If the president's advisory panel on federal tax reform wanted attention, they would've been better off walking down Pennsylvania Avenue in their underwear. But they kept their pants on, and instead suggested the removal of our favorite tax deductions and called for the end of the alternative minimum tax system to get themselves in the news. The panel had its final public meeting Tuesday, and the results are out there to rile the crowd. "They're just trying to see where the wind is going to blow," says David Lifson, CPA, chairman of the New York State Society of CPAs' Committee on Tax Reform. And while the current proposal isn't going to blow away completely, it's far from finished -- even though the panel is supposed to issue a report with final recommendations by Nov. 1. The hodgepodge panel, composed of two ex-senators, a retired congressman, a bunch of professors and the former IRS commissioner, seemed to miss the boat on the original intent of the panel -- simplification of the tax code. Granted, the tax code equates to roughly 7,500 letter-size pages, so the panel has signed up for quite a task. That's why many would argue that it would just be easier to throw the tax code in the recycle bin and start over. Instead, the panel came up with two different proposals, neither of which makes life much simpler. The first proposal is supposed to make the income tax less complicated by lowering rates a bit, getting rid of the AMT and scrapping many reductions and credits. The second suggests using a consumption-type levy in place of an income tax. At this point, most tax pros are focusing on the first plan, because the proposal to eliminate the income tax would require a complete overhaul of the system, and it's hard to believe Congress would ever vote on such a move.
Both plans provide generous new tax breaks for investments and savings, including creating new savings accounts that would let you put away a heap of money tax-free. Neither plan is going to work in its current form because of insufficient details and political posturing. But here are some of the suggested changes from the first plan that are getting the most attention.
Bye-Bye, FavoritesThe panel suggests moving us closer to a flat tax. That basically means getting rid of many of the current allowable deductions and just applying one tax rate to our overall income. While this system could work out well for some, others will see their tax bills increase. For instance, the panel suggests dropping the federal deduction for state and local taxes paid. Now, for folks who live in states such as New York or California, where the state tax is very high, that deduction is a lifesaver. Whatever residents pay to the state is then deducted off their adjusted gross income when calculating their federal tax bill. So it's very hard to see why anyone in those states (yours truly included) would support such a move. Of course, people in Florida and Texas think it's a good thing, because they don't pay state income tax and have felt that those of us who do are getting an extra bonus on our federal return. The panel also suggests tinkering with the home mortgage deduction. For folks with big mortgages, this deduction is a reward for making mortgage payments for 12 months. Under the current system, you can deduct your mortgage interest up to $1 million on the Schedule A -- Itemized Deductions form. The problem is that total itemized deductions are limited based on a formula that includes your adjusted gross income. Basically, as your AGI gets higher, the total amount of your allowable deductions decreases or gets phased out. So if you make a lot of money, you won't get the full mortgage deduction.
The panel is suggesting changing this deduction to a credit. A credit is subtracted right from your total taxable income, so it's not phased out or limited based on income. They're suggesting that the credit be 15% of the total mortgage interest paid, says Bob D.Scharin, editor of Warren, Gorham & Lamont/RIA's Practical Tax Strategies, a monthly journal written for tax professionals. So if you paid $10,000 in interest, you'd get a $1,500 credit. Of course, there's a cap. If your mortgage is more than $312,000, you'll have to walk through some formula to determine your actual credit. So it's not unlimited. And note, this credit is just for your principal residence. So if you have a second home and are currently deducting the interest on that mortgage, you would no longer be able to do so under the new proposal. Here is where the AMT irony comes in. The AMT doesn't allow deductions for state and local taxes or mortgage interest. So by removing these deductions, the panel is essentially throwing us all into the AMT anyway. They're not getting rid of it. They're just repackaging it. And let's face it. As unjust as the AMT is currently, it can't just disappear. It would cost the Treasury $1.3 trillion over the next decade if it did. So an easier way to deal with this conundrum may be to just push us all into it. (Things that make you go hmmm.)
Hello, PerksThere is some good news. The panel would like to move us from six tax brackets to four, with the highest tax rate hitting 33% vs. our current 35%. At this point, we're not sure of the income cutoffs for each rate bracket, so it's too early to know the actual benefits. The panel also is recommending that Social Security benefits no longer be taxable and that dividends paid by U.S. corporations be tax-free to shareholders. Apparently, someone finally woke up to the obvious.
Quite frankly, taxing those measly Social Security checks is unfair anyway. And on the dividend front, the corporations issuing dividends already have paid tax on that money before they distribute it. Thus, those dividends are currently "double-taxed" because you pay tax again when you receive them. So those two suggestions should be no-brainers. On the capital gains front, the panel is looking to take us back to pre-1986. Basically, instead of applying a flat rate on capital gains, like the current long-term rate of 15%, the panel suggests using a capital gains exclusion of 75%. That would mean 75% of your gains would be tax-free and you would owe ordinary income tax on the remaining 25%. So currently, if you have $1,000 in long-term capital gains, you owe $150 (15%) on that money. Under the new proposal, you would owe ordinary income tax on $250 (25%). Using the highest proposed rate of 33%, that would bring your tax bill to $82.50. "So the investing folks become the biggest winners here," notes Scharin. And the investing community generally means the wealthier Americans, and you know what happens when someone suggests a tax break for the rich. Granted, you can't please everyone, but the current system is just too complicated, and right now, the middle class is getting hammered. The panel would do best to stop the politicking and try to focus on helping all hard-working Americans.