Early planning trims 1991 taxes.
The 1991 rates
The top tax rate of 31 percent applies to taxable incomes over $82,150 for married taxpayers filing jointly and $49,300 for single taxpayers. The maximum tax rate on long-term capital gains is 28 percent. The alternative minimum tax (AMT) rate is 24 percent. However, some new wrinkles in the law--the phaseout of personal exemptions and the 3-percent limitation on certain itemized deductions (both discussed below)--may make your effective marginal tax rate (the "real" rate of tax paid on your last dollar of income) higher than the 1991 "maximum" rates. Why? As your adjusted gross income (AGI) increases, the new provisions reduce the amount of your exemptions and deductions, thereby increasing taxable income.
Personal exemption phaseout
Taxpayers lose 2 percent of the personal exemptions deduction for each $2,500, or fraction of $2,500, by which their AGI exceeds the threshold amounts ($150,000 for joint returns and $100,000 for single filers).
For example, if you're married with two children and have $200,000 in AGI, your personal exemption deduction before the phaseout is $8,600 (4 times $2,150). Your AGI exceeds the $150,000 threshold by $50,000. To determine your phaseout amount, divide $50,000 by $2,500, which gives you 20 increments of $2,500 in $50,000. So you lose $3,440--20 times 2 percent times $8,600. This reduces your personal exemption deduction to $5,160 ($8,600 minus $3,440). Assuming a 31-percent tax rate, your additional taxes are nearly $1,070. And, if your AGI is $1 more--$200,001--you would lose another 2 percent of the total of personal exemptions, or $172 (2 percent times $8,600). So a $1 increase in AGI increases your tax by $53 ($172 times 31 percent).
Once AGI exceeds the threshold amount by $122,501, or $272,501 if you are filing jointly, you lose your entire personal exemptions deduction. This exemption phaseout effectively increases your marginal tax rate by about 0.5 percent for each exemption when your AGI is in the phaseout range.
Limitation on certain
The total of certain itemized deductions--qualified residence interest, charitable contributions, state and local income and property taxes, moving expenses, unreimbursed employee business expenses, and other miscellaneous itemized deductions--must generally be reduced by an amount equal to 3 percent of AGI in excess of $100,000 ($50,000 for married persons filing separately). So, for example, you lose $300 in deductions for every $10,000 of AGI above the stated threshold. In no event, however, is the total of otherwise allowable deductions reduced by more than 80 percent. (This provision affects only taxpayers with fairly high AGI and relatively few itemized deductions.) When AGI exceeds the threshold, this new limitation increases the effective marginal tax rate by nearly 1 percent (31 percent of 3 percent, or 0.93 percent). Medical expenses, casualty and theft losses, and investment interest expense are not subject to the 3-percent reduction in deductions.
In calculating the 3-percent floor, all other limitations relating to itemized deductions apply first.
Overall impact of the new law
These two new tax provisions may result in a married couple with two children actually having an effective marginal tax rate of 34 percent--31 percent plus 2 percent (exemption phaseout) plus 1 percent (itemized deduction limit). Since these new wrinkles are based upon AGI, this year more than ever, an important objective is to reduce AGI.
Here are some strategies to trim your AGI in 1991.
* Make the maximum contribution--in 1991, $8,475--to an employer-provided 401(k) plan. You benefit by not only saving 1991 taxes, but also enjoy tax-deferred earnings on your savings and, in many situations, a matching dollar contribution (up to certain limits) from your employer.
If you were to invest that $8,475 elsewhere, your initial investment would be reduced by $2,627 ($8,475 times an assumed 31-percent tax rate) to the after-tax amount of $5,848. Your initial investment would be reduced even more if both the new limitation on itemized deductions and the phaseout of personal exemptions apply. Furthermore, the earnings generated by such a reduced investment would also be subject to tax currently unless, or course, you invested in tax-exempt municipal bonds, for example.
* Consider investing in Treasury bills and bank certificates of deposit maturing in one year or less, with the maturity falling after December 31, 1991. (Note, however, that this strategy will increase your AGI in 1992). Also consider investing in tax-exempt municipal bonds or municipal bond funds.
* Passive losses are deductible only to the extent of net passive income. Losses in excess of income are called "suspended losses" and are carried forward to be used to offset passive income in future years. If you have suspended losses, consider selling the activity that generated the losses, assuming doing so makes economic sense. When you sell a passive investment, you generally can use its suspended losses immediately to offset not only passive income, but any other income, including earned income or wages and portfolio income. (When planning to sell a passive investment, you need to be careful. The sale may generate income, thereby undermining this strategy.)
In addition to reducing AGI, review your itemized deductions to slash taxable income further.
* Consolidate debts with a home-equity loan. Personal interest--e.g., credit cards and car loans--is not deductible. However, interest on a home-equity loan, line of credit, or second mortgage secured by your home is fully deductible provided the debt doesn't exceed the lesser of the fair market value of your home minus the total acquisition debt or $100,000 ($50,000 if married and filing separately). Consider paying off loans generating nondeductible interest with home-equity loan proceeds. One caution: your home is collateral for the loan.
* Bunch deductions that must meet certain thresholds. Only miscellaneous itemized deductions that exceed 2 percent of AGI are deductible. Similarly, only medical expenses that exceed 7.5 percent of AGI are deductible. Plan to bunch the expenses so as to exceed the specific floors to maximize your deductions.
AMT is typically triggered when large deductions reduce your regular tax below your AMT. Because the 1991 AMT rate has increased to 24 percent, more people may be subject to this tax. Before you implement any of these strategies, you will need to know if you are subject to the AMT and what impact it would have.
Mr. Komlyn is the National Director of Technical Tax Services at Price Waterhouse.
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|Author:||Komlyn, Anthony M.|
|Date:||Jul 1, 1991|
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