Start now on 1991 income tax plan

Healthcare Financial Management, June, 1991 by William G. Kistner

For most people, tax planning is a year-end ritual of prepaying expenses, deferring income, and perhaps making a sound investment decision or two.

The Tax Reform Act of 1986 and subsequent tax law changes, such as those included in the Omnibus Budget Reconciliation Act of 1990 (OBRA 90), have complicated the tax planning process. The sheer volume of tax law changes since 1986 alone is cause for confusion. Consequently, it is not too early to consider a 1991 tax plan.

Although the highest marginal bracket for 1990 (31 percent) will be higher than in the past three years, some individuals will pay less Federal income tax in 1991 than in previous years. The highest marginal bracket for many taxpayers in the past year was 33 percent, and capital gain income will be taxed at no more than 28 percent.

On the deduction side, however, itemized deductions for 'high income" taxpayers must exceed a floor of 3 percent of adjusted gross income higher than $100,000. Because the Medicare component of the Social Security tax now has a wage base of $125,000 (as opposed to the Social Security wage base of $53,400), individuals with wage incomes of $125,000 or more can expect an additional payroll tax of $1,038.

As a result of OBRA '90, rules regarding tax planning will change for many taxpayers:

Distributions. Workers retiring in 1991 should carefully evaluate the tax rules on lump sum distributions from qualified pension and profit-sharing plans. Equally important for retirees covered by nonqualified deferred compensation plans is choosing a form of payment.

Because of relatively low 1991 tax rates (compared to 50 percent rates Of six years ago), a lump sum payment should be seriously considered by an employer if the plan permits.

Savings. Tax-sheltered annuities (TSA) and 401(k) plans still provide an excellent opportunity for tax-deferred savings. Because of potentially higher tax rates in 1991, amounts deferred today at 31 percent will generate a greater tax savings than amounts previously deferred at the 28 percent rate over the past three years. But because 1991 tax rates remain low compared to pre-1986 rates and with continued pressure to increase taxes as a revenue source, amounts deferred today may be taxed at a higher rate by the time of distribution.

Several options should be reviewed. First, rather than making contributions to a TSA or 401(k) plan, a taxpayer should consider making after-tax investments in tax-exempt securities. Upon maturity, the principal is returned free of tax.

Second, while the after-tax amount to invest in a municipal security will be less than the pre-tax amount contributed to a TSA or 401(k) plan, the yield on the tax-exempt security may be higher than the yield on a qualified plan.

Finally, a taxpayer could pay down consumer debt in lieu of making qualified plan contributions. Beginning this year, the interest on consumer debt no longer is deductible for tax purposes.

Deductions. Because of 1991's higher tax rates, the benefit of deductions has increased. As a result, a taxpayer's initial reaction may be to accelerate deductions to take advantage of the higher tax rate.

Two factors, however, will limit the deductible amount of itemized deductions:

* Medical and miscellaneous deductions carry limitations based on adjusted gross income. These limitations apply to afl taxpayers regardless of income level; and

* An overall limitation of 3 percent is placed on itemized deductions for taxpayers with adjusted gross income exceeding $100,000. Because the deductible amount of itemized deductions is controlled by an individual's adjusted gross income, a taxpayer should attempt to bunch deductions into a year when adjusted gross income is low.

* AMT rate. The alternative minimum tax (AMT) rate has been increased to 24 percent. With a 1991 maximum individual tax rate of 31 percent, the AMT rate may apply even without substantial preference items, such as miscellaneous itemized deductions, all itemized taxes, and personal exemptions.

Now that Congress and President Bush have taken the first step to increase taxes since the Tax Reform Act of 1986, future tax rate increases may be more easily accomplished. And overall limitations applied to itemized deductions takes the nation one step closer to a flat tax- on income. Along with tax increases and deduction limitations, OBRA '90 changes will complicate tax planning for most individuals.

These are just a few ideas to consider in developing a 1991 tax plan. Although 1991 is a higher tax rate year than recent years, it still is a year with substantial planning opportunities.

William G. Kistner, CPA, is a tax partner with Ernst & Young in Chicago, Hi. Reader's comments and questions are encouraged and can be addressed to: william G. Kistner, CPA, Ernst & Young, 150 S. Wacker Dr., Chicago, IL 60606.