Higher Taxes for the Mass Affluent

Last Updated May 13, 2010 2:47 PM EDT

If you're even moderately affluent, there's a good chance Uncle Sam has been putting the squeeze on you with recent tax changes aimed at nicking "The Rich." That vise is likely to tighten further. President Obama is pushing a budget that would hike income tax rates and capital gains rates as well as limiting itemized deductions for upper-income people. "When I give $100, I'd get the same amount of [charitable] deduction as when some — a bus driver who's making $50,000 a year, or $40,000 a year — gives that same $100," Obama recently said. Here are five new — and pending — tax hits and how to avoid them.

The Home Buyer Hit

The new $8,000 tax credit for first-time homebuyers looks generous — until you see who can’t qualify for it. The credit, for home purchases between April 8, 2008, and December 1, 2009, begins phasing out for singles whose modified adjusted gross income (MAGI) is more than $75,000 and married couples with incomes over $150,000. It’s unavailable altogether once a single person’s income exceeds $95,000 and a couple’s income tops $170,000. And this MAGI is no gift: it’s your adjusted gross income plus various amounts excluded from income, such as student loan interest.

Strategy:

Help your kids, nieces, or nephews buy into today’s housing market and claim the credit. Odds are good that their income falls under the limits.
Caution:

If you give more than $13,000 to any one individual — or loan money without charging interest — you could run afoul of the IRS, says Mark Luscombe, principal tax analyst with CCH Inc., a tax publishing firm in Riverwoods, Ill. So before making a substantial gift, consult your tax adviser.

The College Catch

Nowhere is the wavy line of affluence as pronounced as with the newer education tax breaks, which phase out at different income levels.

The new American Opportunity Tax Credit, for 2009 and 2010, offers a $2,500-a-year tax break to pay for college. But the credit phases out for singles whose modified adjusted gross income exceeds $80,000 and married couples earning more than $160,000. And there’s no opportunity at all for singles with incomes greater than $90,000 or couples with incomes exceeding $180,000. (Still, those limits are higher than with the Hope credit that this credit temporarily replaces.)

The Lifetime Learning Tax Credit, which provides up to $2,000 in annual tax breaks for those paying at least $10,000 in college bills, has phaseouts, too (though they’ve just risen a bit). This credit starts phasing out when a single’s modified adjusted gross income exceeds $50,000 and a couple’s income exceeds $100,000; it vanishes at $60,000 for singles and $120,000 for couples.

Strategy:

Contribute all you can to retirement plans, which will lower your MAGI (and don’t count against you when figuring these tax breaks).
Caution:

Be careful when you pay the tuition bills. Many college tax breaks “sunset” in two years. If you’re under the income limits to get the American Opportunity credit, for example, you could score the break with a college bill paid in December of 2010, but if you waited until January 2011 to pay, you’d lose the $2,500.

The Coming Storm

President Obama’s proposed budget would raise taxes on the affluent in several ways, says Clint Stretch, managing principal of tax policy at Deloitte Tax, LLP in Washington, D.C.:

  • ITEMIZED DEDUCTIONS (such as mortgage interest and charitable contributions) would phase out for singles with adjusted gross income over $200,000 and couples earning more than $250,000, and the value of the deductions would be capped at the 28 percent tax rate.
    Strategy:

    The proposal to limit itemized deductions has fueled a firestorm of controversy, with particularly insistent objections from charities relying on well-heeled donors. You might be able to help prevent this proposal from becoming law by writing or emailing your legislations, noting your opposition.
    Caution:

    If this proposal goes through, it will not only cost you in lost deductions, it’s likely to make filing your return insanely complex. That’s because you’d need to apply two tests to your deductions: one to reduce the amount you can deduct, another to reduce the tax savings you’d receive. The good news is that tax-preparation fees are deductible. The bad news: They’ll be less deductible for you.
  • CAPITAL GAINS RATES: The long-term capital-gains rate, now a maximum of 15 percent, would increase to 20 percent for singles with taxable income over $171,550 and married couples earning $208,850 or more.
    Strategy:

    Consider tax-free retirement accounts and tax-free investments, such as municipal bonds and municipal bond funds (munis). If you own taxable stocks and funds, trade with an eye to offsetting gains with losses. That is, if you plan to take a profit in one part of your portfolio, see whether you can match that gain by realizing a paper loss in another part of the account.
    Caution:

    Putting money in tax-favored retirement accounts will save you taxes today, but dollars withdrawn in the future will be taxed at ordinary income rates, which could be higher than your current rate. If you think you’ll be affluent in retirement, consider funding a Roth IRA, which allows tax-free withdrawals.
  • MARGINAL INCOME TAX RATES: The top tax rates would soar for singles with taxable income over $171,550 and married couples earning $208,850, going from 33 percent to as much as 39.6 percent.
    Strategy:

    Look for ways to avoid reaching those new higher brackets. If your income exceeds the thresholds because you’re part of a two-income family — or if your high-income lifestyle is creating huge stress, maybe it’s time to work less (if you can afford it). Calculate how much that extra income costs in taxes and expenses for daycare, housekeeping, gardening, and accounting. You might be able to save the money by doing these tasks on your own.
    Caution:

    Make sure you have plenty of savings if you scale back to one income. In today’s economy, it might take time for that second worker to reenter the workforce.
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    Kathy Kristof is an award-winning financial journalist and the author of Investing 101.