Reuters Money

Tax reform in an era of deficits

Eric Toder is an Institute Fellow at the Urban Institute and co-director of the Urban-Brookings Tax Policy Center. The opinions expressed are his own.

This post is part of an ongoing series on tax reform ideas. Where do you stand? Come back regularly to be a part of the national debate.

The retirement of the baby boomers over the next 20 years will create enormous pressures on the federal budget. Current tax and spending policies are unsustainable. We will either have to cut substantially benefits for older Americans – the largest component of the Federal budget – or raise more revenues.

There is no political consensus on the correct mix of spending cuts and tax increases, but it is hard to imagine any politically acceptable solution that will not include some increase in revenues as a share of GDP.

Unfortunately, our tax system is too complex, includes within it too much hidden spending and is incompatible with a globalized economy. Simply raising rates on existing tax bases will only make matters worse. If more revenue is to be raised, we need a better tax system. The main components of such a reformed system would be:

Less needless complexity In a complex economy like ours, it is impossible to have a simple tax system that is also fair and even-handed in its treatment of taxpayers with similar incomes. But our tax law is much more complicated than it needs to be for any rational purpose.

For example, we don’t need multiple and overlapping incentives for higher education and retirement saving and we certainly don’t need to require taxpayers to calculate their taxes two different ways (the regular tax and the alternative minimum tax) just to limit a few tax breaks.

Tax breaks can be wasteful spending, too

Seth Hanlon is Director of Fiscal Reform at the Center for American Progress, a Washington think tank. The opinions expressed here are his own.

This is part of an ongoing series on tax reform ideas. Where do you stand? Come back regularly to be a part of the national debate.

The new GOP majority in the House says that it wants to cut wasteful spending.  But it is poised to vastly expand some of the least effective kinds of government spending: Programs that dole out special tax breaks.

By changing House rules, Republican leaders have exempted newly proposed tax breaks from scrutiny or budget discipline — even as they decry our long-term structural deficits. At a time when we should be scouring the tax code to close loopholes, they have declared it open season for tax lobbyists who want to open up new ones.

The United States will never solve its budget challenges with a tax system that gives away as much money in special tax breaks as it collects in revenue. But that’s precisely what ours does today. And if the proliferation of tax breaks accelerates, we’ll find ourselves deeper in debt, even with devastating cuts to other parts of the budget.

“Most federal non-defense spending, other than Social Security and Medicare, is now done through special tax rules rather than by direct cash outlays,” writes Martin Feldstein, former president Reagan’s top economic adviser.  “When it comes to spending cuts, Congress is looking in the wrong place.”

Tax expenditures — the special deductions, credits, and exemptions that steer subsidies to certain businesses and individuals — cost about $1.1 trillion each year. That’s more than twice as much as all non-security discretionary spending, which is the only area of the budget that Republican leaders have targeted for budget savings.

Kill the mortgage deduction and give it to entrepreneurs

Somehow I don’t think President Obama had the home-mortgage interest deduction in mind when he mentioned the U.S. tax code before the U.S. Chamber of Commerce this week.

Yet winding down and eliminating this write-off for homes would be good for business. It’s unfair, doing nothing to revive the housing market and can be put to better use shifting it to entrepreneurs to create jobs.

Most of the job creation in the U.S. economy comes from small businesses, which typically have no public shareholders to sate and are not primarily interested in fattening pay packages of overpaid executives.

The home mortgage deduction needs to go because it doesn’t make housing less expensive, either. If anything, it makes homes more expensive because the subsidy inflates prices. Most homebuyers don’t even itemize to take advantage of it. Nixing it would make homes more affordable.

As Alan Mallach, senior fellow at the Center for Community Progress, wrote in this space: “It is one of the most regressive parts of the tax code, since it affects all house prices, including the price of houses bought by lower-income home buyers, who rarely itemize and get little benefit from the deduction.”

Mallach cites one study found that “barely 10 percent of homeowners earning less than $30,000 take the deduction, but they pay higher prices for their homes to benefit more well-off homeowners. On top if this, it is projected to add $120 billion to the federal deficit next year.”

Will getting rid of the write-off deep-six the already flagging U.S. home market? Mallach noted that Italy pared its residential housing deduction in 1992 and maintains a higher home ownership rate than the U.S.

