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Warning: Tax-cut debate may cause whiplash

After weeks of Washington back-and-forth, President Obama and GOP leaders have reached an uneasy agreement. But will what helps families now hurt them later?

By Money Staff Dec 8, 2010 7:40PM

This post comes from MSN Money's Liz Pulliam Weston.


Liz Pulliam WestonI'm feeling some tax-cut whiplash.


A couple of weeks ago, my husband and I were contemplating a tax bill that would rise at least $6,500 next year if the Bush-era tax cuts expired or weren't extended for households, including ours, that make over $250,000.

Today, we stand to benefit from a deal that not only preserves our current tax breaks, but also gives us an additional $4,200 tax cut -- a giveback much bigger than that enjoyed by the vast majority of workers.


What the hell?


President Barack Obama says tax breaks for the middle class were being held hostage by congressional Republicans. And it would be a severe blow for many working families if the Bush-era tax cuts were allowed to expire. A family with two children making $40,000 a year could have seen its paychecks shrink by $165 a month, according to the Tax Policy Center.


Under the deal, that won't happen. But Obama was unable to secure an extension of another tax break for middle class families: the Making Work Pay credit, which boosted the paychecks of singles who earned less than $75,000 and couples who earned less than $150,000 by about $400 per worker.


Instead, Obama and the Republicans agreed to a one-year cut in payroll taxes. Instead of paying 6.2% of your pay to Social Security, you'll pay 4.2% next year.


That's a better deal for most families, at least for one year. A family making $40,000 will pay $800 less and a family earning $80,000 will pay $1,600 less.


But it's quite a windfall for high-earning households like ours, which made too much to qualify for the Making Work Pay credit. Since both my husband and I make more than the Social Security cap -- the maximum wages on which you have to pay the tax is $106,800 -- we’ll each save more than $2,100.


I wasn't exactly relishing paying more. But giving a bigger tax cut to families like mine makes me uneasy -- and it should make you uneasy as well.


Federal tax burdens are close to the lowest they've been in decades, thanks largely to the Bush-era cuts. The median-income family of four paid 5.9% of its income in federal individual income taxes in 2007, slightly higher than the all-time low of 5.3% in 2003, according to the Urban Institute-Brookings Institution Tax Policy Center.  The "effective tax rate" for the median-income family was lower in 2007 than in any year between 1956 and 2002.


But the real plunge has been among high earners. A family in the top 1% of earners has seen its total federal tax rate drop from 41% to 30% in the past decade.


A lower tax rate means you get to keep more of your money to spend, save and invest as you choose -- which is good for you and likely good for our struggling economy as well. But looming deficits will have to be paid for somehow, someday, and it’s unlikely spending cuts alone will balance the budget. The longer we ignore that fact, the sharper the tax increases we're likely to face down the road.

There's also a real concern that the payroll tax holiday could become permanent and cripple Social Security. In the past, I've advocated for payroll tax reductions, since so many working people pay little in federal income taxes and don't benefit much when income taxes are cut. But I've come to realize that gutting Social Security's funding is a bad move, given how many people will need this program to retire at all.


Derailing this deal isn't the answer, since too many families would suffer -- not just those whose income taxes would rise, but also the millions of unemployed whose benefits are running out and would be extended under the compromise.


But I suggest you start preparing for higher rates now. Take the extra money you'll be getting from the Social Security tax holiday and stick it in a Roth IRA. You won't get a tax break up front, but your contribution and gains will be tax-free in retirement. If taxes are significantly higher then, as I'm betting they will be, you'll be thankful you did.


Liz Pulliam Weston is the Web's most-read personal-finance writer. She is the author of several books, most recently "Your Credit Score: Your Money & What's at Stake." Weston's award-winning columns appear twice weekly, exclusively on MSN Money. She also answers reader questions on the Your Money message board and helps middle-class families cope at Building a Brighter Future.


More from MSN Money:

Dec 9, 2010 9:20PM

The Democrats knew all along that these tax breaks were going to expire and yet they waited until December 2010 to make any serious effort to extend them.


Now they're complaining that they didn't get the deal they wanted. Nonsense. They could have easily passed a middle-class extension in the months following the 2008 elections but instead chose to ignore the issue.


I might add that letting the estate tax lapse in 2010 was a huge giveaway to some upper-rich families and also grossly unfair to those paying the tax in prior and subsequent years.


Are these people even awake? My sympathies go to the struggling middle and lower income families who spent their Thanksgiving stressing about a looming tax increase...

Dec 9, 2010 11:10AM
The primary benefit of a ROTH IRA is if your marginal tax rate post-retirement is significantly higher than your rate when contributions were made. Unfortunately, those who are most at risk of being in a higher bracket post-retirement are high earners - the very group that is prohibited from making ROTH contributions due to the contribution phase-out! Boggles the mind that very few people have figured this out!
Dec 9, 2010 11:04AM
Hey Liz, great idea about the ROTH IRA contribution - except that those of us who actually make as much as you do CAN'T make a ROTH IRA contribution because the government says we make too much to do so. ROTH IRA contributions phase out for a couple with AGI over $177k or singles with AGI over $120,000. How about you lobby Congress to eliminate the phaseout for ROTH's?
Dec 9, 2010 10:40AM
Seriously Liz, cry me a river.  If you must assuage those internalized voices telling you to don sackcloth and ashes, as the others said, you can fill out the donation line on your next tax return -- or better yet, give it to a real charity that operates with far greater transparency and efficiency than the government.  Charity contributions from the top earners are supposedly down 30% due to the recession (information I believe I found on MSN Money of all places!) so they would hardly complain about benefitting from your windfall.  Do that, or go support your favorite local business.  Then you will have gotten the point of the tax cut.
Dec 8, 2010 9:34PM
I can appreciate these tax breaks while the country tries to turn the economy around.  Taking more of my money in the form of taxes only forces me to spend less further hurting the economic recovery.  This move by the administration will keep the money flowing and prevent further job losses.  If anyone feels guilty about not having to pay more taxes, then by all means, write a check to the government.  After many yrs in school, training, and sacrafice, I make a good living to support my family.  I don't think I need to endure another tax  penalty because I made good choices and am successful.  The government needs to stop spending so much money and be as smart with their money as we all are with our family budgets.  I am finally happy with President Obama for looking out for our best interests as Americans. 
Dec 8, 2010 9:02PM
Then give the money back or give it to a worthwhile charity.
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