New Tax Bill Helps the High End

By Neil Irwin
Washington Post Staff Writer
Saturday, May 13, 2006

In the debate over the tax bill that Congress passed this week, supporters toasted it as essential to continued economic growth while opponents described it as a boon to the wealthy that the nation can't afford.

The proposed changes to the nation's tax system, though, which President Bush plans to sign into law next week, have a more idiosyncratic set of winners and losers than the talking points on either side might suggest. The bill would cut taxes by $70 billion over the next decade -- about $23 per person, per year. But the benefits are concentrated among people with very particular tax situations, a relative few people who might save thousands of dollars.

The winners include people with large stock portfolios, affluent Americans with big individual retirement accounts, upper-middle income residents of high-tax states and musicians. The bill is less kind to Americans living abroad or the parents of 14-to-18 year-olds who want to invest money on their behalf.

The provisions evolved that way for a variety of reasons. Some are ideological -- Republicans in Congress argue that low taxes on investment income will help spur economic expansion. Others reflect victories by narrow lobbying groups or tweaking of tax provisions to make the fiscal impact of the tax cuts seem less severe.

"The bill has a lot of little odds and ends in it," said John P. Barrie, a tax partner at law firm Bryan Cave LLP.

Stock investors are the broadest group of beneficiaries of the bill, which extends a 15 percent rate on dividend income and long-term capital gains through 2010 (the low rates were scheduled to expire in 2008). That low rate is particularly helpful to those who live off investment income, said John Rachlin, a wealth management adviser with Merrill Lynch & Co. based in Rockville.

"People who are close to retirement or in retirement see dividend-producing stocks as a way to have a lower taxed income," Rachlin said. "More people are catching on as they see the benefit in the last couple of years."

For example, one of his clients, Isidore Bernstein, pays about $6,000 a year less in taxes with the low dividend rates than he would if they rose back to 2003 levels, when dividends were taxed at the same rate as regular income -- which tops out at 35 percent. That increases the after-tax income of the Bethesda resident, a retired doctor, by 5 percent.

The bill also raises the amount of income exempted from the alternative minimum tax, a system meant to ensure that the wealthy don't pay too little in taxes but that increasingly ensnares middle-income people because it is not indexed to inflation.

The AMT provision doesn't much benefit those with the highest incomes, analysts said, because they're already being taxed at a higher rate. Instead, it's those with upper-middle incomes who win -- those whose households make $100,000 to $500,000 a year. Such families with lots of deductions -- such as from having several children or paying high state income taxes -- have been particularly exposed and therefore stand to benefit.

Deloitte Tax LLP found that a hypothetical family of four with $185,000 in income and $33,000 in itemized tax deductions -- easily attainable in high-income tax jurisdictions like the District and Maryland -- would have faced an AMT of $3,700, but because of the change will pay none.

Other big beneficiaries will be people with six-figure incomes who have large individual retirement accounts. Starting in 2010, even taxpayers with incomes above $100,000 will be allowed to convert regular IRAs, in which money is taxed as it is withdrawn, to Roth IRAs, in which money is taxed when it is deposited. They would pay a large one-time tax payment but then be able to withdraw money from the account tax-free indefinitely, not be forced to withdraw funds, and could pass the money to heirs in a more tax-advantageous way.

Other benefits affect even fewer people. Owners of small businesses won a two-year extension of rules that let them depreciate investments of up to $100,000 immediately, rather than over time, a boon for owners of small companies planning capital spending on equipment and such.

Musicians benefit from another provision. When one sells self-created musical works, the income will be taxed as a capital gain, not at the higher rates of regular income.

Not everyone wins. Parents have long been prevented from avoiding taxes on investment income by investing it in the names of their children under 14. Now they will be prevented from doing so for those under 18.

And there are a complicated changes to tax rules for Americans who work and live abroad, the upshot of which is that expatriates will have to pay $2.1 billion more in taxes over the next decade. Expatriates will face tighter rules on how employer-provided housing will be treated and could face higher taxes on investment income.

There's another set of losers in the tax bill. Because the tax cuts are not being offset by lower government spending, but funded by debt, future taxpayers will have to pay the tab. Future Congresses and presidents could decide to do so in any number of ways, either cutting spending or raising taxes or some combination thereof.

"It makes a discussion of winners and losers hard," said Leonard E. Burman, director of the Tax Policy Center, a joint venture of the Brookings Institution and the Urban Institute. "The fact is, not everyone will get tax cuts, because someone has to pay it back."

© 2006 The Washington Post Company