How to Beat the Biggest Tax Hike Ever Contrary to most reports, the new taxes from Clinton and Congress won't sock only the wealthy. Making key moves will minimize the damage.
(MONEY Magazine) – Taxpayers have been tense and testy for months. The mood emerged not long after President Clinton announced his economic plan in February. Then, as the "deficit reduction" bills worked their way through the House and Senate, taxpayers, like the thumbs-downer (left) at a recent Clinton speech in Cleveland, grew noticeably annoyed. Never mind that the Administration and Democratic leaders downplayed the giant tax package they were assembling as something that would nick only the affluent. Says Karen Mazzarella, a $30,000-a-year life and health insurance agent in Highland, Mich. who in May launched Speak Out America, a taxpayer protest group that plans a march on Washington this fall: "I'm one of those people who woke up one morning and found out I was rich -- in the government's eyes. No matter how you look at it, we're all going to get hit." How right she is. It's true that roughly 80% of the estimated $250 billion of slated tax increases will fall on those making more than $100,000 a year. But that leaves some $50 billion for the middle class to foot, mostly through taxes on seniors and on the energy we all use. In addition to their share of deficit reduction, middle-class families face increased costs to help fund the health reform changes that are likely to become law by 1996. Analysts interviewed by MONEY believe the $30 billion to $90 billion annual tab for reform will come out of new taxes on 1) doctor and hospital services; 2) your health benefits if they're generous; and 3) cigarettes and alcohol. Many employees will also face increases in health-care premiums and out-of-pocket costs -- taxes by another name. The prospect, then, is for the biggest tax hike in history. The new tax law and health reform will extract from Americans more than $400 billion, according to the Tax Foundation, a research group in Washington, D.C. The next largest increase, passed in 1982, raised just $254 billion (in 1992 dollars). By 1996, many taxpayers making $60,000 a year could see 4% of their annual income -- or $2,400 -- go to pay for the new tax plan plus health reform. All in all, 50% of your marginal income could be gobbled up by federal income taxes, payroll taxes, energy taxes, health reform and state and local taxes, even though you are only in the 28% federal bracket. Financial moves you make immediately or in the coming months can help minimize the impact for years. Your tax pro is your first line of defense, so be sure to consult him or her as soon as the law passes (see "Help From Your Tax Pro" on page 62). As MONEY went to press, a few details of the tax legislation remained to be worked out by Congress. And health reform's precise taxes won't be determined until next year at the earliest -- after fierce partisan battles. Yet the broad outlines of both are already in place: -- Energy taxes. A 4.36 cents- to 7.5 cents-a-gallon gasoline tax, plus probably a kind of sales tax equal to 3% to 5% of your home utility bills, starting as early as 1994. Added cost to a typical family: up to $114 yearly. -- Social Security taxes. Starting next year, as much as 85% of some seniors' Social Security benefits will be taxed, up from 50% today. -- Income taxes. The top income tax rate will rise from 31% to 36% for couples with taxable income -- after deductions -- of $140,000 ($115,000 for singles). Added tax for a couple making $200,000: $1,000 or so. A 10% surcharge on people making $250,000 or more will put them in the 39.6% bracket. Chances are, the entire rate hike will be phased in over two years and become fully effective on Jan. 1, 1994. This year's top rate would be 33.5%, 35.3% with the surtax. The alternative minimum tax (AMT), a special tax designed to ensure the wealthy pay their fair share, will rise from 24% to new rates of 26% and 28%, also phased in over two years. -- Health-care taxes. Once reform is under way, the value of employer-provided health benefits above a government-set limit will likely be taxed. Added cost for a middle-income family getting $1,000 of benefits above such a limit: $280 a year. -- Sin taxes. Those who smoke will face federal tax hikes of as high as $1 a pack, and alcohol taxes may rise by about 50 cents for a six-pack of beer, a bottle of Chardonnay or a fifth of Scotch. -- Taxes on the self-employed. The new income tax rates hit entrepreneurs inordinately, since they often have high incomes. What's more, starting in January, self-employed taxpayers making more than $135,000 will pay today's 2.9% Medicare payroll tax on all income. (That's double the 1.45% employees pay.) Currently, income over $135,000 isn't subject to the tax. This tax package will come down hardest on four groups of taxpayers: the middle class, people with taxable incomes above $115,000, well-off seniors and the self-employed. If you fit into any of those categories, follow the timely advice below gleaned from interviews with more than 35 tax pros, benefits consultants, financial planners and investment managers:
