Tax Time

How Congress spells relief

Michael W. Lynch from the March 1998 issue

On a dreary day early last November, some 350 Smith Barney clients crowded into a Virginia conference room to hear from experts just what the "Taxpayer Relief Act of 1997" will do for them. What they discovered--and what you will discover, too--is that most of the act's relief has been reserved for accountants and tax lawyers, who will earn plenty for poring over the details of the 300-plus-page bill. "If this is a relief, I would hate to see what they were going to do to me if they were going to make things hard," one certified public accountant told the Smith Barney crowd.

Rife with exceptions, exemptions, exceptions to exemptions, and myriad time and income-level thresholds, this law is a case study in why Washington politicians, even when trying to provide taxpayers with some relief, are incapable of doing so. On prominent display are two of Washing-ton's central operating principles.

First, political capital is maximized when every dollar in Washington appears to be spent more than once. This principle is apparent in complicated provisions that sound soothing when reported on the nightly news--"Americans can now set aside tax-free money each year for their children's education"--but are so narrowly tailored and poorly designed that in practice they will do little good for anyone.

The second principle embodied in this act concerns political wealth: It is created by passing out benefits today and pushing off the costs into the future. It is the inverse of wealth creation in the private sector. It is exemplified by the practice of frontloading perceived benefits and backloading real costs, something Republicans railed against while out of power but managed to come to terms with after settling into committee chairmanships. They've decided that Americans send their representatives to Washington to pass out candy, not to administer medicine.

Consider the much-touted expansion of Individual Retirement Accounts. Congress and the president want us to save. As a prod, they've now given us five IRAs: the traditional, deductible IRA; the non-deductible IRA; the rollover IRA; the Roth IRA; and the Education IRA. The last two are this year's additions.

The Roth IRA--named after William V. Roth (R-Del.), the Senate Finance Committee chairman who championed it--is a perfect example of passing the bill to future Congresses. With traditional tax-deferred IRAs, money goes in tax-free, accumulates interest tax-free, but is then taxed at time of withdrawal. For the Roth IRA, the deposits have already been taxed, but both the earnings and withdrawals are tax free. Congress is encouraging people to convert (or roll over) their traditional IRA to a Roth IRA by allowing individuals to spread the federal taxes owed over four years. Why? For the simple reason that it would pocket the taxes paid on the current balances, while making up the forgone income is a problem for future Congresses.

Thus, not only does the Roth IRA not cost this Congress anything, but--if people take the rollover bait--it gives legislators more money to spend. Since burgeoning revenues and shrinking deficits are already leading to bipartisan talk of increased government spending, that's actually dangerous.

Then there are the education incentives, which come in highly qualified and mutually exclusive packages: the Hope Scholarship Tax Credit; the Lifetime Learning Tax Credit; and the Education IRA.

The Hope Scholarship Tax Credit is a good deal for couples who earn under $80,000 a year. (All income thresholds refer to gross income.) Spend $2,000 on your child's college education, and you will receive a $1,500 credit on your taxes. This is good for the first two years of college (unless your child is convicted of a drug felony) and is available in 1998.

After June 1998, the Lifetime Learning Tax Credit kicks in, letting taxpayers claim a credit of up to $1,000 for the first $5,000 they pay out of pocket for higher education, including graduate school. Then there's the Education IRA, a nifty vehicle which allows any individual with annual earnings of no more than $95,000 to contribute up to $500 each year to an IRA dedicated to any child's college education. The contribution is taxed, but interest accrual and expenditures are tax-free.

These incentives may seem generous, but given Washington's imperatives, the whole is literally less than the sum of its parts. For starters, the Education IRA's $500-per-year cap is low, and the money can't be combined with the other two tax credits. If you plan to claim the Hope Credit or the Lifetime Learning Credit, any expenditure from the Education IRA will be taxed--which means Washington gets a cut when the money goes in and another when it comes out. In addition, the income cap is on contributors, rather than the child's parents, which prohibits generous individuals who earn more than $95,000 a year from setting up Education IRAs for needy children.

None of these restrictions makes sense if the goal is to increase educational opportunity. They make perfect sense, however, if the goal is to appear to expand opportunity while giving up as little as possible.

Investors will face the law's absurdities when filing their 1997 taxes. We know that capital gains taxes have been reduced, but there is disagreement, even among experts, as to how much.

"They [Washington's politicians] say the rates have come down to 20 percent," the CPA explained to Smith Barney's clients. "This is really a misconception... there are really five rates."

Not according to Ric Edelman, author of the best-selling The Truth About Money and founder of the Edelman Financial Center in Fairfax, Virginia. "Thanks to the new law, there now are not one, not two, but nine capital gains tax rates, and to make matters worse, there are lots of conditions, exceptions and exclusions," writes Edelman in a special edition of his newsletter. (For a third opinion, The Ernst & Young Tax Saver's Guide 1998 claims to have found eight rates.)