Middle Class Likely to Keep Most Tax Shelters : House Committee Seems Determined to Preserve Nearly All Special Preferences and Write-Offs

To most middle-class families, the tax shelters available to the wealthy--with their glittering promises of big tax write-offs for exotic ventures in oil drilling, box-car leasing or cattle raising--must seem impossibly out of reach.

But, in fact, some of the tax code’s best deals are readily available to millions of Americans on the relatively comfortable side of the middle-class spectrum. And despite President Reagan’s proposal to overhaul the current tax code, tax writers on the House Ways and Means Committee appear determined to perpetuate nearly all of the special preferences that many middle-class taxpayers have come to know and love.

Panic Not Justified

“There’s a lot more panic out there about the tax bill than is justified,” said Larry Axelrod, a top tax accountant in the Washington office of Touche Ross, the accounting firm. “Congress is going to largely preserve most of the middle-class tax breaks.”

Not only will the prized home mortgage deduction remain sacrosanct--even Reagan did not dare tamper with it--but also apparently safe are state and local tax deductions, interest payments of at least $20,000, most employer-provided pension and fringe benefits, earnings on whole-life insurance, and a host of other favored tax breaks.

“Most of our constituents aren’t willing to give up any of their tax breaks simply for the promise of lower rates,” said Rep. Robert T. Matsui (D-Sacramento), a member of the Ways and Means Committee. “The tax code is an expression of political reality and that’s why so many of these tax preferences for favored groups are going to remain practically untouched.”

Only a few popular tax breaks, such as retirement programs like 401(k) plans and income-shifting to children, are likely to be scaled back--and even then only the most affluent taxpayers should feel the pinch.

The Reagan Administration, as part of its tax revision package, recommended eliminating state and local tax deductions, income- averaging, 401(k) provisions that allow companies to provide their employees with tax-deferred savings until retirement, and so-called Clifford trusts, which enable parents to transfer income-earning assets to their children to avoid higher taxes.

The White House also proposed a tough $5,000 cap on second-home and other consumer interest payments, taxing interest earned on life insurance contracts and taxing the first $25 a month ($10 for singles) in employer-paid health insurance premiums.

Except for the end of income averaging and cutbacks on income transfers to children, none of those recommendations are likely to be followed by congressional tax writers.

Legislative Obstacles

All provisions approved in the closed-door sessions of the Ways and Means Committee must overcome many more legislative obstacles before they can become law. The committee itself is not expected to complete action until close to Thanksgiving Day and even though a House vote is likely this year, Senate action will not begin until 1986.

And Reagan expressed misgivings last week about the changes in his tax plan already approved by the Democratic-controlled panel, suggesting that he may withdraw support if the bill does not meet his standards.

Nonetheless, some of the changes accepted by the committee could be included in any tax bill that emerges from Congress.

Probably the most widely felt step would affect taxpayers who contribute to an Individual Retirement Account and to the increasingly popular 401(k) plans, currently used by an estimated 12 million to 15 million employees.

401(k) Contributions

Under the proposal, annual contributions to a 401(k) plan by an individual would be limited to $7,000 and IRA payments would have to be reduced by the same amount applied to a 401(k). Thus, an individual who contributed $2,000 or more to a 401(k) would be unable to take advantage of an IRA, whose maximum annual contribution is $2,000. Since nearly all employers match part of their employees’ 401(k) contributions to make them more attractive, the proposal is likely to limit IRAs to workers who do not have access to 401(k) plans.

The $7,000 cap on 401(k) payments would affect only the top 3% of all participants, according to committee staff members, but a further proposal to impose a 15% penalty on any premature withdrawals of money from a 401(k) plan or an IRA account could alter financial planning for nearly all participants.

Under current law, many employers permit penalty-free early withdrawals from 401(k)s to buy a first home, meet catastrophic medical expenses or send a child to college. Early withdrawals from an IRA currently pay just a 10% penalty and financial planners point out that money taken from an IRA after just five years provides a greater after-tax return for most taxpayers even after paying the penalty.

Reducing Tax Burden

To help save for college expenses, many families also reduce their tax burden by giving money or securities to their children, so that the income from such assets would be taxed at the child’s lower tax rate. Congressional tax writers generally have followed Reagan’s suggestion that any unearned income of a child under 14 in excess of $2,000 a year should be taxed at the parent’s highest tax bracket, effectively eliminating the advantage of giving large sums to children.

The proposal also would put an end to the future use of Clifford trusts, under which income-earning assets are temporarily put in trust for a child for a minimum of 10 years, because all such earnings would be taxed at the parents’ top tax rate.

But families could avoid the limits by receiving donations from other relatives, since everyone but a child’s parents would be permitted to put money in a special account that would continue to be taxed at lower rates.

Tax Preferences

The use of such tax breaks, along with other preferences, has mushroomed in recent years. And although most of the benefits of tax preferences continue to flow to wealthy individuals and business, some analysts argue that tax revision has failed to generate widespread public enthusiasm largely because more and more Americans now believe they have a stake in keeping the complex tax code as it is.

“Tax preferences are getting out of hand, and the American public knows it,” said Donald H. Straszheim, chief economist for Merrill Lynch & Co. in New York. “Yet as tax preferences are becoming more important, the beneficiaries are more numerous. Hence, there are more defenders of the status quo with respect to tax law.”