Write a separate check for IRA fees, save big

If you’re getting investment advice for your Individual Retirement Account (IRA), Roth IRA or Rollover IRA, you’re probably paying for it, even if the charges aren’t obvious. But by making that payment explicit, and covering it with funds from outside of your retirement account, you can magnify your retirement savings and get an extra tax deduction, too.

That’s because the Internal Revenue Service has ruled that money paid to financial advisers for managing IRAs doesn’t have to count against the annual IRA contributions limit. Put simply, if the fee you’re paying to your adviser is a wrap fee, or a fee calculated as some percentage of the assets your adviser is managing, you can write a separate check for it and not allow it to deplete your retirement account. If, instead, your adviser is compensated by trade-related commissions, you can’t separate them from your account and take advantage of this break.

The recent ruling, which came in the form of a letter to an investment firm released by the IRS on January 28, 2011, reiterates a position the IRS has taken before. As is typically the case with the so-called private letter rulings, the name of the company that requested the ruling is not released, and the findings only apply to that particular letter writer. But this isn’t the first time the IRS has taken this position, says Bob Trinz, an analyst with the Tax & Accounting business of Thomson Reuters. “As a practical matter, you can do this,” he said.

That presents planning opportunities that are especially potent for Roth IRA  holders, says Ed Slott, an IRA expert and editor of Ed Slott’s IRA Advisor, a newsletter. By writing their check to their money manager from outside funds, they avoid depleting the funds in their tax-sheltered account. And the fees they pay can be deductible as miscellaneous expenses. That means they aren’t deductible until they exceed 2 percent of adjusted gross income, but these fees can be significant. For example, someone with a $1-million IRA paying 1 percent of assets under management to their adviser would pay $10,000 a year in fees.”By paying that from outside, you’ve added $10,000 to your IRA that would otherwise have been spent on fees,” says Slott. “And the tax deduction is like gravy.”

Not everyone will choose to write the separate check. If you’re close to the withdrawal-phase of retirement, it might make sense to let your adviser pull her fee from within the account. That’s because money withdrawn from a tax-deferred IRA is subject to income tax. Paying the broker directly from within the account wouldn’t necessarily create a taxable event; pulling the money out first and then writing the check would cause a taxable distribution to you.

The ruling does provide one more bit of impetus to switch away from a commission-earning adviser to one who charges fees instead. Investors seeking conflict-free advise have been moving in that direction anyway.

Finally, the separate-check for fees approach offers one more benefit to investors. It will show you in stark relief, how much you’re actually paying for that advice. The obvious next step? Deciding whether it’s worth it.

Fed benefits gap draws LGBT ire

Herb Burtis and John Ferris met while both were undergraduate music students at Michigan State University in 1948. Burtis was 18, and Ferris was a 22-year-old veteran of the U.S. Army. They studied with the same organ teacher and connected initially through their mutual love of music

Burtis and Ferris committed to one another and ultimately spending 60 years together. They were married in 2004, after Massachusetts became the first state in the country to legalize same-sex marriage.

“I told him I was only marrying him for his benefits,” Burtis recalls with a laugh. At the time, he was just kidding about the benefits– but it turned out to be no laughing matter.

Ferris was diagnosed with Parkinson’s disease in 1992, and he died of the slow-moving disease in August, 2008. Both Herb and John enjoyed careers as accomplished musicians and teachers, but John had the better-paying job, working for 32 years as university organist and choirmaster at Harvard University. Herb held similar posts at a church in New Jersey, performed internationally and worked independently as a voice teacher. The two owned a home together in western Massachusetts.

Many employment benefits are geared to employee earnings history. But married couples often can take advantage of policies that allow lesser-earning spouses to tap the benefits of the higher-earning partner. That option often isn’t available to LGBT couples – including those who reside in one of the five states (and District of Columbia) that currently have legalized marriage for same sex couples. That’s because the Defense of Marriage Act (DOMA) of 1996 defines the word “spouse” as applying only to different-sex married couples for any purpose involving interpretation of federal law.

DOMA blocks Burtis’ access to one of the most important features in the Social Security program – the survivor benefit. Under Social Security’s rules, when a spouse dies, the survivor is entitled to receive the greater of his or her own benefit, or 100 percent of the spouse’s benefit – including any cost-of-living increases the spouse has received along the way. In Burtis’ case, that means foregoing about $700 in monthly benefits.

