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'Cliff'' or no, wealthy face first tax hike since 1993

Published December 16, 2012 9:24 pm

Investing • Budget talks, code overhauls, other factors create certainties — and some doubts.
This is an archived article that was published on sltrib.com in 2012, and information in the article may be outdated. It is provided only for personal research purposes and may not be reprinted.

Taxes will rise for wealthy Americans next year. It's still a question of how much.

U.S. income tax rates for top earners and investors will go up for the first time since 1993. They will see levies rise on unearned income and wages starting Jan. 1 to finance the 2010 law that sought to expand health-care coverage. President Barack Obama wants higher taxes on their compensation, capital gains, dividends and estates to reduce the deficit, proposing to raise the top marginal rate to as much as 43.4 percent on some income from 35 percent.

Lawmakers in both political parties have called for an overhaul of the U.S. tax code, which also could curtail tax breaks for home mortgage interest, municipal bonds, charitable contributions and retirement savings used by wealthy people.

"The prevailing emotion for our clients is frustration with the current situation with regard to taxes," said Leo Kelly, managing director and partner at HighTower Advisors' Kelly Wealth Management. "They really feel like they're being held hostage because they can't get information to make an intelligent decision."

Investors and high earners have less than three weeks before the end of the year to make financial moves, such as selling assets or giving money to heirs, and lack certainty about tax laws, said Kelly, whose Hunt Valley, Md.-based firm typically serves clients with at least $5 million in investable assets.

Talks on a budget plan remain deadlocked because Democrats have said they won't accept spending cuts unless Republicans agree to higher tax rates for top earners. House Speaker John Boehner, R-Ohio, is insisting the administration propose specific cuts to entitlement programs such as Medicare and Medicaid before a deal on deficit-reduction can be reached.

The Congressional Budget Office has said that if nothing changes, the stalemate probably would lead to a recession in the first half of 2013. More than $600 billion in spending cuts and tax increases are scheduled to take effect in January if Congress doesn't act on what's known as the fiscal cliff.

Rates on income, capital gains and dividends are scheduled to rise in 2013 unless Congress acts because tax cuts enacted during the presidency of George W. Bush — and extended by Obama in 2010 —expire Dec. 31. Obama has proposed letting income tax rates increase to as much as 39.6 percent from 35 percent on annual income exceeding $200,000 for individuals and $250,000 for married couples.

The president wants to raise taxes on the long-term capital gains of those same earners to 20 percent from 15 percent, and treat dividends as ordinary income, pushing the top rate to 39.6 percent. Capital gains and dividends are subject to an additional 3.8 percent levy starting Jan. 1 because of provisions in the 2010 health-care law. That means the top rate on capital gains would be as much as 23.8 percent and 43.4 percent for dividends.

With all those changes, a family in New York state earning $400,000 a year with $35,000 in dividend income and $20,000 in long-term capital gains would see a tax increase of about $11,500 next year if Congress doesn't act on expiring tax cuts, said Jay Messing, a senior director of planning at the private bank unit of Wells Fargo & Co. The analysis assumes the family has two children, $27,000 in home-mortgage interest, $20,000 in property taxes paid and $15,000 in charitable contributions.

Rates on income specified by the U.S. tax code haven't increased for top earners since 1993 and declined in 2001 and 2003, said Jim Nunns, a senior fellow at the nonpartisan Tax Policy Center in Washington. That will change next year, budget deal or not, when the 3.8 percent investment income tax takes effect.

The 3.8 percent levy is considered an income tax because it applies to so-called unearned income including interest, dividends, rents, royalties and other passive activities. Revenue from the tax will flow to the Treasury Department's general fund, unlike Social Security payroll taxes, Nunns said.

The additional investment tax is one of the few certainties facing top earners and investors for next year, said Susan John, president of Financial Focus in Wolfeboro, N.H., who advises clients with at least $2 million in net worth.

John said she has been advising investors to put money into municipal bonds, which aren't subject to the levy. She also suggests they consider selling appreciated assets before Jan. 1 to take advantage of current rates on long-term capital gains and dividends if they anticipate needing capital in the next year.

Next year, if the Bush-era tax cuts expire, high-income taxpayers will see reductions to their personal exemptions and itemized deductions. Obama has proposed capping the benefit of deductions for top earners at 28 percent, including other tax breaks for municipal bond interest and retirement savings contributions. Under such a proposal, someone in the 39.6 percent bracket who makes a $1,000 charitable contribution would be able to deduct $280 instead of $396.

The biggest federal tax breaks for individuals include those for mortgage interest, charitable contributions, state and local taxes, incentives for retirement savings and the exclusion of employer-provided health care.

Limitations on such deductions will affect high-income taxpayers, particularly those with multiple homes, those in high-income-tax states and who give to charity, Messing said.

"That deduction is not usually what motivates them," Messing said of clients who donate to charity. "But it's certainly something they think about when they're doing their calculation of how much they can give."

The current exemptions on gifts and estates also are scheduled to expire from their current levels. Individuals now can transfer up to $5.12 million, or $10.24 million a couple, and amounts higher than that are taxed at a maximum 35 percent rate. The lifetime gift exclusion will drop to $1 million in 2013 if Congress doesn't act and the rate on excess gifts will increase to a top rate of 55 percent.

That has caused many wealthy families to put money into trusts for their children and future generations before year end. Some are even triggering a gift tax by giving more than the exclusion amounts to take advantage of the 35 percent rate, said Jim Cody, a managing director of estate, trust and philanthropy advisory services at Harris myCFO, a unit of the Bank of Montreal.

Billionaire investors Warren Buffett and George Soros called on Congress last week to increase the estate tax. In a joint statement, Buffett and Soros, along with more than 20 other wealthy individuals that included Vanguard Group Inc. mutual fund founder John Bogle, asked lawmakers to set the estate- tax exemption at $2 million for individuals and to raise the top rate to more than 45 percent. Obama wants to reinstate the 2009 levels, which include a $3.5 million exemption and a 45 percent top rate.

"You're seeing this mad dash to establish and fund irrevocable trusts before year end," said Michael Harman, a wealth adviser at the private bank unit of JPMorgan Chase & Co.

Many wealthy clients are calling their advisers with questions about pending tax increases and the budget deal as they follow daily news reports on the stalemate, said John of Financial Focus.

"It just feeds their fears," John said of the coverage. "We're suggesting to a lot of them that get really upset about it that maybe they should watch the 'Animal Planet.' "