Disparate impact
Tax reform would mean higher bills for some
By Andrea Coombes, MarketWatch
Last Update: 7:43 PM ET Nov. 6, 2005
SAN FRANCISCO (MarketWatch) -- Accountants are wearing their pencils down to stubs to assess which taxpayers win and which lose under changes proposed this week by the President's Advisory Panel on Federal Tax Reform.
There's no doubt millions of Americans would celebrate the end of the alternative minimum tax, not to mention lower tax rates overall, untaxed dividends and a lower effective capital-gains rate.
But there's no guarantee you would enjoy lower taxes under either of the two proposed systems, as both include plenty of tax hikes -- not surprising given the panel's mandate to create reforms that don't reduce the federal government's current tax revenue. See full story.
About the only certain thing is the reforms' effect varies widely, even for filers with similar situations.
For instance, a married couple with two children and a combined income of $50,000 that does not itemize deductions saves $150 in taxes under the Simplified Income Tax Plan, one of the two proposals, according to an analysis comparing that plan to 2005 tax law by CCH, a tax-research, publishing and software firm in Riverwoods, Ill.
But take that same married couple and throw in $6,000 of child-care expenses, and you'll see their tax levy rise by $1,050 because there's no dependent-care credit under the new plan.
"Everyone's going to have to run" the numbers, said Jeff Kelson, a tax partner at BDO Seidman, an accounting and financial-services firm in New York. "You might lose 60% of your mortgage interest deduction, but the tax rates are going down too. It's a tricky thing."
More sample scenarios
Among many other changes, the Simplified plan reduces the highest tax rates, eliminates some tax brackets and allows a greater amount of money to be taxed at the lowest rate. Read the full report.
For instance, under the plan a married couple's first $78,000 is taxed at 15%. Currently, that couple's upper limit for the 15% rate is $59,400.
Here's a situation where a filer benefits from the changed tax brackets under the Simplified tax plan: If you're single, a non-itemizer and earning $50,000, you'd save $165 under the new plan, because -- although your tax increases $765 because of the repeal of the 10% bracket and other changes -- you make up for that with $930 in savings from the expanded 15% bracket, according to CCH.
If that same single filer also donates $2,000 to charity, he'd save $540 under the proposed plan, according to CCH.
That's because the Simplified proposal eliminates almost all deductions, but does allow one for charitable donations exceeding 1% of income -- and it offers that to all filers (there would be no more "itemizers").
But very-low-income filer might suffer from elimination of the 10% bracket. Under the new plan the lowest ordinary income rate is 15%.
For some filers, changes would be minimal. A married couple with two children, $100,000 in income and $15,000 in itemized deductions including $9,000 in mortgage interest, $4,500 in state and local taxes, and $1,500 in charitable contributions, would see their tax bill increase just $45.
The outlook is worse for a married couple with two children in the following situation:
$300,000 in income, including $3,000 in dividend income and $10,000 in long-term capital gains from a stock sale
$50,000 in itemized deductions, including $5,000 in charitable contributions, $15,000 in state and local taxes, $20,000 mortgage interest on principal residence, $8,000 mortgage interest on vacation home and $2,000 interest on home equity loan
That scenario leads to a tax bill that's $2,720 higher under the Simplified plan, according to CCH.
If that same couple has employer-provided health insurance valued at $15,000, their tax bill could rise as much as $3,887, as the proposed plan taxes health benefits valued in excess of $11,500 at ordinary-income rates.
Not yet simple
Under the plan, taxpayers' filing wouldn't necessarily become simple. "If you have the most confusing thing known to man and you make it somewhat easier, it's simplified. That doesn't make it simple," said Kelson, of BDO Seidman.
But taxpayers would no longer have to wrestle with "the whole standard deduction, itemized deduction dichotomy," noted Martin Nissenbaum, national director of personal income tax planning at Ernst & Young.
Still, the plan's authors acknowledge the ongoing need for experts. "On the form that they propose, they do have a line for the paid preparer," Nissenbaum said.
While it's not simple to figure out where you would fall under the proposals, there are some rules of thumb.
For instance, investors are clear winners. The tax rate on dividends from U.S. companies would drop from 15% to zero, and taxes on gains from stock sales would fall from 15% to an effective rate no higher than 8.25%.
But taxpayers living in states with high income taxes will suffer from the loss of that deduction on their federal form.
Then again, some of those people will benefit from the repeal of the alternative minimum tax.
But the proposed eradication of other deductions has some tax planners concerned. "They are eliminating the deduction for medical expenses [and] casualty losses," said Bernie Kent, a personal-finance partner with PricewaterhouseCoopers.
"Say someone was a victim of Hurricane Katrina and lost everything: Under current law there's a casualty loss."
Homeowners' favorite tax-time treat
The picture is similarly confusing for homeowners. Those who don't itemize benefit, because the proposals allow them to take the home-mortgage-interest credit (currently you have to itemize to enjoy the mortgage-interest deduction).
But most homeowners won't appreciate the switch from a mortgage interest deduction to a credit, limited to 15% of the interest paid. Plus, the credit is limited to interest paid on mortgage debt of no more than about $412,000 (depending on where you live), compared with the current $1.1 million limit.
That change "is going to hit people above the 15% bracket in two ways," Nissenbaum, of Ernst & Young, said.
"Not only does it cap the amount of mortgage on which you can deduct interest, it also changes the deduction to a credit ... you'll get a credit on the interest you pay of 15%, which is obviously a lot less valuable then getting a deduction at 35%," Nissenbaum said.
But "the big loser is the person with the vacation home," said Bob Scharin, editor of RIA's Practical Tax Strategies, a monthly journal written for tax professionals. New York-based RIA is a unit of Thomson Corp. (TOC:
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The mortgage-interest credit is limited to primary residences, while current law allows homeowners to deduct interest on second homes.
The whole tax package? Not likely
That proposed mortgage-interest change is one among many reasons why few people expect the proposals to become law as is.
"I haven't heard a single congressman endorse the panel's recommendations for cutting back the mortgage-interest deduction," said Mark Luscombe, a principal analyst with CCH, noting the upcoming election year.
Still, portions of each proposal may gain traction as a result of the tax panel's efforts.
"Repeal of the alternative minimum tax, especially with this panel's endorsement, is looking more likely," Luscombe said, "but the issue there is how you pay for it."
Andrea Coombes is a reporter for MarketWatch in San Francisco.
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