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Five Crucial Tax Issues for Wealthy in Deficit Reduction Plan

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We’ve all read about some of the possible tax hikes in the Deficit Reduction proposal from the bi-partisan National Commission on Fiscal Responsibility and Reform.  Created by President Obama, the Commission is Co-Chaired by Erskine Bowles, Chief of Staff to President Clinton, and Alan Simpson, former Republican Senator from Wyoming. Reductions in Social Security, a higher tax on gasoline and potential elimination of popular tax deductions have been widely reported. But what would this mean to wealthy investors?

Most would agree that the tax system needs overhaul and simplification. “At least we have some legislative individuals that realize the need to adhere to some fiscal responsibility and are willing to put some proposal ideas on the table," says Andrew Rice, VP and CFO of Money Management Services, Inc., in an e-mail. Rice blogs about taxes at —see his latest post, Obama ‘Care’ Or Obama ‘Tax?’

Because the proposals are in draft stage and no one can predict whether their final form will be able to garner the 14 of 18 votes needed to even bring forth a proposal to Congress, it is hard to project what this will ultimately mean. But from the Co-Chairs' Proposal, and their $200 Billion in Illustrative Savings, we can project what shape some of the issues would take.

Here are the “five basic recommendations" of the Co-Chairs’ proposal:

1. Enact tough discretionary spending caps and provide $200 billion in illustrative domestic and defense savings in 2015.

2. Pass tax reform that dramatically reduces rates, simplifies the code, broadens the base, and reduces the deficit.

3. Address the “Doc Fix” not through deficit spending but through savings from payment reforms, cost-sharing, and malpractice reform, and long-term measures to control health care cost growth.

4. Achieve mandatory savings from farm subsidies, military and civil service retirement.

5. Ensure Social Security solvency for the next 75 years while reducing poverty among seniors.

Rice agrees with “the broad features,” proposed: “Simplifying the tax code, cutting spending across the board, deficit and debt reduction, and some form of mandatory savings, however, the details associated with each are still government benefited and not consumer driven.” What we need, he notes, are “decisions that are growth-based, spending controlled, consumer driven and corporately run.”

Five Crucial Issues to Consider

While there is no mention of the estate tax, there are other parts of the proposed plan that, if enacted, would affect wealthy investors. Five that immediately come to mind are:

  • Treatment of dividends and capital gains as ordinary income;
  • Elimination of some or all of the mortgage interest deduction;
  • Elimination of the state tax deduction on federal returns;
  • Abolishing the alternative minimum tax (AMT); and
  • Imposing a limit on charitable deductions.

Qualified Dividends and Cap Gains

With qualified dividends and cap gains at a 15% tax rate now, most investors, and certainly wealthy investors, would pay more tax on gains and dividends under the proposed plan. That said, it would seem that taxable bond income would be more favorably treated, as that is currently taxed at ordinary income-tax rates and new ordinary-income tax rates would theoretically be lower than the current 35% highest federal rate.

Interest on Mortgages

The mortgage interest deduction would be tough on anyone who owns a home with a mortgage. One of the most attractive things about home ownership in the U.S. is the leverage that mortgages provide (under ordinary economic conditions, anyway)—freeing capital to invest in other goods and services—and the mortgage interest deduction. Boosting the cost to own a home won’t likely be politically feasible, and in the current economy, it is hard to imagine this getting through Congress. 

However, market implications aside, does this make property less attractive to own, and what would the effect be for regular homeowners—who in normal times could count on their home as their largest asset and a fundamental part of their net worth and retirement assets? The proposal mentions eliminating the deduction entirely, or limiting it to “exclude second residences, home equity loans, and mortgages over $500,000.”

If mortgage interest is eliminated, presumably housing prices drop further. This doesn’t bode well for state and local tax revenues, which are already reeling from the current drop in value of homes. Eliminating the mortgage interest deduction would probably boost taxes for some homeowners.

State Tax Deductions

Eliminating state and local tax deductions is an area where there may be complex consequences for investors in terms of taxes and even investor behavior. 

Because taxes vary widely from state to state, this would be a very uneven tax consequence, with little effect in low-tax states, but large effect in high-tax states like California, New York, New Jersey and some others. The effect is, of course, magnified by income. It would make tax-exempt municipal securities more attractive, and taxable securities less attractive, but would be bad for Build America Bonds (BABs), Treasury securities and other governments.

What would the elimination of the state tax deduction do to the tax for those who live in one high-tax state and work in another—such as New York and New Jersey? Will people move? Will real estate values fall then in states with high state and local taxes? And what does this do to the municipalities and munis from those states—munis would be more attractive, and at the same time, more risky. It’s a paradox.

Charitable Deduction

Capping the charitable deduction at 2% of adjusted gross income (AGI) will undoubtedly raise the amount of money subject to tax for some wealthy investors, whether they give beyond the 2% or not. Whether it changes behavior is another question entirely. If the deduction were capped, will philanthropists continue to give?

These questions are just a few of those that will occupy wealth managers and their clients as the debate on reducing the deficit continues.  While the proposal is still in draft form, the CoChairs put “everything” on the table. There will undoubtedly be quite a discussion on the best way to move forward.

Rice comments in his e-mail to that what we need are “decisions that are growth based, spending controlled, consumer driven, and corporately run. We need a country that is run like it is the biggest corporation in the world looking to make the most earnings per share for its shareholders (the American citizens).” He also suggests that the government pay “yearly dividends back to American taxpayers based on each person's tax revenue paid in.”

All of this bodes well for wealth managers as asset location and tax planning will make great advice even more essential.

The political implications are vast—see's Washington Bureau Chief Melanie Waddell’s report: “Deficit Commission's Proposals Blasted by Retirement Plan Officials.”


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