The individual provisions of the Omnibus Budget Reconciliation Act of 1993.

On Aug. 10, 1993, President Clinton signed the Omnibus Budget Reconciliation Act of 1993 (the "1993 Act"). Although a few of President Clinton's original high-priority proposals--such as the investment tax credit and the broad-based Btu energy tax--ended up on the cutting-room floor, the broad outlines of his original plan remained intact: estimated deficit reduction of close to $500 billion over five years; some tax incentives and investment spending; cuts in defense and Medicare spending; an energy tax; and most of the additional tax burden falling on higher-income individuals.

This article will highlight the tax provisions of the 1993 Act that generally affect individual taxpayers, and provide planning ideas. Many of the provisions are complex and far-reaching, and may require immediate action.

Individual Tax Rates

Beginning in 1993, a new 36% tax rate applies to taxable income of more than $140,000 for a married couple filing a joint return ($115,000 for an unmarried individual). The existing 15%, 28% and 31% tax brackets continue to apply as under prior law.

A fifth tax bracket of 39.6%, referred to as a "surtax," applies to taxpayers with taxable income of more than $250,000, whatever their filing status. (Note: Married individuals filing separately will pay the surtax beginning at $125,000 of taxable income.)

As under prior law, capital gains are taxed at a maximum 28% rate (i.e., the surtax does not apply to capital gains).

The thresholds for the new 36% and 39.6% tax brackets will not be indexed for inflation until Jan. 1, 1995. Thus, for the 1994 tax year, the thresholds for imposition of the 28% and 31% tax rates will be adjusted for inflation from their 1993 levels, but the higher-rate thresholds will not be adjusted. All of the rate bracket thresholds will be indexed for inflation after 1994.

The current-law phaseout of personal exemptions and disallowance of a portion of itemized deductions are both made permanent.

* Observation

Taxpayers subject to the surtax (except married individuals filing separate returns) will face a marginal tax rate of at least 39.6%. A taxpayer will effectively face an additional 0.74% marginal rate for each personal exemption, to the extent exemptions are still being phased out above the surtax level of taxable income, and an additional 1.2% marginal rate if the scaleback of itemized deductions still applies when taxable income is above the surtax level. For example, a taxpayer with four exemptions would face a marginal income tax rate of up to 43.76%.

Also effective for 1993, the individual alternative minimum tax (AMT) rate is increased. The AMT rate is currently 24% on all alternative minimum taxable income (AMTI) in excess of an exemption of up to $40,000 on a joint return ($30,000 for a single individual). The rate is increased to 26%, with a second 28% bracket starting at $175,000 of AMTI in excess of the exemption. The maximum exemption is raised to $45,000 on a joint return ($33,750 for an unmarried person). There is no surtax on AMT liability.

* Observation

The increase in the top individual tax rates also increases the so-called marriage penalty/bonus (the difference in total tax liability of a couple filing as single taxpayers versus filing married on a joint return).

Example 1: B is a single father with two children; C is a single mother of one. Each earns $100,000, has $20,000 of itemized deductions and files as a head of household.

Under present law, their combined separate tax liabilities if both were to file as single taxpayers would be $33,814; if they marry and file a joint return, their liability would increase to $40,430, resulting in a marriage penalty of $6,616. Under the new law, their combined separate tax liabilities remain the same, but their married filing jointly liability would rise to $41,156, increasing their marriage penalty by $726 to $7,342.

Individuals who realize a marriage bonus under present law will in many cases increase that bonus under the new law.

Revised tax withholding tables are not planned for the remainder of 1993, and the 1993 Act waives 1993 estimated tax penalties resulting from the tax rate changes. Thus, individuals may compute their Sept. 15, 1993 and Jan. 18, 1994 estimated tax payments as if old-law rates were in effect but will need to make a catch-up payment by Apr. 15, 1994, the due date for 1993 individual tax returns.

However, because of the potential burden from imposing the higher tax rates retroactively, individuals can elect to pay the portion of their increased 1993 income tax liability arising from the new 36% and 39.6% rates in three installments, due Apr. 15, 1994, 1995 and 1996. The deferral election does not apply to increased liability due to the new AMT rates. Interest and penalties will not be charged on the deferred tax payments, but all unpaid tax will become due if an installment payment is missed. The election must be made on the 1993 tax return.

* Observation

Some states' income tax rates may also be retroactively increased as a result of the Jan. 1, 1993 effective date for Federal individual rate increases.

* Strategies

1. Taxpayers expecting to be subject to the new 36% and 39.6% marginal tax rates should consider investing more savings in municipal bonds. Municipal bonds generally are not subject to Federal income tax, and certain municipal bonds are not subject to state income tax.

2. The amount of income deposited in tax-deferred retirement programs should be maximized. If the employer sponsors a Sec. 401 (k) plan, consider making the maximum contribution permitted (for 1993, the maximum amount is $8,994).

3. If funds can be invested for an extended period of time, consider investing in tax-deferred annuities and life insurance investment products. The cash values of tax-deferred annuities accumulate tax free until payment is received. The increase in the cash surrender value of life insurance is not subject to income tax unless the policy is sold or surrendered.

4. Because the maximum tax rate on capital gains remains 28%, seek out investments that generate capital gains. Exchanging ordinary income for capital gains can increase the after-tax rate of return by 19%.

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