The Obama tax proposals: Tailored cuts and hikes

President Obama's State of the Union plan proposed several tax changes that will benefit middle-class taxpayers but cost wealthy taxpayers and financial services companies more.

The proposals could raise $320 billion over 10 years, according to White House estimates. The president hopes to use that money to give $175 billion in tax breaks to middle-class taxpayers and to fund his $60 billion proposal to make community college free for two years.

The tax increases:

A higher capital gains tax for the wealthy

The tax on long-term capital gains — gains on assets such as stocks held for more than a year — is lower than the tax on ordinary income. For tax year 2014, the maximum capital gains tax is 23.8%, which includes a 3.8% tax on net investment income. The maximum federal income tax rate is 39.6%.

The president's proposal would hike the capital gains rate for wealthy taxpayers to 28%. In the 2014 tax season, single filers with taxable income above $406,750 and joint filers with taxable income above $457,600 pay the highest capital gains rate.

The proposal would also raise the tax on qualified dividends to 28%. There are separate capital gains schedules for precious metals, collectibles and commercial buildings. Details on those, if any, haven't been released.

The White House notes that the capital gains rate under President Reagan was 28%. Jon Traub, managing principal of the tax policy group at Deloitte, notes that the maximum income tax rate during President Reagan's term was also 28%, so the comparison is not entirely apt.

The end of the step-up basis. Under current tax law, if you buy a stock for $25 a share and it soars to $500 a share, you can pass the entire amount on to your heirs without paying capital gains tax on your $475 gain. Instead, the entire amount passes tax-free to your heirs, and their cost basis — the amount used to determine capital gains tax — would then rise to $500.

The Obama proposal would eliminate that, calling it "the single largest capital gains tax loophole." Capital gains taxes would be owed at death — in the case of couples, at the death of the second spouse. Capital gains of $100,000 — $200,000 in the case of joint filers — would be free from tax. Couples would have an exemption of $500,000 on the gains on their personal residences, and no taxes would be due on inherited small-family businesses until those businesses were sold.

Just how that tax would be collected is an open question — whether, for example, it would be collected as part of the estate or when it's transferred to the individual, says Edward Karl, director of the tax division of the American Institute of Certified Public Accountants.

A fee on large financial institutions to discourage excessive borrowing. The fee would be 0.07% of liabilities annually, levied on about 100 companies with $50 billion or more in assets.

The tax breaks:

• A tax credit of up to $500 for two-earner filers. Unlike deductions, which reduce your taxable income, tax credits reduce your taxes dollar for dollar. The credit would be available in full for two-earner families with incomes up to $120,000, with partial credits available to those with incomes up to $210,000.
• Expand the earned income tax credit for workers without qualifying children, increase the income level at which the credit phases out, and make it available to workers 21 and older.
• Increase the child care tax credit to $3,000, and make the maximum credit available to most families with incomes up to $120,000.
• Make the American Opportunity Tax Credit permanent, and give college students a tax credit of up to $2,500 a year for five years. Part-time students would be eligible for a $1,250 AOTC.
• Simplify the student loan interest tax deduction.

As a way to pay for some of the tax credits for students, the president's plan would roll back distribution rules on popular 529 college savings plans, and make distributions from those plans taxable to students.

The proposals would also encourage retirement savings and discourage what the administration considers abuses of retirement plans. Every employer with 10 employees would have to enroll workers automatically in an individual retirement account. Workers could opt out if they wanted. Any employer with 100 or fewer workers would get a $3,000 tax credit for offering an auto-enroll IRA. Employers would get a $1,500 start-up credit for setting up a plan.

Long-term part-time workers would also be allowed to enroll in company retirement plans.

Finally, the president's proposal would target individual retirement accounts that have unusually large balances. The Government Accountability Office reported last year that between 700 and 1,000 taxpayers had IRAs worth more than $10 million, and 300 have balances above $25 million. (One of those may be former presidential candidate Mitt Romney, whose IRA was estimated at between $20 million and $100 million.) The president's proposal would limit contributions and accruals of IRA benefits higher than about about $3.4 million.

The reaction

"My initial reaction is that nothing is going to happen in a Republican-controlled Congress," says Nicole Hart, director of trusts and estates at Sontag Advisory in New York. "Our advice to clients is that we're not worried this is getting passed."

Why, then, the proposals? "It's not a secret that the Democrats think the tax code needs to be more progressive, or that the Republicans think it's progressive enough," says Deloitte's Traub. But the proposals may be the first moves in negotiations over a larger tax reform bill with Republicans. "If you move one piece, it's difficult, but if there are a lot of moving pieces, then there's more movement to play," Traub says.

Simply throwing out ideas sometimes works, says Matt Brady, senior director of wealth planning at Wells Fargo Private Bank. "You never know what will come out of the congressional sausage factory. And once an idea gets suggested, it has a long shelf life."