MIDDLE-INCOME TAXPAYERS Fund your retirement plans to the max while you can. Because Social Security will be increasingly taxed, it will contribute less to your retirement. Consequently, "You'll need to take advantage of every tax-deferred savings plan you can get into today," says Paul Yurachek, a financial planner with Dennis M. Gurtz & Associates in Washington, D.C. What's more, a little-known part of the new law could make it harder to take full advantage of a 401(k) company retirement plan after this year. The provision, designed to prevent high-income employees from getting overly generous pensions, reduces from $235,840 to $150,000 the maximum salary level permitted for calculating retirement-plan benefits beginning in 1994. The catch: The new formula may also harm many of those earning as little as $64,245 -- the point at which the law will make you face tougher restrictions as a "highly compensated" employee. You could find yourself barred from making the maximum contribution, currently $8,994, to your 401(k). The Wyatt Co., a benefits consulting firm in Washington, D.C., estimates that many employees accustomed to stashing 12% of their salaries may find their contributions limited to 10%. If you earn more than $64,245, check with your benefits department to see if your maximum 401(k) contributions are likely to be reduced and by how much. In the meantime, contribute the current maximum, even if you have to stretch to afford it. Make full use of a company flexible spending account. Currently, employees of 52% of large companies can pay up to $5,000 of their unreimbursed medical costs with pretax dollars, through flexible spending accounts (FSAs). But health-care experts believe that the FSA could be a casualty of health reform, probably starting in 1996. The reason: Congress is likely to decide that employees will shop more carefully for health care if their share of the expenses isn't shielded from taxes through FSAs. So plan to make maximum use of an FSA for the next two years. You generally must give your benefits department an irrevocable decision in November about whether you will use the FSA in the year ahead and how much of your pay you want to withhold. Get energy-efficient. The likely home and auto energy-use tax provides a strong incentive to conserve. Call your local utility and ask about discounts for energy efficiency. For instance, Southern California Edison offers rebates of $150 to customers who buy special heat pumps with efficiency ratings of 8.7 or higher.
HIGH-INCOME HOUSEHOLDS Shift income into this year and defer deductions into 1994. Since the income tax rates will likely be phased in over this year and next, look for ways to accelerate into 1993 such anticipated income as bonuses and freelance fees. Similarly, postpone to '94 elective deductions such as charitable contributions and unreimbursed business expenses. If you were thinking of exercising so-called nonqualified stock options in 1994 -- incurring taxable income equal to the discount on the stock price -- you might want to do so in 1993, before your tax rate goes up the second time. Embrace capital gains and eschew ordinary income. Capital gains on investments held for a year or more will still generally be taxed at a top rate of 28%, although Congress might raise that to 30.8% for people owing the high-income surtax. Those capital-gains rates will seem heavenly compared with the new top income tax rates of 36% and 39.6%. Although taxes should not be the primary reason for choosing an investment, you might consider taking advantage of the spread between income tax rates and capital-gains rates by investing in growth stocks, which tend to offer little or no dividends but pay off in capital gains when you sell. Three current favorites of Arnold Kaufman, editor of Standard & Poor's Outlook newsletter: Great Lakes Chemical (recently traded on the New York Stock Exchange at $68), which promises 10% to 20% annual earnings growth over the next two years, thanks partly to demand for its flame-retarding and water-treatment products; Microsoft (over the counter, $85), whose leadership in spreadsheet and word-processing software will bring 20% to 25% annual earnings growth over the next few years; and Superior Industries (NYSE, $54), a manufacturer of lightweight aluminum wheels for autos, whose earnings could rise 20% annually for two years. If you prefer growth-stock funds, stick with those whose annual portfolio turnover is less than 50%, minimizing the gains the funds distribute. John Rekenthaler, editor of the Morningstar mutual fund rating service, recommends no-loads Gabelli Growth (up 10.1% annually for the three years that ended June 30; 800-422-3554), T. Rowe Price New America Growth (up 15.6%; 800-541-8832) and William Blair Growth (up 12.6%; 800-742-7272). Growth funds are expected to underperform value funds over the next year or two, however. (For details, see page 128.) Take a fresh look at tax-exempt investments. The argument in favor of tax- free municipal bonds and bond funds gains strength as your tax bracket rises. If you will be boosted into the 36% or 39.6% brackets, intermediate- term municipal bond funds (ones holding issues maturing within 10 years) will easily provide better after-tax yields than you could get from taxable bond funds. Intermediate munis are also less volatile than longer-term bonds. Sheldon Jacobs, editor of the No-Load Fund Investor, recommends three intermediate-term muni funds that invest mostly in top-quality bonds: Dreyfus Intermediate Municipal ($2,500 minimum investment; current yield: 5.6%; 800-782-6620), Fidelity Limited Term Municipals ($2,500 minimum investment; 5.7% yield; 800-544-8888) and Scudder Medium Term Tax Free ($1,000 minimum investment; 5.8% yield; 800-225-2470).
