New Millionaires' Tax Bracket: Coming Soon?

Last Updated Sep 30, 2010 1:28 PM EDT

Momentum is growing for a millionaires' tax. While President Obama frequently accuses the Republicans of trying to give "millionaires and billionaires" a tax break, his own proposal would boost taxes for people a few rungs down on the economic ladder, starting with couples making more than $250,000. Now, lawmakers seem to be moving closer to matching the rules with the rhetoric, and only allowing the Bush tax cuts to expire for people with seven-figure incomes.

Sen. Jim Webb, a conservative Democrat who's not afraid to speak his mind, tells the New York Times that $250,000 is too low. And Talking Points Memo reports that some House Democrats want to create a new tax bracket for people earning $1 million and up.

For starters, there's a political advantage -- while Republicans can argue that the $250,000 set includes some small businesses, it's tougher to defend the average millionaire's right to a $100,000 tax break. More importantly, there's a fairness issue. As the Times story points out, "Mr. Obama's plan would charge the same rate on the 382,551st dollar of earnings as it would on the 30 millionth."

The $250,000 cutoff is flawed in other ways too. At that level, cost of living discrepancies around the country have a big impact. In Cleveland, where the average home sells for $87,000, a couple making a quarter million dollars can certainly be considered wealthy. In Manhattan, where the average apartment costs more than $900,000, that same quarter million after taxes wouldn't be enough for the 25 percent down payment that most co-op boards require.

Historically there's ample precedent for adding tax brackets; as far back as 1913 the top bracket was $500,000, which would be more than $10 million in today's dollars. And given that income disparity is at an all-time high, it stands to reason that tax policy should adjust accordingly. The lame-duck Congress will have to wrestle with this issue after the election, but in the meantime, what can you do about it?

For starters, recognize that however this tax skirmish shakes out, current U.S. government revenues are utterly inadequate to pay for future promises, namely Social Security and Medicare. Even if politicians could dramatically slash discretionary spending, we wouldn't come close to closing the deficit. This reality suggests taxes are going up for more than millionaires. Second, because politicians hate to raise taxes, there's a decent probability they will allow inflation to reduce the real cost of those future obligations. Here's how to prepare:

Get tax efficient. In your taxable investment accounts, consider owning tax-exempt municipal bonds. Given the shaky financial condition of many state and local governments, own them through a diversified mutual fund, so that a default won't wipe you out. Also take tax-efficiency into account in your stock portfolio -- one of the best ways to reduce your capital gains exposure is to own index funds.

Prepare for inflation. In the short term, deflation is more cause for concern than inflation. But over the long term, it's a different story. Warren Buffett has noted that politicians are more likely to allow inflation than make tough choices about taxing and spending. To protect your savings, MoneyWatch blogger Larry Swedroe recommends TIPS, which are government bonds that increase in value to keep pace with inflation, as well as foreign stocks, while John Keefe notes that commodities and gold offer a good hedge against a weakening dollar.

More on MoneyWatch:
What's Next for Taxes
What's Your Tax Bracket?
How to Invest for Deflation
How to Guard Against Inflation Through TIPS
Is Your 401K Prepared for Inflation?

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