(Bloomberg News) The year 2013 may snap a 12-year winning streak for wealthy Americans on taxes due on income, capital gains, dividends and giving money to their heirs.
The U.S. deficit, forecast by the nonpartisan Congressional Budget Office to reach a two-year cumulative total of $2.5 trillion in 2012, has prompted calls by some in President Barack Obama's administration, Congress and a bipartisan commission to limit tax breaks for home mortgage interest, charitable contributions, municipal bonds and retirement contributions.
"The deficit is an issue," said Bill Fleming, managing director at New York-based accounting and advisory firm PricewaterhouseCoopers LLP. Many wealthy taxpayers "have already decided in their minds that something is going to happen and they're going to pay higher taxes."
Rates on income, capital gains and dividends will rise in 2013 because tax cuts extended last year are scheduled to expire at the end of 2012, unless Congress acts. In 2013, top earners also face additional levies on unearned income and wages to help pay for health-care reform.
Obama has proposed letting income-tax rates increase to as much as 39.6 percent from 35 percent for couples making more than $250,000 annually or individuals earning at least $200,000. Capital gains and dividends would be taxed at a top rate of 20 percent, up from 15 percent. The highest earners face an additional 3.8 percent tax on unearned income such as realized capital gains, plus a 0.9 percentage point rise in the Medicare payroll tax on wages starting in 2013 as part of the health-care bill passed in March 2010.
Poll on Taxes
A majority of Americans favor increasing taxes on the wealthy, at least two polls this year found. A Quinnipiac University poll released May 4 said 69 percent of voters back raising taxes on households earning $250,000 or more, while a March Bloomberg National Poll reported the figure at 59 percent of respondents.
For a married couple with two children in Connecticut, which has the third-highest state and local tax burden in the U.S., the increase in rates Obama has proposed, along with levies from health-care reform, mean their tax bill may jump to $142,160 in 2013 from $126,410 this year, or 12.5 percent, according to an analysis Fleming ran for Bloomberg News.
That's based on $485,000 in earnings, $2,000 in interest on investments, $3,000 in dividend income and $10,000 in long-term capital gains, and the following deductions: $20,000 in mortgage interest and charitable donations of $10,000, said Fleming, who works for PwC's private company services tax group in Boston and Hartford, Connecticut.
Tax Scenario
The scenario includes interest payments of 5 percent on a $400,000 mortgage, Fleming said. If the mortgage deduction is eliminated, the family's tax bill would increase 19 percent to $150,080 in 2013 from 2011, according to the analysis.
States such as Connecticut and Illinois have raised taxes this year, according to the Washington-based Tax Foundation. Hawaii and Oregon have the highest state income tax with rates as high as 11 percent.
The federal government is under pressure to come up with ways to reduce deficits and the national debt, or it may lose its AAA credit rating, Standard & Poor's said on April 18. The budget situation is causing some lawmakers to call for cuts in spending and others to advocate for tax increases, said Mark Robyn, economist for the Tax Foundation, a nonpartisan research group in Washington. "Politically, you're probably going to see some combination of the two," Robyn said.
Biggest Breaks
The biggest federal tax breaks for individuals include those for mortgage interest, charitable contributions, state and local taxes, incentives for retirement savings and the exclusion for employer-provided health care, said Clint Stretch, managing principal of tax policy at Deloitte Tax LLP in Washington. Each of them would be "politically pretty toxic" to eliminate or reduce, Stretch said.
Phasing out the mortgage interest deduction would increase federal revenue by $214.6 billion over the next 10 years, according to estimates from the Joint Committee on Taxation in a March report by the CBO. Curtailing deductions for charitable giving would raise an estimated $219 billion over the next decade, the CBO study said.
Other revenue-raising options include taxing interest earned on municipal bonds and reducing the cap on all contributions to 401(k) retirement plans to $14,850 annually and to $4,500 for individual retirement accounts, according to the CBO report. That compares with a maximum of as much as $22,000 this year for individual contributions to 401(k)s and $6,000 for IRAs.