SENIOR CITIZENS Consider increasing your investments in tax-free municipal bond funds too. If your benefits are taxed now -- and if your total income exceeds $32,000 (including half your Social Security benefits) for singles or $40,000 for couples -- your taxes may go up next year, perhaps considerably. According to the American Association of Retired Persons, most seniors over those thresholds will face added taxes of $360 to $1,200 a year. A 65-year-old couple with $50,000 in pension and investment income who also earn the current maximum Social Security benefit of roughly $27,000, however, could see a staggering $2,650 tax increase. Here's how a muni bond fund investment can help deflect the Social Security tax: Say you earn about $2,000 in interest annually from a taxable corporate or Treasury bond fund. If you're in the 28% tax bracket, you wind up with $1,440 after taxes. But the IRS counts the whole $2,000 against you in deciding how much of your Social Security benefits to tax. If you instead received that $1,440 from a tax-free bond fund, your income for Social Security purposes would drop by $560, saving you as much as $133 in tax a year. Think about shifting some earnings into this year. If you are likely to owe additional taxes on your Social Security income next year, try to accelerate into 1993 some income you would otherwise receive in '94. For instance, if you work part time and get paid by the project, finish up some jobs and take payment in 1993 instead of early next year. Don't forget: If you are under 70, you will lose some of your Social Security benefits if you earn more than $10,560 this year.
THE SELF-EMPLOYED Amend last year's federal income tax return to write off 25% of your 1992 health insurance premiums. The law permitting the self-employed to deduct 25% of their health insurance premiums expired June 30, 1992. But the upcoming tax legislation will reinstate the write-off as of July 1, 1992. So if you paid $325 a month for health insurance last year -- typical for family coverage -- and deducted only six months' worth of premiums, you will be able to deduct another $487 by sending the IRS an amended '92 return (call 800-829-3676 for a 1040X form). Fully fund a Keogh or SEP plan this year. You can contribute as much as 13.043% of your self-employment income to profit-sharing Keogh accounts and simplified employee pensions, which are tax-favored retirement plans for the self-employed that allow flexible contributions each year of as much as $30,000. A money-purchase Keogh, which locks you into specific annual contributions, lets you salt away up to 20% of your income, subject to the $30,000 cap. Starting in 1994, though, the maximum you will be allowed to contribute to profit-sharing Keoghs and SEPs will be $20,000 if you earn more than $150,000 a year. If you'll be hit and still want to save $30,000 each year, set up a money-purchase Keogh or put the $10,000 that you can no longer contribute into growth stocks and growth funds instead. Consider incorporating. It's not unusual for all the profits of an unincorporated business to be taxed at the top individual tax rate, since that money gets stacked on top of your salary, which alone could push you into the top bracket. Should you decide to incorporate, however, you could pay only 15%, the lowest corporate rate, on as much as $50,000 of business income that you don't take as salary or use to pay deductible expenses. Say, for example, you had $25,000 of such profits you planned to reinvest in your business. Without incorporating, you might be left with only $15,100 after taxes, compared with $21,250 if you are a corporation, notes Deborah Walker, a partner with accountants KPMG Peat Marwick. Like many of the strategies that will help minimize the new taxes, it's advisable to run this by a competent tax pro. As long as you are self-employed, the cost of the session will be tax deductible, a precious commodity these tax-tough days.
BOX: Where the new taxes will hit hardest
If you live in Stamford, Conn., you will be in the epicenter of pain when the new tax program becomes law. That's because your metropolitan area has the highest percentages of wealthy taxpayers and seniors. The listings below, compiled exclusively for MONEY, rank in descending order the metro areas hit hardest by the new taxes on the affluent and the elderly.
THE WEALTH TAX Stamford, Conn. Norwalk, Conn. Lake County, Ill. Naples, Fla. Danbury, Conn. Long Island, N.Y. San Francisco Newark Bergen/Passaic counties, N.J. West Palm Beach, Fla.
THE SENIORS TAX Stamford, Conn. Honolulu Norwalk, Conn. Washington, D.C. Naples, Fla. Long Island, N.Y. Anchorage San Jose Orange County, Calif. Bergen/Passaic counties, N.J.
Source: Donnelley Marketing & Information Services Note: The Newark metro area includes Essex, Morris, Sussex and Union counties.