TAX NEWS - June 2010

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U.S. Tax: Major tax hikes in 2011 and 2013 - Watch Your Assets

With the federal deficit soaring, Washington is preparing a grab bag of taxes. What you should do right now to shield cash from Uncle Sam.
As if the financial crisis and the weak economy weren't enough, a big setback of another kind is looming for the nation's top earners: major tax hikes in 2011 and 2013, on everything from wages and capital gains to royalties and rental income. In all, taxpayers—mostly those in the highest brackets—could be forking over an extra $1 trillion or more over the next decade. It isn't a done deal; Congress has yet to set the barrage of increases in motion, and Republicans have vowed to oppose tax increases on any segment of the population.

But lawmakers look ready to act this year, and the smart money says that hikes will be approved for the top two income brackets, or couples earning more than $250,000 a year—on top of tax increases already signed into law under the health-care overhaul bill.

It isn't hard to see what's happening: The national debt has become gargantuan, and is still growing—thanks to bailouts, wars and ambitious social programs. At $13 trillion, it's the equivalent of 89% of U.S. gross domestic product and is likely to exceed it in 2012. The last time the U.S. got that deeply in hock was during World War II—but back then, it was easier to dig out. Spending cuts came easily after the war, and the debt problem dissolved.

Things are different now. With almost 60% of national spending devoted to Medicare, Social Security and other mandatory programs, shrinking the deficit with budget cuts would require the elimination of virtually all entitlement outlays, according to Clint Stretch, director of legislative affairs at Deloitte & Touche.

"The political question is coming down to: What are the alternatives to solve this problem?" he says. "You can't solve the deficit problem with spending cuts alone. It's inevitable that we're going to have to raise taxes to do so."

For savvy taxpayers, that's a clarion call for action. There are any number of steps you can start taking in order to blunt the impact of the likely increases, from speeding the sale of a house, to selling and buying back some of your stocks (to reduce the cost basis and capital-gains bite), to overfunding your life-insurance policy and tapping it for cash.

FIRST, IT PAYS TO TAKE a good look at exactly what is happening in Washington.

With congressional elections approaching in November, many policy makers would be more comfortable sidestepping the politically charged issue of taxes. But if Congress takes no action, the tax cuts enacted by President Bush in 2001 and 2003 will expire at year's end, and tax rates could go up significantly for almost all taxpayers. The current 10% bracket will disappear. While income cutoffs haven't been specified, couples earning up to about $70,000 would probably pay a 15% rate. The 25%, 28%, 33% and 35% brackets would most likely pop up to 28%, 31%, 36% and 39.6%.

Letting the Bush cuts lapse also would push the long-term capital-gains rate from 15% to 20%. Dividends, now taxed at 15%, would become subject to rates on ordinary income.

But the chance that Congress will allow all of that to happen is close to nil. "The hit to the economy would be too huge," says Roberton Williams, a tax-policy analyst at the Urban-Brookings Tax Policy Center in Washington. "People would hold off buying cars and houses." With some economists watching for a double-dip recession, the country can't afford to slow growth, Williams and others say.

Instead, Congress probably will settle on what President Obama outlined in his 2011 budget proposal: Extend the tax cuts for most taxpayers, but let them expire for couples earning more than $250,000 and singles making more than $200,000. This means that the top two tax rates would rise to 36% and 39.6%. Folks in those brackets also would see the capital-gains rate go up to 20%, and dividends, some savvy observers think, would be taxed at either 36% or 39.6%. That's higher than the Obama proposal's 20% rate for dividends.

While most people making less than the income thresholds would see their tax rates remain the same under the Obama proposal, their effective tax rates would actually be lower than they are now, thanks largely to the Making-Work-Pay

That item — a $400-per-worker credit that phases out for couples earning $190,000 and singles earning $95,000 — was put in place in February 2009, and originally was intended for only 2009 and 2010. But the Obama proposal extends it to 2011.

Consider a married couple with two children. With a household income of $150,000 and itemized deductions amounting to 18% of income, their tax bill under the Obama proposal would be 4.2% lower than it would if this year's tax law is extended to next year, according to Mark Robyn, staff economist at the Tax Foundation in Washington. The lower you go down the income scale, the greater the savings. For example, if the same married couple earned $85,000, they would save 14% on their tax bill under Obama's plan, according to Robyn's analysis.

Conversely, the more the income is over $250,000, the greater the additional tax burden.

For example, for a couple with a $500,000 household income who have no children, and have itemized deductions equal to 18% of income, the tax bill under Obama's proposal would be 5.2% higher than it would be under current tax law. If the couple earned $1 million, it would be 21% higher.

Obama has also proposed to extend the so-called AMT patch, which adjusts the alternative minimum tax's exemptions to keep the number of AMT payers constant. With the top two rates bumped up to 36% and 39.6%, a number of people in those brackets who have been snared by the AMT in the past may soon escape that tax. But those taxpayers shouldn't assume they will be paying less as a result, Robyn says. That $500,000 couple, who would have paid about $124,000 under an extension of the Bush tax cuts, would now pay about $130,000.

Further tax increases are scheduled under the health-care bill to help pay for provisions expected to cost $938 billion over the next 10 years. It calls for a new Medicare tax of 3.8% on investment income, including capital gains, interest, dividends, royalties, rent and annuity income, and an additional 0.9% Medicare payroll tax on top of the 1.45% already deducted from workers' wages.

The 3.8% tax goes into effect when adjusted gross income, or AGI-that is, wages and investment income combined—exceeds $250,000 for couples and $200,000 for singles. The tax will be applied to the lesser of net investment income or any adjusted gross income in excess of AGI thresholds.

