How to live with tax reform until next round

Tax reform will, in all likelihood, live longer than a mosquito. How much longer is anybody's guess. Already, many members of Congress are talking about ``correcting inequities'' in last year's tax reform law, looking for new ways to raise revenue (like a tax on security transactions), and counting the months until Ronald Reagan moves out of the White House so a more sweeping tax increase can be enacted to deal with the federal budget deficit.

Still, we have to coexist with the current law this year at least. Having completed - or almost completed - their 1040s for 1986, most people are ready to put the old tax laws behind them and learn what the new rules mean for spending, saving, borrowing, investing, and retirement.

One approach might be to think of 1987 as a year of transition until 1988, when most of the rules of tax reform, especially the 28 percent top rate, will go into effect.

Then, think of 1988 as the one ``golden'' year when you will probably enjoy the lowest tax rates you have ever seen - or are likely to see again.

For many people, living with tax reform is already a more pleasant experience. Their first paychecks of 1987 were somewhat larger, reflecting lower tax rates and higher personal exemptions. But if they haven't yet filled out one of the incomprehensible new W-4 forms (or its new, somewhat easier sibling, the W-4A), that enjoyment may be short lived. Without that form, their employers may not be withholding enough to cover 90 percent of their tax obligation.

``Most people were a little surprised'' by their first paychecks of 1987, says Marilyn Capelli, a financial planner in Naperville, Ill. ``With the extra money, they seem to be reducing debt, or at least they should be.''

The reduction of debt, financial experts hope, will be one of the most visible effects of tax reform in 1987. Because only 65 percent of consumer interest is deductible this year, 40 percent next year, and none in 1991, people may cut back on debt now that they know Uncle Sam is no longer subsidizing their interest payments.

For others, the gradual reduction in tax rates will not be as important as the immediate loss of many deductions. No longer will sales taxes or consumer interest be deductible; charitable contributions will be deductible only for itemizers; only medical expenses that exceed 7 percent of adjusted gross income can be deducted; and miscellaneous expenses - subscriptions, tax preparation charges, and accounting fees - will be deductible only if they add up to more than 2 percent of adjusted gross.

``It's safe to say tax reform will affect different people in very different ways,'' says Richard Shapiro, tax director at the accounting firm of Oppenheim, Appel, Dixon & Co. ``For some people, tax reform may not even mean a tax reduction. Some people may actually see their taxes go up.''

Living with tax reform, then, will involve changes in behavior in several areas of people's lives. Here are some of the most important: Saving

Lower tax rates make taxable savings (bank acounts, certificates of deposit) more attractive. But loss of the dividend exclusion will hurt those with money in savings-and-loan associations. Some banks are offering deferred interest CDs. These feature simple interest that is paid next year - at next year's lower rates. Also look at tax-free savings vehicles, like municipal bond funds, zero-coupon bonds, and US Savings Bonds. You may find, however, that while five-year CDs cost more to purchase than savings bonds, they pay more in the end.

Be careful with zero-coupon investments, though. Unless they are made up of tax-free securities, the IRS will tax the ``phantom'' income that builds up within taxable zeros, even though you don't get that income until maturity. Borrowing

Will people actually go back to saving for things - putting a little aside every week for that new television, a recliner to watch it from, or a VCR to tape more programs, instead of charging them?

``I don't know if our society will go that far,'' says Norman R. Milefsky, tax partner at Coopers & Lybrand. ``But I do think people will be much more conscientious about borrowing less.''

If you do continue to borrow, especially on your credit card, look for the lowest-interest cards you can find. Thanks to their state legislatures, banks in Arkansas and Connecticut have the lowest rates in the country.

The hottest thing in borrowing this year seems to be the home equity loan - ``the 1980s euphemism for a second mortgage,'' Mr. Shapiro calls it. With the loss of deductible interest on other consumer debt - car loans, credit cards, installment loans, and personal bank loans - lenders are touting home equity as the modern way of debt.

For those who can truly manage their debt, and would be borrowing for things like a car or home improvements anyway, this might make sense. An equity-based loan for a specific purpose is probably a safer bet than an open-ended home equity line of credit.

Most of these loans have floating rates, tied to an index like the prime rate. So if rates rise, so will your monthly payments, which could make havoc of any financial planning or budgeting plans.

Remember that interest deductions are permitted only for the cost of the home plus improvements, unless the loan is for medical or educational purposes.

