The tax law changes made in late 2012 largely affected upper tax brackets – most notably an increase of the top tax bracket to 39.6% from 36% and an increase in the marginal estate tax rate to 40% from 35%.
Long term gains and dividend tax rates were raised for some upper income earners to 20% from 15%, but the tax increases were generally below what many expected. The added healthcare tax of 3.8% brings the possible marginal rate to 43.4%.
But from Washington has come a new round of proposed tax increases. These, if enacted will have far broader impact on taxpayers at both upper and middle levels. Some of them are quite complex. There will be consequences for tax revenues in the short run, and possible longer term unintended consequences for individuals and the broader economy.
Itemized deductions will be limited to 28% for taxpayers in higher brackets. The limit may include state and local income taxes, charitable deductions, mortgage interest, and contributions to 401k plans.
People who itemize deductions—about 30% of taxpayers—are currently allowed to deduct most of these items from their taxable income. The proposed tax plan would limit the value of itemized deductions and other income-tax breaks for higher-income households—defined as couples earning more than $250,000 a year. The tax theory is that it is unfair for higher-income earners to get more tax savings than a middle- income household does from a given deduction.
There are implications for charitable giving since this deduction is largely voluntary, unlike taxes and mortgage interest. It is more likely that donors to charities will react to the limitation on their giving. The economic consequences of this change will be dramatic for both taxpayers and charities. The table shows the impact on a taxpayer in a 42.4% bracket at a federal level and a 7.25% state level. Assuming a $1,000 donation to charity, the donor gets a tax “subsidy” or refund of $479 from the federal and state government when he files his taxes. At the new rate, that “subsidy” drops to $306. It will not take donors long to figure that the donation is costing them $173 more than it did before the new tax law limited their deduction. Looked at another way, in order for the donor to spend no more “out of pocket” on a gift to charity, he must cut his charitable giving 17%.
Source: CornerCap Investment Counsel
Now, doubtless many donors will continue to give at the same level as before. Others will never go through this numbers analysis, but they will sense that there is a definite cost involved for them. And yet another group will do the math for themselves, or more likely among the very wealthy – an army of tax accountants, lawyers, and planners will do the math for them and explain the consequences.
It would be naïve to think that charitable giving in the U.S. will not be impacted by such a tax law. The biggest givers are the ones who derive the most from the tax deduction. They are already feeling the impact of the higher taxes from 2012, and the deduction limit will add yet another dimension.
The question is not WHETHER charitable giving will decline, but HOW MUCH.
Savings Plan Adjustments – IRAs and 401ks
Proposed changes to individual savings plans also can have a broad impact. The major one for most people will be the limit on the amount one can accumulate in savings accounts like IRAs and 401ks. The proposal is complicated, but it basically says that a person will be allowed to accumulate only the amount of money that will produce an annual pension of $205,000 a year for life, beginning at age 62. On the surface, this seems very reasonable. Why should anyone want more than that in a savings plan? An annual income over $200,000 should be enough for anyone. The intention is to disallow huge tax breaks on these accounts that can build up exceptionally large pools of money that is either tax deferred in a regular IRA, or tax free in a Roth. Again, this seems pretty fair.
But the devil is in the details, and like the charitable deduction change, there are very likely to be unintended consequences. Right now, the pension accumulation limitation above equates to $3,000,000 in savings. Again, this is a large number that few people are likely to reach, so what’s the problem? To begin, the size of the cap on savings is not fixed. It is based on current interest rates, the rate that the calculation assumes money will grow in the IRA. Rates are low right now, so it takes a lot more money to earn $205,000 a year.
It is not clear who gets to set the rate or what rate is used. But if interest rates rise, the cap will be much lower. For example, the interest rate used to set the cap is now about 2.5%. If the rate rises, to say 8%, then the amount of the cap is $1,823,000 – a cut in the cap of 39%. This “floating number” conjures up all sorts of questions – and unintended consequences. If the cap goes up, can people add to their IRAs to reach the new cap? If the cap goes down, must people take money out of their IRA? What happens to the person who has deposited money expecting to earn a high rate, and then at age 62 experiences an interest rate decline? He is trapped because he no longer works and can’t add money to his IRA, and yet at the low interest rates, he cannot hope to earn enough to give him the pension he needs. In an extreme case, such as the early 1980s when interest rates fell from 16% to 5% in a few years, the pensioner might have found himself in the position of being capped at $1,000,000 and yet in a few years finding that this amount would produce only about $90,000 of annual income, not $205,000 – a drop of 56% In retirement income. Without an inflation adjustor, over their working lives a large percent of young people could fall into this trap, just as millions now pay AMT, originally intended for only a few very wealthy individuals.
IRAs as an Estate Planning Tool
The tax argument being made is that savings plans were never meant to be estate planning tools. But the rules about inherited IRAs make them just such a vehicle. Many people are looking for a way to leave a nest egg to their children, and the IRA offers just such an opportunity. And the advantage is not just for the superrich. It applies nicely to anyone who pays taxes. The Roth IRA is especially attractive. It allows an IRA owner to pay all the tax due on the IRA today and then never pay tax on it again. Another feature of the IRA is that if it is left to children or grandchildren, the new owner can withdraw the money in small amounts each year over his or her lifetime. It has been an excellent advantage of both kinds of IRAs. And while there was no guarantee of this, there has been an implicit guarantee that the gifting feature would be maintained in the tax law, else it would not be worthwhile for the owner to dig into his own pocket and pay the tax for the future generation. The proposed new law would require anyone who inherits an IRA (except a spouse) to draw it all out within five years. Such a change will mean that those who have already paid the tax to convert to a Roth have essentially wasted their money.
Broader Unexpected Consequences
Beyond these individual examples, a bigger concern is tax policy that discourages people from saving for their future. We are already a nation of consumers:
- Who are not putting aside enough for our retirement as individuals.
- Who are making pension payout promises to future retirees, both public and private, with no real hope of keeping them because the assumptions about the earnings on those funds are so unrealistic.
- Who are piling government debt on our children and grandchildren, who have no say in the matter.
- Who are not laying aside the savings to fund new businesses and economic growth.
The last thing we need is a tax policy that limits the amount of money that can be saved for whatever purpose. Sure, there are always the super-rich who exhibit bad behavior and are perfect poster children to support the idea of a huge estate tax and progressive income tax. But there are also millions of families who are not super-rich, who have worked for decades to build a farm, ranch, or small business. Yes, these people may have accumulated something more than $10 million dollars over their lifetime. But it is often tied up in illiquid assets - plants, equipment and land. In these cases, the estate tax can mean being forced to sell something that they have spent a lifetime building, and at a discount as well, since the tax collector isn’t very patient about being paid.
So before we go down this road of high taxes on charity and thrift, we need to consider the long term unintended consequences.
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