Some Tips for Handling Changes in Tax Rates

Americans’ taxes are going up and there is not much they can do about it. But there are a few steps that taxpayers can take to soften the blow. Here are answers to some common questions about the new tax changes Congress approved Saturday:

Question: When do the tax increases take effect?

Answer: Most of the tax hikes would bite starting on Jan. 1, 1991. That includes changes in income tax rates for upper-income taxpayers, limits on itemized deductions, a phaseout of personal exemptions for affluent taxpayers, and an increase in the amount of earnings subject to the 1.45% Medicare portion of the payroll tax. Taxes on tobacco, alcoholic beverages and luxury items will also be going up at that time.

But the 5-cent-a-gallon increase in gasoline taxes and rise in the airline ticket tax from 8% to 10% will go into effect sooner--on Dec. 1.

Q: Is there anything I can do right away to save money on my income taxes?

A: Very wealthy taxpayers should try to shift income into 1990 because their effective tax rate is going to rise next year. This applies generally to families whose taxable income this year will be above $210,000 and to individuals with incomes above $110,000 or so. Under current law, such taxpayers pay a 28% rate on each additional dollar of income, but next year they will face a 31% rate, plus higher taxes due to the loss of a portion of their itemized deductions. Most such taxpayers already are denied the benefit of the $2,050 personal exemption for themselves and their dependents.

But a few upper-middle income people might consider following the opposite strategy if they can, by deferring income to 1991. Families with taxable incomes over $80,000 and overall income of less than $100,000 will see their tax rate edge down slightly, from the 33% rate that they have been paying on each extra dollar to a new rate of 31%. Even so, under the complex new legislation, those with adjusted gross income above $100,000 face an extra 0.9% marginal tax rate due to the $300 reduction in itemized deductions for every $10,000 in income above $100,000. They also will have to fork over an extra 1.45% in payroll taxes on earnings between roughly $55,000 and $125,000.

Q: Are there any other moves I can make to save money on taxes?

A: Not many. If you are planning to buy an expensive fur, a costly piece of jewelry or a luxury car, you could save some money by doing it before the start of next year. The new law imposes a 10% tax on the value of luxury purchases above certain thresholds ($10,000 for furs and jewelry; $30,000 for autos; $100,000 for boats and $250,000 for private aircraft). For example, a $40,000 Lexus automobile is $10,000 over the threshold. That $10,000 will be taxed at 10%, adding $1,000 to the cost of the car.

Q: Should I sell my stocks now, or hold on to my investments?

A: Financial advisers generally suggest that investors should base their decisions on factors other than taxes. But there is one change investors should consider. The new law establishes a maximum capital gains rate of 28% for all taxpayers. Under current law, some taxpayers in the 33% bubble (roughly $80,000 to $210,000 for a family of four) could pay as much as 33% federal tax on profits from investment in stocks, bonds, real estate and other assets. Those people could save a few dollars by waiting until next year to take their profits.

Q: What should I do about my retirement accounts?

A: The tax changes make employer-sponsored retirement plans--which already are a good deal for those taxpayers who are eligible--even more attractive. With marginal tax rates going up slightly for most affluent taxpayers, retirement accounts will save even more because they allow individuals to contribute pre-tax dollars and help reduce their taxable income. Individual retirement accounts don’t generally provide a tax write-off for those with incomes above $50,000, but they allow earnings to grow tax-deferred. That makes it more attractive to hold them as long as possible, because early withdrawals for affluent taxpayers would be subject to higher effective rates on top of the 10% penalty.

Q: Does the new law make municipal bonds a better buy?

A: Not necessarily. The slight increase in the top marginal rate is probably not significant enough to cause most people to shift from taxable bonds to tax-free bonds issued by state and local governments. Moreover, to the extent there is any sudden increase in demand, that is likely to drive the price of tax-free bonds a little higher, sending yields down a bit.

Q: Should affluent taxpayers try to limit itemized deductions to avoid the new limits?

A: In nearly all cases, that would be useless. Each $10,000 in income above $100,000 will cost a taxpayer $300 in deductions. More than 96% of all taxpayers with incomes above $100,000 file tax returns with itemized deductions, and the new law won’t change that. Since the cutback is based on income and affects the first dollar in deductions, there is practically nothing you can do to lessen the hit unless you can eliminate itemized deductions altogether and take the standard deduction instead.