Deficit Report
The bipartisan deficit commission suggested overhauling tax rates in a separate report in December that would set a top tax rate of 28 percent, down from the current 35 percent. That plan also would tax capital gains and dividends as ordinary income and convert the mortgage interest and charitable contribution deductions into limited credits.
"Individuals have a real problem," Stretch said of the varying proposals. "It's sort of like going through a tunnel when you're driving: You turn up your lights and you keep up your speed. You got to pay attention to it. You got to see where risks and opportunities are, but the worst thing you could probably do is to be paralyzed, to stop planning."
Less Spending Money
A reduction in tax breaks or increase in rates means taxpayers will have less money to spend in the economy and it may discourage investing, said Bloomberg Government tax analyst Matthew Caminiti in an interview.
Investments are the main asset of the wealthy while for the middle class it's their home, said Edward Wolff, a professor of economics at New York University. The top 10 percent of wealth holders in 2007, the latest data available, owned 81 percent of stocks, Wolff said. "The preferential tax treatment of capital gains and dividends in the tax code definitely mainly benefits the rich," he said.
Congress also may take a "close look" at the tax benefits of municipal debt as soon as 2012, said George Friedlander, chief municipal strategist for Citigroup Inc. in New York. "If they actually get around to doing a bona fide cut in future spending then state and local finance will be on the table next year," Friedlander said.
Muni bonds generally are exempt from federal taxes as well as state and local levies for residents in most states where they're issued. For high earners and retirees seeking tax-free income any changes to the tax benefits of municipal bonds would be "impactful," said Christopher Johnson of the wealth advisory group for Barclays Wealth in New York.
Retirement Benefits
Proposals to cap tax incentives that encourage Americans to save for retirement are "short-sighted," Robert Reynolds, chief executive officer of Boston-based Putnam Investments, said in a statement yesterday. Reynolds urged the Massachusetts Congressional delegation to oppose any such policy shift.
"Those most severely hurt if savings incentives were cut would be low and moderate income workers who need help in saving for their futures," he said.
Limiting retirement benefits also may change strategies used by the wealthy, said Johnson, whose clients typically have at least $10 million in investable assets. Many high-net-worth individuals use accounts such as Roth IRAs to pass wealth down to their children, Johnson said. If such opportunities are removed, there will be a "rebalancing" toward whatever areas remain opportunistic, he said. "It's going to be difficult to anticipate in advance what those will be."
Make a Gift
The uncertainty means wealthy families should consider taking advantage of favorable gift taxes that are scheduled to expire at the end of 2012, said Linda Beerman, chief fiduciary officer of Atlantic Trust Private Wealth Management.
Under the tax-cut compromise passed in December, individuals generally may gift up to $5 million during their lifetime without paying tax. That threshold will revert to $1 million in 2013 unless Congress acts.
"Move that $5 million now to your children or grandchildren to lock that in if you're afraid that will go away," Beerman said. That way the appreciation on those assets is out of an estate, Beerman said.
The debate around taxes and deficit reduction will continue into the 2012 election because lawmakers can't agree, said Deloitte's Stretch. "People who want clarity will have to wait."
Stabilizing Debt
"Over the last decade this country has failed to live within our budget," Senator Max Baucus, a Montana Democrat and chairman of the Senate Finance Committee, said in a May 3 budget-hearing statement. "It is time to craft deficit reduction legislation that will stabilize debt held by the public by 2014 or 2015."
During a May 16 speech, House Budget Committee chairman Representative Paul Ryan, a Wisconsin Republican, said that cutting spending and reforming government programs will reduce the U.S. debt. "The government cannot close its enormous fiscal gap simply by taxing the rich," Ryan said in his prepared remarks before the Economic Club of Chicago.
It's unpatriotic for the rich to oppose higher taxes because the distribution of wealth in America has become so skewed, said Jerry Rockefeller, 81, of Brandon, Florida.
"The country is calling on the wealthy to kick in and help," as when everyone "stepped up" during World War II, said Rockefeller, who's retired and used to run his own consulting business in New York for publishing firms. "The middle class can't do it. They've been kicked dry."