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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 10, 2010 1:23PM

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.


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Dec 24, 2010 1:07PM

Ms weston says, what the hell!

Treasury will accept her check, all she needs to do is explain she isn't paying enough.

We all know they will use it wisely.

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