Whether or not they borrow on home equity, ``I would encourage people to own their homes,'' says Glenn Pape, senior tax manager at Arthur Andersen & Co., accountants. ``It's one of the few shelters left.''

If you do need to borrow, remember that with 65 percent of interest deductible this year and 40 percent next year, a short-term loan to be paid off this year or next will still have some tax benefits, though not the 100 percent deduction of previous years. Deferring income

Greg Confair, a financial planner in Allentown, Pa., calls 1988 ``the receipt year of choice.'' That means any income, including investment income, that can be taken next year instead of this year should be deferred until then, he explains. For many people, including those who do free-lance work or receive bonuses, this won't become an issue until later in the year. But if you can get someone to hold off paying you until 1988, the tax bite will be smaller.

Be careful in trying to put off income. If you can make a deferral arrangement with your employer, it must be done before the money is earned. Investing

Tax reform could spark a renewed emphasis on total return - income plus appreciation. Since both will now be taxed at the same rate, dividends will be more attractive. And without the long-term capital-gains exclusion, investors will hold on to stocks as long as it makes sense - no less, no more.

While long-term gains will be taxed at the same rate as other income in 1988, this year these gains will be taxed at 28 percent, which could be lower than next year for some people. So taking profits this year could save five percentage points in tax. Also, because short-term gains taken this year can be taxed up to 38.5 percent, putting off selling for six months could cut that tax to 28 percent.

Apart from stocks, other investments will have to be looked at in a new light under tax reform. Municipal bonds, for example, may not make as much sense if you're just trying to save taxes, since tax rates are coming down. But with fewer deductions and fewer ways to shelter income, and with more people - especially two-earner couples - tax-free income will become more valuable.

Also, if states have to raise their taxes to offset lost federal revenue, municipal bonds from your state will save state taxes as well. Besides, municipal bonds are paying historically high yields - about 6.3 percent - compared with taxable vehicles, so this is a particularly good time to be shopping for munis. College

Beyond the possible use of home equity for college bills, there are other changes in strategy here. First, if you have children over five years old, you must get them their own social security number this year. That's so the Internal Revenue Service can keep track of earnings and wages in the child's name.

If the children are under 14, all investment earnings are taxed at the parents' rate. There is a $500 exemption and the child's standard deduction, also $500, so $1,000 a year could be earned in a child's account tax-free.

Because children will be taxed at the parents' rate, Clifford trusts, those once-popular savings vehicles, are now all but useless. If you have money in such a trust, you'll have to leave it there; under the still-valid rules for Clifford trusts, that money belongs to the child for life.

The best strategies seem to be available to parents - and grandparents - of very young children. For them, deferral is the name of the game. Zero-coupon bonds, growth stocks, US Treasury certificates, and savings bonds can all grow tax-free until they are sold or redeemed, which could be after the child is 14. Planning for retirement

``People will have more take-home money,'' Mr. Pape says. ``And they will probably spend more, but they should be saving more for retirement.''

Four major changes, however, could make this more difficult:

Loss of deductible IRA contributions for some people may discourage use of IRAs. Starting this year, the deduction for IRA contributions is eliminated for couples whose adjusted gross income exceeds $50,000 and singles over $35,000. Couples with incomes under $40,000 (singles under $25,000) get the full deduction. In between, the deduction is phased out. If neither spouse is covered by any kind of pension plan, the full IRA contribution can be deducted.

Stiffer penalties for early withdrawal will encourage people to put money in municipal bonds, single-premium life insurance, and other tax-free or tax-deferred vehicles instead of IRAs.

A $7,000 cap on annual deferrals to 401(k) plans (down from $30,000 or 25 percent of earning whichever was less) should also encourage use of other tax-deferred vehicles.

Ten-year averaging has been replaced by five-year averaging and it can only be used once, ever. Before, you could use 10-year averaging for a lump-sum retirement plan distribution as often as you liked up to age 59 and once after that. Now, you can only use five-year averaging just once, so if you receive a distribution, make sure you won't be receiving another in the future. This could happen if you change jobs. If you don't want to use averaging, roll the money into another retirement account, like an IRA. You may not get the deduction, but the money will grow tax-free until retirement.

So with tougher withdrawal penalties on IRAs and 401(k)s, plus the loss of the IRA deduction for many people, those planning for retirement might start using other long-term saving vehicles, like annuities, to build financial security.