There has been great debate over the years about whether our tax system is fair and who is getting the short end of the stick. Some contest that the tax code has always favored the rich, while others maintain that virtually all Americans pay way too much in taxes, and some even think Americans don't pay enough tax. Of course, the definition of what is right and fair in this sense is somewhat subjective. There are some who feel that the tax code as it is written now offers some incentives for those who don't work for a living at all.
The Estate Tax
Although the Unified Tax Credit is planned to revert to $1 million per person in 2013, the tax code has allowed wealthy taxpayers to transfer up to $10 million of their assets to heirs (other than spouses or charities) with no estate tax in recent years. While doing so may be easier said than done for low- and middle-income taxpayers, some tax experts and politicians feel that the wealthy have received a pass on inheritance taxes that is inappropriate. They contend that those with substantial estates should have to fork over some of that money to Uncle Sam when they die. If the inheritances left by the wealthy in 2009 had been subject to income taxes, the total bill would have come to approximately $90 billion that could be used to improve our education and infrastructure or reduce the deficit.
The tax code clearly seems to favor investors over workers when it comes to taxation. Although some types of investment income, such as short-term capital gains, are taxed at rates comparable to ordinary income, they are never subject to payroll taxes of any kind. Social Security, Medicare and FUTA are never withheld from any type of investment payout, regardless of its nature. Long-term capital gains have been taxed at an ever lower rate, and investors in the lowest tax bracket have had a 0% rate on their long-term gains for the past few years, although this rate will increase in 2013 if the fiscal cliff cannot be avoided. Of course, these tax breaks were designed to encourage people to save and invest money and stimulate the markets, but those with enough wealth to live off of their investment income without working have clearly benefited the most. Municipal bonds offer the greatest tax savings to wealthy investors, as their interest is tax-free at the federal, state and local levels (although this type of interest can become an AMT preference item if enough of it is paid during the year).
People who work for a living pay several types of taxes. Not only is their earned income taxed as ordinary income, it is also subject to other taxes like Social Security and Medicare withholding, which amounts to 7.65% of their pay up to the amount of the Social Security wage base if they are employees - and twice that amount if they are self-employed. Taxpayers with Schedule C income can generally expect to pay about half of their income away in a combination of income and payroll taxes. Furthermore, current tax rates can go as high as 35% for high-income earners, and that doesn't even include state or local taxes. Therefore, someone who earns $400,000 in a year can reasonably expect to pay at least a third of that to Uncle Sam, whereas someone who realized a long-term capital gain of that amount would only pay 15% in 2012. Someone who inherited that amount would pay no tax.
The Bottom Line
The argument about whether the tax code favors those who don't work is not going to be resolved any time soon. Taxpayers can only look at their own situations in order to find out what they can do to minimize their own taxes and act accordingly. For more information on the taxation of various types of income, visit the IRS website, or consult your tax or financial advisor.