduce tax deductions and credits that are affected by AGI – increasing the effective tax rate of the increase.

As a side bit of unfairness, because increased SS or RR benefits increase AGI, the increase can potentially result in some qualified dividends and long-term capital gains, which have caused the increase in taxable SS or RR, being effectively taxed at more than the “advertised” 0% or 15% rate.

The Solution – tax Social Security benefits the same as any other pension with “after-tax” employee contributions, using the “Simplified Method”.  The taxable portion of the benefit would be calculated by SSA and reported as such on the SSA-1099 and RRB-1099, similar to the way partially taxable pension income is reported on the Form 1099-R.  Or perhaps treat Social Security and Railroad Retirement like a “ROTH” investment, as employee contributions are not deductible, and do not tax benefits at all.  These benefits were not taxed at all until 1984.

(2) Taxation of Gambling Winnings

Gross gambling winnings, reported on Form W-2G, are generally reported in full as income on Line 21 of Page 1 of the Form 1040, increasing AGI, while gambling losses, to the extent of reported winnings, are deductible as an Itemized Deduction.  So, it is possible for a taxpayer to pay additional federal income tax on net gambling losses.

John Q Taxpayer buys $10 in state lottery tickets each and every week.  One week he hits for $500.  He has no other gambling activity for the year.  He must report the $500 win in full as taxable income and, if he receives Social Security, potentially increase taxable SS benefits by $425.  So, his AGI could increase by $945.  If he is unable to itemize due to the increased Standard Deduction he does not get a tax benefit for his losses.  So, if he is in the 22% bracket he would pay from $110 up to $204 in federal income tax on $20 in gambling losses.

If the $500 win does cause his taxable SS benefits to increase by $425 but he can itemize and deduct $500 in losses on Schedule A he is still paying $94 in income tax in the 22% bracket.  And if he can deduct medical expenses the net taxable income is increased by $69 because the additional income reduces the allowable medical deduction.

Thankfully Tax Court decisions and IRS regulation revisions have corrected this problem for some casino gambling – but not for all gambling situations.

I have no problem with limiting the deduction for gambling losses to gambling winnings – just with where and how the losses are deducted.

The Solution – obviously, report only net gambling winnings, after deducting losses, but not less than 0, as income on Page 1 of Form 1040, as is done on the NJ-1040.

(3) The Marriage Tax Penalty

The Marriage Penalty manifests itself in many ways in the US Tax Code.  The result is that two married individuals, each with their own separate sources of income (i.e. W-2 or pension income), pay more income tax by filing as a married couple then by filing two separate returns as unmarried Single taxpayers merely living together.

Filing as Married Filing Separately does not always remove or reduce the Marriage Penalty.  Some deductions are “per return” and not “per spouse”.  And many tax benefits allowed on a Single return are reduced or just plain not allowed on a Married Filing Separate return – such as the Credit for Child and Dependent Care Expenses, the Earned Income Credit, the Credit for the Elderly or Disabled, or the HOPE or Lifetime Learning Education Credit.  A couple filing separately can pay more tax than if they filed a joint return.

The maximum amount of combined income or sales and property taxes that can be deducted on Schedule A is $10,000 – but only $5,000 if Married Filing Separate.  Two unmarried individuals living together can each deduct $10,000, for a total of $20,000.  If the 22% bracket applies, the marriage tax penalty for this item alone is up to $2,200. 

A married couple can deduct up to $3,000 in net capital losses per year – but only $1,500 if Married Filing Separate.  Two unmarried individuals each with capital losses for the year, or carried forward, in excess of $3,000 can each deduct $3,000, for a total of $6,000.  You do the math.

There is also a Marriage Tax Benefit – for households with only one earning spouse.  Because of the doubling of many tax benefits on a joint return the couple pays less tax than the earning spouse would pay on a Single return (if one spouse has no taxable income and was not married there is no need to file a return and the Standard Deduction is not claimed if filing as single – but twice the Standard Deduction is allowed on a joint return reporting the same total income; granted the earning taxpayer could claim the non-earning taxpayer as a dependent on the one Single return and possibly get additional tax benefits – but not as much as Married Filing Joint).

In my opinion there should be neither a tax penalty or tax benefit for marriage.

The solution – allow a two-income married couple to file separately as if they were each filing a Single return, with all the benefits and the same tax table and rate schedule as a Single filer.  I deal with this in more detail in “The Tax Code Must Be Destroyed”.  This at least does away with the marriage penalty.  I am not quite sure how to remove the marriage benefit, or if it actually should be removed.

There are many other inequities in the current US Tax Code.  I will discuss more in future posts.

Do you have any examples to share.

TTFN