The Basics of President Obama's State of the Union Tax Plan

January 21, 2015

Last night during the State of the Union address, the president spoke briefly about taxes:

“Let’s close the loopholes that lead to inequality by allowing the top one percent to avoid paying taxes on their accumulated wealth. We can use that money to help more families pay for childcare and send their kids to college. We need a tax code that truly helps working Americans trying to get a leg up in the new economy, and we can achieve that together."

Prior to the speech this past weekend, the president released details of his tax plan. The President’s proposed changes would increase taxes on investment income and end some tax programs in order to pay for new and expanded tax programs aimed at lower and middle income families.

Proposed Tax Increases

According to reports, the president’s proposal includes $320 billion in tax increases over ten years.

Increases Capital Gains and Dividend Tax Rate to 28 Percent

The largest tax increase in the president’s proposal is an increase in the capital gains and dividend tax rate to 28 percent. The current top tax rate on capital gains and dividends is 20 percent plus the 3.8 percent investment surtax from the Affordable Care Act, for a total of 23.8 percent.

This makes it unclear whether the president proposes an increase from 20 percent to 28 percent (for a total of 31.8 percent) or 20 percent to 24.2 percent for a total of 28 percent. Recent reports point towards a total top rate of 28 percent (24.2 percent plus 3.8 percent).

Ends “Stepped-Up Basis”

Currently, when a person who owns a stock passes away and bequeaths that stock to his or her heir, the basis of the stock is adjusted (“stepped up”) to the value at the time of the transfer. For example, say your relative buys a stock for $1 and the value of the stock has increased to $10 by the time of his or her death. Stepped up basis would minimize the capital gains tax for the heir by classifying the base for the gain as $10, instead of $1.

The president’s proposal would eliminate this adjustment which would make the heir liable for tax at the time of the transfer (in the case above, a tax on the $9 in capital gains). The proposal would treat all bequests and gifts as realization events, meaning that the new rules would not apply only to inheritances.

The proposal includes an exemption on capital gains up to $100,000 for an individual ($200,000 for a couple). Additionally, the proposal would allow for an exemption of $250,000 per person for personal residences ($500,000 for a couple).

For estates that do not qualify for the estate tax (those under $5,250,000), the elimination of stepped-up basis creates a new, 28 percent estate tax of sorts for lower income individuals. For the estate that are already liable for the 40 percent estate tax, this adds an additional tax to the heir’s estate tax burden.

Creates a Bank Tax

The president’s proposal would create a 0.07 percent tax on the liabilities of financial firms with assets over $50 billion. The White House estimates that this would hit around 100 firms in the U.S. This is similar to a bank tax included in former Rep. Dave Camp’s tax reform plan.

Places Limits Retirement Accounts

The president’s proposal would create a cap of $3.4 million on retirement plans and IRAs. This means that taxpayers would no longer be able to use tax-neutral savings accounts once they reach these limits.

Limits to Education Savings Accounts and Student Loan Interest Deductibility

President Obama’s plan would alter the tax structure of 529 plans, used to save for college. Currently, parents can save $14,000 a year in after-tax income for a child and the child can spend that money on their education without paying taxes (similar to a Roth IRA). The president’s proposal would eliminate the neutral tax treatment in the account. Under his proposal, when the student spends the money for education they would face a tax on the withdrawal. This eliminates virtually all tax benefits of the 529 plan.

Additionally, the president proposes the elimination of student loan interest deductibility. The plan would protect interest deductibility of those currently paying student loans, but eliminate the deduction for future students.

Corporate Tax Changes: Worldwide Tax System and Lengthened Depreciation Lives

In his speech, President Obama touched on his plan to change the corporate tax system. Three key features of the president’s plan are a 28 percent corporate tax rate, a minimum tax on all foreign earned profits, and lengthening depreciation lives. The plan is projected to be a net tax increase on corporations.

Proposed Tax Cuts

The plan uses the revenue from these tax increases, which are directed towards high-income taxpayers (except for the changes to 529 plans, which hits the middle class), in order to cut taxes for the middle class.

A New $500 Tax Credit for Two-Earner Families

The president proposes a $500 tax credit for two-earner households. This credit would phase-in like the EITC at 5 percent per dollar earned by the spouse with the lesser income and would max out at $500 when the spouse earns $10,000. The credit would begin to phase out when a couple earns $180,000.

Expands the Child and Dependent Care Tax Credit

The current Child and Dependent Care Tax Credit reduces a family’s tax bill to defray the cost of child care. The size of the credit is based on family income and the family’s cost of child care. The maximum credit is $1,050 per child for those earning $15,000 and below. The credit phases down between $15,000 and $43,000 and has a minimum value of $600 per child.

The president’s plan would triple the maximum credit to $3,000 and make it available to families with higher incomes (up to $120,000).

Expands the Earned Income Tax Credit

The president’s plan would double the EITC for taxpayers without any children from the current $503 to around $1,000. The credit size for other eligible taxpayers would remain the same. In addition it will make the expansion to the EITC (and the Child Tax Credit) from the stimulus package permanent.

Consolidates Higher Education Tax Credits While Expanding the American Opportunity Tax Credit

Currently, the federal government has four separate tax benefits for college education: the American Opportunity Credit, the Hope Credit (currently superseded by the American Opportunity Credit), the Lifetime Learning Credit, and a deduction for tuition and fees.

The president’s plan would eliminate the Hope Credit, the Lifetime Learning Credit, and the tuition and fees deduction, leaving only the American Opportunity Credit.

The American Opportunity Credit would then be expanded by increasing the refundable portion to a flat $1,500. The credit would also be expanding to part-time students and allow taxpayers to claim the credit for five years.

Finally, the value of a student’s Pell Grant would be excluded from Modified Adjusted Gross Income, meaning that Pell Grants will not reduce the size of the American Opportunity credit.

Exempts Pay-As-You-Earn Loan Forgiveness from Income Taxation

Under current law, a student can borrow money for college and pay back the debt over 20 years with their monthly loan payment capped as a percent of his disposable income. If the full value of the loan is not paid back of 20 year, the entire loan is forgiven. However, since the forgiven loan is essentially a windfall for the student, income tax is due.

The president’s plan would completely exempt the value of the forgiven loan from income taxation.

Creates Auto-Enroll Retirement Accounts and Encourage Businesses To Offer Retirement Plans

Currently, businesses can offer their employees the option to deduct a portion of their paycheck and deposit it into a tax deferred retirement account known as a 401(k). Although available, not all businesses offer them and sometimes when businesses do offer them, individuals do not opt-in.

The president proposes offering new tax credits to businesses that offer auto-enroll retirement vehicles. Employees that work for businesses that offer these “MyRA” accounts would be automatically enrolled and would have to opt-out. The size of the credit ranges between $1,500 and $4,500, depending on the size of the business and whether the business is newly offering a retirement plan, or is simply adding the auto-enroll feature.

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