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My friend Robert is conservative. I am not.

One of our discussions centered around taxation. He tried to prove a point by asking a question about income. He got his question answered, and a bit more when I turned it around to demonstrate the difference between income and wealth.

A Question About Income; A Response About Wealth

My Friend Robert

Robert and I work for the same company. We don't see each other often, but I truly enjoy it when our paths do cross. We both enjoy discussing politics and economics. We see things quite differently, and spend most of the time trying to convince each other that we are correct in our thinking. It doesn't work very well. What I like best about Robert is that we both get to talk, we both get to listen, and we part ways agreeing to disagree rather than thinking the other person is some sort of ogre for not agreeing.

One of our discussions and disagreements was about taxation. Robert thinks the wealthy pay as much in taxes as they should pay. I disagreed. I think the wealthy should pay more in taxes. Robert disagreed.

Robert posed a question to me about income. The answer I gave had him thinking. I don't think it changed his mind, but I could tell he was thinking about it.

I posed a scenario about wealth. We were interrupted before he could reply. The person who joined us didn't have the same appreciation for amicable debate as we enjoy, so, after about a minute or two, I excused myself as politely as I could, and bid them both farewell.

Robert’s Question About Income

Robert’s hypothetical question involved a person investing $20,000 in the stock market. "If that investment grew to $30,000, how much tax would be due?"

"Zero," was my answer.

He then explained to me that there would be no taxes due on the $20,000 that was invested, but a gains tax would be due on the $10,000.

I told him the question was asked incorrectly. For his answer to be true, the question should have been "if a person invests $20,000 in the stock market, and sells the investment for $30,000, how much tax is due." The tax for the gain on investment becomes due when the gain is realized. A gain or loss is realized upon sale.

He wasn’t certain that I was correct, but I was certain. I told him that he also didn’t include dividends in the question. Those, I told him, are taxed as income, but the increase in the value of the stocks would, indeed, be taxed as gains if, and only if, the stocks were sold so the gain were realized.

He was thinking about it, so I expounded.

How It Works With Wealth

I offered him an example that was a bit more complex, but not far-fetched.

If a person has a stock portfolio worth $400 million and it grows in value by 10% delivering a return of dividends of 6%, the income is $24 million. The value is now $440 million. There is a stock within the portfolio of which the person has a million shares that he paid $10 per share, but is now worth only $5 per share. He sells all one million shares for $5 million. The porfolio value is now $435 million, and his income is now $19 million, even though he now has $29 million in cash.

He has to pay taxes on the $24 million in dividends less the $5 million realized loss on the sale of the stock. So, even though he would pay a lower rate had he realized a gain, he benefits additionally by reducing his income which would be taxed at a higher rate.

He tried to interrupt me, but I was on a roll.

He has a "hunch" about a stock that is selling for $1 per share, but has the potential to boom because the guy he got the hunch from knows something. He buys 5 million shares of the stock, and, sure enough, General Motors wants to continue putting steering columns in their vehicles! The stock booms to $20 per share because he and his friends who purchased a controlling interest in the company told GM they wouldn’t sell them steering columns unless they got a large share of the bailout money.

His income is still $19 million because he made $24 million in dividends, and realized a loss of $5 million on the stock he sold. He now has only the $24 million in cash from the dividends, the sale of the stock, and the purchase of the other stock. His portfolio is now worth $535 million since the new stock value is $100 million.

This is the point at which the other person interrupted us. For you, though, I can draw the conclusion.

There was realized income of $24 million. There was a realized loss of $5 million. There will be taxes due on the $19 million, and those taxes due will be more than what most of us will make in our lives. However, there was also an unrealized gain in wealth of $135 million on which there will be no taxes due. Also, since it was passive income, there would be no Social Security or Medicare tax due on the income.

My point to him would have been, and to you is, that’s the difference between income and wealth. And that’s the difference between wage earners and the wealthy.

However, Robert is not easy to persuade. He probably still feels they are taxed too heavily.

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