Burtis is one of a group of Massachusetts residents who are plaintiffs in a lawsuit challenging the constitutionality of DOMA. Gill et al. v. Office of Personnel Management argues that the federal government’s exclusion of legally-married same sex couples is a violation of the Constitution’s equal protection clause. The plaintiffs are seven married couples and three widowers affected by federal marriage discrimination. A federal court judge ruled in the plaintiffs’ favor last summer, and the case is on appeal.

Do your tax homework for better mutual fund returns

The mutual fund portions of your 2010 income tax returns aren’t just about taxes. You can use the annual tax forms you received from fund companies to improve future investment results. Here’s how:

* Confirm that your total fund assets are suitably allocated among the three broad asset classes — stocks, bonds, and cash reserves — for somebody your age and in your circumstances. If they aren’t, your analysis should persuade you to rebalance your portfolio.

* Determine whether funds you own in taxable accounts are underperforming on an after-tax basis because their portfolio management practices tend to increase your tax bill.

Rebalancing fund assets. In a recent Prism Money post, Year-end planning: the 2011 fund outlook, I raised the possibility that rebalancing had become desirable for investors with an overweighting in bonds after rushing to bond funds or stocks after equities rose a lot.

To see how your fund assets were allocated at the end of 2010, copy the total value of each account, which you find at the bottom of every year-end statement, into one of three columns: stocks, bonds, and money market. Then add each column and calculate the percentage of your total fund assets that each column’s total represents.

If you own a mixed-asset fund, divide its year-end value according to how its assets were divided between stocks and bonds; you usually can ignore the cash. For percentages, you need to go to its website.

How much of your assets should be in stocks now? There never is, of course, one answer.

Taxes: It’s good to be average

Taxpayers who stand out tend to draw the attention of Internal Revenue Service auditors. Claim too much in interest, health expenses or charitable deductions, and it’s like waving that proverbial red flag in front of the tax man.

The agency knows, to the dollar, how much people at your income level typically write off for these categories. When you claim a higher-than-average amount, it doesn’t necessarily mean that you’re cheating, but it raises questions. You could be claiming a much higher medical deduction because your family had a horrible year, healthwise. And that over-the-top charitable write-off could just signify your extreme generosity.

But it might also signal that you’re not claiming enough income to cover the vast amount you say you’re paying in deductible expenses, so a really out-of-whack Schedule A (where deductions are claimed) can cause problems.

None of that has stopped Americans from making the most of their deductions, according to CCH, a tax research firm. In 2007, the last year for which these statistics are available, the average return claimed $26,268 in itemized deductions, up 4.5 percent from 2006. For example, returns claiming between $50,000 and $100,000 in income claimed, on average, $7,102 in medical expenses; $6,050 in state and local taxes; $10,659 in interest and $2,693 in charitable deductions, according to the firm, which crunched IRS data to compile these figures.

Being way above average doesn’t mean you should leave cash on the table, it just means that you should be extra careful about documenting the deductions and income that you have. And if you’re way under average, you might go back over your credit card statements and checking account records to make sure you’re not forgetting items you should be claiming.  Check out the table below to see what 2007 deductions looked like in your tax bracket.

Time to end the mortgage interest tax deduction

Alan Mallach is a senior fellow at the Center for Community Progress and a visiting scholar at the Federal Reserve Bank of Philadelphia. The opinions expressed here are his own.

This is part of an ongoing series on tax reform ideas. Where do you stand? Vote below and come back regularly to be a part of the national debate.

If someone proposed a tax “reform” designed to push house prices up and encourage buyers to borrow to the limit of their ability at taxpayers’ expense, it is unlikely that they would get much support. Yet that is precisely what the home mortgage interest deduction does.

The research evidence is in. No matter what real estate agents say, there is no evidence it encourages home ownership overall. When it comes to home ownership rates in developed countries, the United States is roughly in the middle of the pack, about the same as Australia and Canada, which don’t have a similar deduction. Italy abolished its deduction in 1992, and still has a much higher home ownership rate than the U.S.

The deduction does two things. First, by changing the relationship between the sticker price of the house and the actual carrying cost, it pushes prices upward and encourages people to buy bigger, more expensive houses. Second, it encourages them to borrow more instead of putting more of their savings into home buying, because in essence they get a federally-financed rebate on every dollar they borrow.

It is one of the most regressive parts of the tax code, since it affects all house prices, including the price of houses bought by lower-income home buyers, who rarely itemize and get little benefit from the deduction. One study found that barely 10 percent of homeowners earning less than $30,000 take the deduction, but they pay higher prices for their homes to benefit more well-off homeowners. On top if this, it is projected to add $120 billion to the federal deficit next year.

