President Clinton's tax offensive is sending upper-income taxpayers and their accountants into serious strategy huddles for 1993 and beyond. Many of them began planning for these changes last year by moving income into 1992 to take advantage of lower tax rates, deferring deductions to offset proposed increases, and investing to reduce taxable income. With rate hikes almost certain, such tactics will prove even more critical for the months ahead.
Many of those tactics will try to take advantage of the wider gap between taxes paid on ordinary income and long-term capital gains. The top income bracket, now 31%, will rise to 36% for couples making $140,000 a year ($115,000 for singles), vs. a long-term capital-gains rate that will remain at 28%. And with a 10% surcharge pushing the bite on $250,000-plus earners to 39.6%, "there will be a distinct advantage to making investments that generate capital gains instead of interest or dividends," says Kevin Roach, a tax partner at Price Waterhouse in Morristown, N.J.
CASH TRAP. One way to do that is to transfer capital from cash and bonds into stocks and real estate. The more savings you keep in cash holdings, the harder you will get hit. If you park your money in certificates of deposit or money-market funds, for example, and you're in the 36% bracket, you take home only $64 after taxes on $100 in interest vs. $72 on the same amount of capital gains. "You just lost $8 of your return for the lower risk that a CD may provide," says Roach. "That's a pretty steep penalty."
On the other hand, profits from stocks and real estate, as well as distributions from some mutual funds, can be treated as long-term capital gains. Small-company growth stocks are especially attractive because they usually appreciate fastest and don't pay dividends, which are taxed as ordinary income. Also the new pan offers tax credits to small companies, including a provision that would exempt 50% of your gains from investments of five years in companies with a capitalization of $25 million or less. Real estate also benefits from the plan, which extends a tax crediit for low-incoming housing. And if your principal business is real estate, you may be celebrating the return of the passive-loss deduction: Under the Clinton plan, you can use passive losses to offset real estate gains.
Of course, you don't want to liquidate all your bond holdings. If you trade actively, you can realize capital gains from selling bonds that have risen in price. And tax-free municipal bonds, though unaffected by capital gains considerations, are still a good way to reduce taxable income. They offer tax-equivalent yields of 8% to 10%. EE savings bonds also offer tax-deferred compounding and yields of 4.6% after six months and at least 6% after five years. And if your income is less than $66,900 and you use EE bonds to pay for college, the interest is also tax-free, ways William Brennan, a partner at Ernst & Young.
SLICK MOVES. Financial experts expect a whole new generation of tax shelters to crop up to take advantage of the lower rate for capital gains. But accountants warn that you must examine any investment on its merits exclusive of capital gains. After all, thers's no guarantee stocks you buy will go up. Indeed, a major drawback of small-company stocks is that "the mortality rate on startups is higher than any other," warns Sam Murray, a contributing editor to Bender's Tax Week.
Then there are such tried-and-true methods as income shifting, tax-deferred retirement plans, and flexible spending accounts. These hardy perennials become more valuable as taxes rise.
Currently, Clinton intends to make the tax hikes retroactive to Jan. 1, 1993. If he's successful, and you're in an affected bracket, you'll want to put off claiming income until next year and move up deductions into this year. But there's a chance the plan may get phased in, in which case you should do the opposite: accelerate income to tax as much as possible at 1993's lower rate and defer deductions, which become more valuable at next year's higher rate. Shifting income and deductions will be especially helpful if your income is close to one of the trigger points. "People on the fence may find it useful to do something to stay in the 31% bracket or under $250,000 to avoid the surtax," says Price Waterhouse's Roach.
Assuming rate increases are retroactive, you could hold off selling appreciated securities and delay bonuses--as long as your employer agrees to do so before you've done the work that merits the bonus. Make charitable donations of appreciated property. Clinton's plan makes it easier to deduct the market value of a gift of stock or artwork that has risen in value without paying any taxes on the appreciation. Your best shot at overcoming limitations on itemized deductions is to bunch up, say, discretionary medical and miscellaneous expenses into '93, said Kenton Klaus, a tax partner at Arthur Andersen.
If you can't escape the alternative minimum tax, you may want to move up income into 1993 and defer deductions instead, says Tom Ochsenschlager of Grant Thornton. Clinton proposes raising the AMT rate from 24% to a maximum of 28%, depending on your income level. This tax, which disallows many itemized deductions, ensures that wealthy people don't deduct their way out of paying their fair share.
Annuities, life insurance policies, and pension plans can shelter sizable income while compounding the pretax interest on them. Put the maximum contribution in IRAs, simplified employee pension plans, 401(k)s, and Keoghs now instead of waiting until Apr. 15, 1994: You'll cut your income--and get an extra 14 months of compounding.
Remember that the 20% witholding on lump-sum withdrawals from retirement plans goes into effect in 1993. If you leave a job or retire, have the trustee of your account transfer the money directly to the trustee of a new tax-deferred vehicle. Otherwise, the feds will withold 20% of your savings. You can apply for a refund with your tax return, but depending on what you owe, you may not get all of it, and you'll lose any interest you could have earned on it in the meantime.
Another way to avoid giving the government an interest-free loan is to adjust your withholding so you're only paying what you owe, says Klaus. Many people use withholding as a way to save. You're better off investing the extra money in an interest-bearing account or using it to pay off nondeductible debt.
Taking out a home-equity loan to pay credit cards and other nondeductible debt is another smart move. You can get up to $100,000, the interest is deductible, and you can use it for any purpose. Replacing credit-card debt of $10,000 at 18% interest with a $10,000 home-equity loan at 8.5% reduces your annual carrying cost from $1,800 to $612 if you are in the 28% bracket, according to Kiplinger's Sure Way to Cut Your Taxes.
LITTLE HELPERS. Take advantage of any flexible spending accounts your employer might offer for health and child-care expenses, says Michael Kennedy of Coopers & Lybrand. Just make sure you accurately estimate what you need, since you forfeit any money left at yearend.
Your kids aren't the great little tax shelters they used to be, but they can still help. The first $600 of earned income is tax-free for kids under 14, the send $600 is taxed at the child's rate of 15%, and anything more is taxed at your rate. So you can give your child $10,000 tax-free as part of the annual gift-tax exclusion, for example, and pay little or no taxes on the interest it makes. Bonds timed to mature when your child hits 14 make sense, too, since after that all the child's income is taxed at 15%.
But avoid making decisions on the basis of tax savings alone. You don't want to forfeit income, you just want to pay taxes as if you had.