The 0.9% increase in payroll tax will be applied to wages of more than $250,000 for couples and $200,000 for singles, and would be in addition to the 1.45% Medicare tax currently deducted from wages.

For the couple with $400,000 in wages, the 0.9% would apply to $150,000, and their annual payroll deduction would rise from $5,800 to $7,150.

All told, 85% of the tax burden under the bill will be shouldered by the top 1% of taxpayers, who will see an average $28,500 increase in their annual federal tax bill, according to the Tax Policy Center.

Tax advisors are already busily studying ideas for how to reduce their clients' tax bills under the increases likely for next year and in 2013. Here are some of the best moves you can make.

If you've been considering selling any highly appreciated investments—whether a stock or a second home—consider doing so in advance of the capital-gains increases. "You wouldn't want to make a decision to sell based only on taxes, but if you've been planning on selling, doing it a little earlier could save you on taxes," says Jennifer Ellison, a principal at Bingham Osborn and Scarborough, a financial-advisory firm in San Francisco.

You may even want to sell investments and buy them back, assuming the gains are sizable enough that they are unlikely to be totally wiped in a market rout. When you sell the stock later, you will have fewer gains that are subject to the higher rates, says Mark Nash, a partner at PricewaterhouseCoopers.

Also, carefully plan when to use any losses you are carrying forward. You may get more mileage out of them if you wait and use them once capital-gains rates have gone up, he says.

If tax rates on dividends go up for top earners, as expected, consider holding dividend-paying stocks in tax-deferred accounts, Ellison says. "With rates at 15%, investors have been able to really not care if they hold stocks that pay high dividends in taxable or tax-deferred accounts," she says. "That will have to change."

Strategies to bulk up on tax-free income will be increasingly attractive with every bump-up in rates. While municipal bonds are typically favored by retirees for their tax-free income, Nash suggests investors of all ages compare munis' tax-equivalent yields to those of corporate bonds.

Loans against whole-life insurance policies are another way to pocket tax-free cash, says Tom Karsten, principal of Karsten Strube, a tax-advisory firm in Fort Worth, Texas. He suggests overfunding a policy (you pay the insurer more per month than the policy charges) to build up a large cash value, then taking out policy loans to meet cash needs. The loans aren't required to be paid back to the policy.

The caveat: If you cash out of the policy during your lifetime, the loans would have be taxed as ordinary income, Karsten says.

To mitigate an increase in income tax and the rising Medicare payroll tax, carefully consider the timing of events that add to your income, such as bonus payments, the vesting of restricted stock options, and the exercising of stock options, says Nash of Pricewaterhouse. It may make sense to accelerate these to this year, and to the months prior to the 2013 tax increases, he says.

An effective strategy for some would be conversion from a traditional IRA to a Roth IRA. Withdrawals from regular individual-retirement accounts are taxed as ordinary income, but they are tax-free from Roth IRAs once you are 59½ years old. The Roth's tax-free status is already attractive; with income taxes likely to rise to 39.6%, it is looking sweeter than ever.

A conversion to a Roth may shield some retired folks from major tax increases. For those whose required minimum distributions from a regular IRA—which go into effect after the IRA owner turns age 70½— would push them over the $250,000 or $200,000 thresholds for higher federal taxes, a Roth conversion may be a wise move, says Steve Kunkel, director of taxes at CBIZ MHM, a tax-advisory firm in Los Angeles. With a Roth, withdrawals aren't required and you can keep the account growing, intact, for your lifetime.

Limits on who can convert have been lifted for 2010, but not everyone will jump at the chance. Income taxes are owed on any amount you convert, so you must be confident that the Roth's tax-free gains will outweigh the upfront tax bill over time.

WEALTHY TAXPAYERS SHOULD be on the lookout for changes in the estate tax next year. The tax expired at the end of last year—it has been zero for 2010—but is scheduled to return next year at pre-2001 levels. That would mean that estates of as much as $1 million would be exempt, and the top estate-tax rate will be 55%. That compares with last year's $3.5 million exemption and top rate of 45%.

Michael J. Graetz, professor of tax law at Columbia University, says to expect either a resumption of last year's exemption and rates, or—if certain Republican proposals prevail—a $5 million exemption and a 35% rate.

Many analysts predicted that Congress would have already acted to restore the estate tax this year to increase revenues.

But at this late stage, the likely outcome is that Congress eventually will offer a choice to estates that owed no taxes in 2010: Either pay the estate tax retroactively under the new rules, or lose the step-up in cost basis that beneficiaries typically get when inheriting appreciated assets, asserts Graetz.

EVEN THESE TAX HIKES won't get the government out of its budget mess. "It isn't going to be enough to fiddle with income-tax rates," Williams says. To whittle the deficit down to 2% of gross domestic product—a normal level since 1900—it would be necessary to raise income-tax rates by 50%, according to a study by the Tax Policy Center. If rate increases were focused on the top three tax brackets, they would have to go up 117%.

What's more likely: introduction of a consumption tax, known as a value-added tax, or VAT—essentially a federal sales tax. Some 140 nations have a VAT. "The VAT is in our future, because at some point, it will be the only thing standing between us and insolvency," says Len Burman, former deputy assistant secretary of the U.S. Treasury department, and now a professor at Syracuse University's Center for Policy Research. A 5% VAT rate would raise $293 billion in 2012, and $3.3 trillion by 2019, according to the Tax Policy Center.

What will it take to bring about a VAT? A big wake-up call—perhaps a failed Treasury auction, or a downgrading of U.S. debt. Then Washington will rush to impose a big new tax.

Desperate times have always called for desperate measures. But for taxpayers who make the right moves now, there is no reason to despair.

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