The mortgage interest tax deduction distorts the American economy; penalizes the nation’s lower income home buyers; and, moreover, costs the U.S. an amount equal to the total discretionary spending of the departments of Agriculture, Education and Housing & Urban Development.

Will 2011 be a year of state tax increases?

It’s hardly a secret that state budgets are tight. Still, when budgetarily-beleaguered Illinois raised its individual income tax rate to 5 percent from 3 percent, it raised eyebrows — and questions about what other states might follow.

The Tax Foundation, in a recent research report, notes that fewer states raised taxes in 2010 than had been expected to do so, but that with the temporary federal stimulus aid ending mid-year and many states in budgetary trouble, “2011 may be a year of dramatic tax increases.”

“So far, the big news has been Illinois,” says Joseph Henchman, the Tax Foundation’s director of state projects and author of the report. “It is at one extreme in state budgets, but other states are piling up debt right now, and not solving their problems.”

Among the states facing budgetary problems are California, New York, Pennsylvania, Wisconsin, Ohio, Washington and Maryland, Henchman says. Whether these states will follow Illinois, or get creative on raising funds in other ways, remains to be seen. New York’s newly-elected governor, Andrew Cuomo, a Democrat, for example, has pledged no new taxes.

“I’m not sure you’re going to see a lot of rate increases given the political pressures, so states are going to have to find other more creative ways [to find cash],” says Stuart Rosow, a tax partner at Proskauer. “It may also depend how desperate the state is. I think the bellwether will be California.”

States typically do anything they can to bring in cash — fees, sales taxes, sin taxes, etcetera — before raising income taxes. In 2009, according to the Tax Foundation, 18 states raised cigarette taxes; another seven followed in 2010. New York’s cigarette tax, the highest in the country, is now $4.35 a pack.

Last year, Rhode Island legalized fireworks, boosting sales-tax revenues by some half-million dollars, and a flood of states got in on Powerball and Mega Millions to raise funds. This year, Washington state considered, and then ditched, a plan to require people to pay to park on state beaches, while New York has proposed a 2.75 percent surcharge on purses at horse races around the state.

Don’t lose retirement money with a rollover mistake

Elizabeth Kinkel, a 27-year-old architect in Washington, D.C., let her 401(k) with her former company languish after she was laid off in 2009. “I forgot about it,” she says. By the time she pulled her money out of the 401(k) and reinvested it in a Roth IRA, her $6,000 had lost about $1,500 in value.

Kinkel isn’t alone. Due to layoffs and job changes, many individuals have left several unattended retirement accounts scattered in their professional wake. Regardless of what often keeps people from taking action — procrastination, indecision or confusion — it’s important to consolidate retirement accounts.

“Having multiple employer plans makes for difficult reporting and understanding how your portfolio is allocated,” says Phillip C. Lee, a fee-only certified wealth manager at Modera Wealth Management. It also makes estate planning much more complicated. “It is far easier to change the beneficiary of one [Individual Retirement Account] compared to six former employee retirement accounts,” says Lee.

It isn’t difficult to consolidate and roll over retirement accounts. In fact, the process itself has been streamlined, and at many companies today, you can do it entirely online, says Taren Coleman of Coleman Financial Group. “The biggest issue is processing the transfer of funds without triggering any current taxes” and Internal Revenue Service (IRS) penalties, she says.

First, you either need to open an IRA or have an existing IRA available so that the rollover money has some place to be deposited. Next, you want to make sure you don’t “handle the funds directly (i.e. having the check made out to your own name) as that would be considered a taxable distribution and would trigger tax withholdings,” says Lee.

Call up your former employer’s custodian and request a trustee-to-trustee transfer for a direct rollover. In this case, the check is made payable to the financial institution that holds your IRA — not to you. The check will be mailed directly to your IRA financial institution. Ask the originating trustee how the funds will transfer into your IRA so you know what to expect. “In order for the rollover into the IRA to continue to be tax-deferred, the funds must be deposited in the account within 60 days,” says Lee.

Sometimes, people make the mistake of letting the check come to them. Even if they roll it over within the 60-day window, there is a 20 percent withholding penalty. “If the money just goes from the employer and you don’t touch it, there’s no taxes,” says J.J.Montanaro, a certified financial planner at USAA Financial Planning.