Stealth Taxes: They go in, but will they ever come out?

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For 2006, there are six tax brackets: 10 percent, 15 percent, 25 percent, 28 percent, 33 percent and 35 percent. But these seemingly simple numbers can pack a hidden wallop.

More than 90 percent of the households in the country are dunned for taxes at the three lowest rates of 10 percent, 15 percent and 25 percent. But what about those who are taxed at the three highest rates of 28 percent, 33 percent and 35 percent?

They should know that these official rates frequently are less than the true top rates for millions of upper-middle and high-income individuals. Their marginal rates are boosted by cleverly concealed tax hikes that went on the books in 1991 and were immediately labeled “stealth” or “backdoor” hikes because their effect is to exact more taxes without raising rates. They work their mischief with a double whammy on affluent individuals who are deemed to be undeserving because their AGIs (adjusted gross incomes) are above specified amounts.

First, their dependency exemptions are phased out, that is, gradually reduced. Second, there’s a limitation on most of their itemized deductions. Both curtailments are indexed, meaning adjusted annually to reflect inflation, same as the tax brackets and standard deduction amounts. Exemptions begin the phasing out process when AGI exceeds designated amounts. For 2006, the AGI is $150,500 for singles; $225,750 for joint filers; $188,150 for heads of household; and $112,875 for married persons filing separately. The exemptions vanish altogether when AGI is greater than $273,000, $348,250, $310,650 and $174,125 for singles, joint filers, heads of household and married persons filing separately, respectively.

There’s a partial disallowance of allowable write-offs for most itemized deductions when AGI surpasses a specified amount. For 2006, it’s $150,500. The $150,500 figure drops to $75,250 for married persons filing separately. Going that route doesn’t raise the threshold for a couple to a combined $301,000. Generally, the disallowance is 3 percent of the amount by which AGI exceeds the specified amount. Put another way, every $1,000 of AGI above the specified amount causes the loss of $30 in total itemized deductions.

The 2001 tax act abolished these stealth taxes, but not right away and maybe not at all. The repeal is phased in, which is IRS lingo for a law change that becomes effective gradually, or only after several years elapse. What the 2001 legislation did was start a gradual elimination of the automatic cutbacks in 2006 and finish the job in 2010, which is equivalent to further reducing the top rates by about 1 percentage point, and, as a sort of congressional afterthought, actually simplified the tax code.

On returns for 2006 and 2007, the required disallowance for exemptions and itemized deductions is just two-thirds of what would otherwise be disallowed. On returns for 2008 and 2009, the required disallowance is just one-third of what would otherwise be disallowed.

In the meantime, stealth taxes remain on the books, at least through 2009. And who’s to say that ballooning budget deficits won’t provide Congress with a reason to renege on the cancellation before 2010? After 2009, the cancellation expires or “sunsets,” meaning stealth taxes will be resurrected to what they were before passage of the 2001 act, unless Congress moves to abolish them again.