Since the tax increases that Congress recently enacted won’t solve all of the country’s financial woes, it seems very likely that many popular tax deductions that have been around for as long as I can remember may be on the way out. With any tax deduction, the primary beneficiaries are those taxpayers who have the greatest income. This result is due, obviously, to the fact that our Tax Code is graduated, meaning, the more income you make, the greater the tax bite on the next dollar of income that you earn.
One very popular tax break that may get the ax is the current tax-free nature of employer-provided health insurance. The Kaiser Family Foundation recently estimated that more than 150 million of us get tax-free health insurance provided for us by our employers. Were those benefits to be taxed, the federal government would suddenly find itself with an additional $150 billion of our money to spend every year. Rather than eliminate this tax benefit entirely, the federal government may decide to gradually include the cost of these benefits into the taxable income of taxpayers above a certain threshold of income, say $250,000.
Another deduction that I believe will get a trim job, at the minimum, is the current deduction for mortgage interest. Under the present tax provisions, interest on residence loans of less than $1 million is deductible. The current benefit extends to second homes as well, as long as the total indebtedness does not exceed the $1 million threshold. Watch for Congress to reduce the maximum permitted loan amount down to, say, $500,000, or the deduction could be phased out, again, for those whose incomes exceed a threshold amount. Moreover, I believe that we can say goodbye forever to the deduction for second home mortgage interest.
Sadly, the deduction for charitable contributions may well be reduced or even eliminated. I suspect the Congress will do something like limiting the deduction to those contributions above some percentage of AGI. For example, medical expenses above 7.5 percent of one adjusted gross income are deductible for 2012. A similar approach could be adopted for contributions to charity, or the deduction could be phased out gradually as income goes up.
Currently, 4 million of us who must pay the Alternative Minimum Tax are not permitted to deduct our state and local tax outlays. Since this deduction totaled some $260 billion in 2010, I believe that taxpayers of every income ilk may be forced to say “Adieu” to the deduction for state and local taxes.
Investors in high-tax brackets have long favored municipal bonds since the interest that such bonds generate is currently exempt from federal taxation. Interest from bonds issued by South Carolina municipalities is also exempt from S.C. income taxes. In those states with high state tax rates, the total tax leverage from these bonds can be huge.
One way that Congress could curtail this tax benefit is to limit its maximum value to those in tax brackets of 28 percent or less. That would mean that an investor in the 39.6 percent bracket would pay an 11.6 percent tax rate on municipal bond interest. Since the current exclusion of this bond interest costs the federal government about $50 billion this year and since this treatment benefits primarily the wealthy, I believe that it will definitely be reduced or eliminated going forward.
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Greg Roberts is a certified financial planner with 35 years of financial and estate planning experience.