Stealth Tax Hikes

By Daniel Kadlec

A common misconception is that taxes are going down. Sorry, it just isn't so. True, some tax rates have fallen. And tax reform last year gave us tax credits for education and tax deductions for long-term savings. But new targeted breaks total maybe $20 billion, which pales next to Americans' annual tax burden of nearly $3 trillion. In 1998 it took the combined incomes of everybody in the U.S. through May 10 to pay all taxes owed for the year--the latest "tax freedom" day ever, says the Tax Foundation, which figures the date will be even later this year.

That's not all bad. A prosperous economy leads to more personal income, which shoves more taxpayers into higher tax brackets, so they owe more in taxes. Thus the taxpayer burden may grow faster than income, and taxpayers still get ahead. That's the way our progressive tax system works: the more you make, the higher your tax rate. But it is one of the hidden ways taxes are on the rise. Here are some others, and what to do about them:

Rising FICA burden. Beginning this year, you will pay Social Security tax on the first $72,600 you earn--up from the $68,400 threshold in 1998. That's a 6.1% hike, a rate that is roughly double the pay increase most wage earners will see. For anyone whose income exceeds that higher level, it means an extra $260.40 a year owed to the feds. Tip: earnings stashed in a flexible-spending account at work are exempt from FICA withholding. In a two-earner household, it may pay for the lower earner to fund the account.

Alternative minimum tax. Designed to afflict only the superrich, this monster increasingly soaks the middle class. More than 1 million taxpayers will owe it this year, and 9 million by 2008--including many earning considerably less than $100,000 a year. Little more than a decade ago, fewer than 100,000 people were subject to the AMT. It's a complicated tax that targets folks who avoid most traditional income taxes through large credits and deductions. High earners in high-tax states are most vulnerable, but anyone taking a large deduction for business expenses can fall victim. Tip: consult a pro. Avoiding the AMT may call for such radical action as accelerating income and deferring deductions, which is precisely the opposite of normal strategy.

Mutual fund taxes. Heaping insult on injury, many investors owe 1998 tax on capital gains recorded by their mutual funds, even if those funds lost money. More than 30% of stock funds were down through November, and 11% of those--including such popular funds as Heartland Value, Lindner Dividend, Brandywine and Templeton Growth--also distributed a taxable capital gain to shareholders, says fund-research company Wiesenberger. Tip: taxable distributions typically result from rapid-fire trading. This year, look for funds with a low turnover rate, something less than 100%. Stock index funds are among the most tax efficient. And never invest in a stock fund just ahead of its annual distribution, usually in November or December.

Roth conversion. Moving from an old IRA to a Roth IRA can trigger unexpected tax consequences. The additional income recorded during the conversion year may result in fewer itemized deductions. That's even more likely now, since last year's one-time opportunity to spread the income over four years has expired. Tip: converting to a Roth still makes sense for the young, as it does for older folks who won't need to tap their IRAs for daily expenses.

See time.com/personal for more on taxes. E-mail Dan at kadlec@time.com And see him on CNNfn Tuesdays at 12:45 p.m. E.T.