HENRYs = High Earners Not Rich Yet?

That's what the Harvard Business Review (HBR) and Fortune Magazine are calling it. HBR editor Justin Fox writes:

The Tax Plight of the $250,000 to $500,000 Crowd

My former colleague at Fortune magazine, Shawn Tully, has been trying for a while to popularize an acronym of his devising: HENRYs, for high earners, not rich yet. Yes, it's a stretch, but it describes a real phenomenon: Very successful households (two-income couples, mostly), on the young side, who are making $250,000-$500,000 a year but don't have a whole lot in the way of assets — and may have big housing and/or education debts — don't feel particularly rich, and bear just about the heaviest tax burden of any income group....

...They're well-represented among HBR.org readers, and they're the fulcrum of the current U.S. tax debate. The tax cuts pushed by the Bush administration and approved by Congress at the beginning of this decade are set to expire next year (because the Bush administration and Congress were unwilling to come up with any spending cuts to make up for the revenue loss). The Obama administration wants to preserve most of the cuts, but only for those making less than $250,000 a year. So $250,000 marks the dividing line between the middle class, who are deemed deserving of continued tax relief, and the rich, who are not.

It's not the craziest of dividing lines: Only about 2% of American households take in more than $250,000 a year, so while there are many words that can be used to describe this income group, "middle" clearly is not one of them. It's also not as sharp a line as it's often made out to be: the higher tax rates would apply to income over $250,000 (or so), not every penny that the HENRYs make.

Actually, the Harvard Business Review doesn't have that quite right. And they are not alone in their misconception.

The Obama administration does NOT proposing to tax income over $250,000 at higher rates, it is proposing to tax "taxable income" over $250,000" at higher rates.

For a typical HENRY couple, there is a big difference between their "income" and their "taxable income."

Start with their gross wages and investment income. That's what most people think of when you refer to their "income."

But that is not what the Obama tax proposal targets at all when it sets that $250,000 figure for raising marginal rates.

Let's take an example HENRY family to illustrate. Let's say they are a married 2-earner couple with two kids who live in New York State in the suburbs of New York City.

They made $350,000 in wages last year. (We'll leave aside their investment income for the moment, assuming their investments are all in a 401(k) plan or an IRA or perhaps their investment income is in the form of unrealized capital gains, so it doesn't even show up on their current tax return.)

Will they get hit with the higher tax rates that the Obama administration folks?

Quite possibly not! Why? Because their taxable income is very likely under $250,000.

Start with the $350,000. They can each put in up to $16,500 into their 401(k) plans, which means that $33,000 gets excluded from their income for tax purposes right off the top. Now we are down to $317,000.

Also, they can each put $5,000 into flexible spending accounts to pay for childcare (a nanny, a baby sitter, daycare centers, even daycamp in the summer.) They also put $2,500 each into their health care flex spending accounts. Knock off another $15,000 from income for tax purposes. Now we are down to $302,000 in what the IRS refers to as "Total Income" (Line 22 of Form 1040).

But, wait, there's more! (As they say on late night TV infomercials.)

They get to subtract itemized deductions and personal and dependency exemptions. A reasonable estimate of property taxes paid on a home in suburban New York is $15,000. Their mortgage interest might run around $35,000. They also pay about $20,000 in New York State income tax. Even if they give little or nothing to charity, their itemized deductions and exemptions will knock their taxable income below $250,000. (Exactly how far below $250,000 is a slightly complicated calculation, due to phaseouts and other bed buffaloes in the tax code.)

So we started with a family with an "income" of $350,000, as most people define the term income, and wound up with a taxable income below $250,000, safely out of range of the administration's proposed increase in tax rates.

And wait, there's even more for the true policy wonks like your professor! The Haig-Simons definition of their true economic income would likely be well over $350,000, because you'd have to add in employer contributions to health care, employer matching contributions to retirement plans, other tax-free fringe benefits provided by the employer (life insurance, disability insurance, tuition assistance, incentive stock options, commuting benefits such as free transit passes or a bicycle or vanpool or free parking, an employer-provided on-promises family gym membership.) The broadest Haig-Simons definition of income would also include the value of unrealized capital gains on their investments, as well as imputed value of other services they consume (e.g., owner-occupied housing, cars, consumer durables) and other items.

But, even leaving Haig-Simons aside, it is clear that households can have gross incomes well above $250,000 and still remain untouched by the administration proposal to raise marginal tax rates on taxable incomes over $250,000.