January 16, 2021

Amid Fiscal Stalemate, How to Handle Tax Rate Uncertainty

So we’re left with no idea how much we’ll be paying in federal income taxes in 2013, and a wide range of possibilities for taxes on investments and estates and tax deductions for mortgage interest and charitable contributions. Plenty of people will spend the next several days feeling helpless, with one eye on the stock market and the other on Washington.

For all the uncertainty, though, we do know a bit about how things will change next year. For example, new taxes, some of which will help pay for Medicare, will affect a few million affluent households.

We also know that in all likelihood, whatever happens in Washington in the coming days or weeks won’t come close to solving the problem that tends to clear the room when you say it aloud: We are not collecting enough money to pay for the promises we’ve made to one another. It isn’t just Medicare, either. Many states have steadfastly refused to set aside the trillions of dollars they will need to cover benefits for public workers once they retire.

As for what you should do about all of this, the answer, for now, is probably nothing. In the short term, stock prices may decline and the economy may get the hiccups, but it’s foolish for amateurs to try to alter their investment portfolios to take advantage of the situation. Leave that to the hedge funds, and watch how many of them get it wrong.

In the long term, however, prepare to make the kind of attitude adjustment that can take a while to embrace. A decade or two from now, most of us will probably be paying more in taxes or getting fewer services from the government than we do now. Once that happens, you’ll need to earn more, save more, live on less or take better advantage of legal tax avoidance strategies.

In fact, you may want to try to do all of these things in the next couple of years, just to see which ones you can accomplish with the least amount of pain.

Here is what we do know will happen in 2013. First, there is a new tax of 0.9 percent on wages, other compensation and self-employment income above $200,000, if you’re single, or $250,000, if you’re married and filing your taxes jointly. This is on top of the existing Medicare tax.

Second, there is a new tax of 3.8 percent on investment earnings, including interest, dividends and capital gains, in addition to whatever the capital gains tax ends up being. It applies to single people with modified adjusted gross income of $200,000, or $250,000 for married couples filing jointly.

There is still some time to maneuver around the second tax. If you have winning investments you were planning to sell soon anyway, say for a down payment on a house, you might as well do it by Monday. That way, you can avoid the new tax if you’re certain you’ll be in the qualifying income category next year.

A few other changes: For now, you can generally take a tax deduction only for unreimbursed medical expenses that exceed 7.5 percent of your adjusted gross income. That floor will rise to 10 percent next year, except for people 65 and over, who won’t be subject to it until 2017.

Also, if you save money in a flexible spending account for health care expenses, 2013 will bring a $2,500 cap on what you can set aside each year while avoiding income taxes. Many people routinely saved $5,000 in the past.

In the next few weeks, we’ll presumably learn more about the new tax rates on income, capital gains, dividends and estates. A solution may come in stages, with a temporary patch now and the promise of a longer-term deal later.

But this is only the beginning, and if you want to read the Stephen King version of our collective fiscal story, there are a few sources to consult. You could start with the radical centrists at Third Way, a research group, who are the best splashers of cold water that I’ve read on the topic of the federal budget. They present some truly scary data while trying to persuade Democrats to accept cuts to Medicare and other programs.

In 2010, for instance, 11,712 people turned 25 each day, while just 6,670 turned 65. By 2030, 12,499 people will be turning 25 each day, but the number turning 65 will jump to 10,948. The 65-year-olds in 2030 will probably live longer than the people who turned 65 in 2010, and keeping them alive could cost a lot more.

The Pew Center on the States, using the states’ own actuarial data, estimates that there is a $1.38 trillion dollar gap between what governments have set aside to pay for public employees’ pensions and retiree health care costs and their actual obligations. Robert Novy-Marx, an assistant professor at the University of Rochester’s Simon Graduate School of Business, and Joshua D. Rauh, a professor at the Stanford Graduate School of Business, believe the shortfall in pension financing alone is actually $3 trillion to $4 trillion.

If states were to try to fill the gap solely by raising taxes, Mr. Novy-Marx and Mr. Rauh estimate that the cost per household in 2011 would have been $2,250 in New York, $2,000 in New Jersey and $1,994 in California — and we’d need to pay that amount every year for 30 years, with adjustments for inflation. Happy New Year!

These numbers boggle the mind, which is why you’re not seeing them in the newsletters that state legislators send to your home. Instead, lawmakers are trying to change the benefits promised to public employees. But even minor changes have led to lawsuits that could take a decade to resolve. By then, the obligations will probably have grown much larger.

Read enough of these reality checks, and a hazy sort of reckoning starts to take shape. It’s not clear how high taxes will go or how many services — from retiree health care to garbage removal — we may someday need to pay more for, or cover ourselves. But it’s going to cost you more money one way or the other, unless you’re in a truly low tax bracket.

That brings us to those legal tax avoidance maneuvers, which often benefit people who can save. Flexible spending accounts for medical costs will still save you hundreds of dollars in taxes each year, even with a $2,500 cap. A health savings account, the kind that pairs up with a high-deductible health insurance policy, can grow into a sizable pile if you save the money and use it in retirement instead of to pay out-of-pocket medical expenses now. And the fact that the affluent can still avoid capital gains taxes, and get an income tax break in many states, on hundreds of thousands of dollars of college savings via 529 plans is a minor miracle.

There is also the Roth individual retirement account, where even the low-six-figure set can put away money on which they’ve already paid income taxes, leave it there for decades in stocks and bonds, and pull it out without paying a dime of capital gains or other taxes.

That’s the story — for now, at least. In 30 or 40 years, if things are really grim, might the federal government try to tax withdrawals from Roth accounts with enormous balances? As we’re learning now, most great tax deals, like the mortgage interest deduction for beach houses and the tax-free health insurance benefits that many of us get from our employers, may not last forever.

We don’t have much control over what will happen in Washington or our state capitals next year, or 10 years from now. But most of us can probably find ways to earn a little more, save a little extra or spend a little less. Pick just one of those options, make it your New Year’s resolution and see if it helps you feel more in control of your financial destiny by this time next year.

Article source: http://www.nytimes.com/2012/12/29/your-money/how-to-handle-tax-rate-uncertainty.html?partner=rss&emc=rss

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