Look who pays for the bailout: Meet the HENRYs

Just out of college, he was earning a six-figure salary at a telecom company and sleeping in his parents’ basement. Now he’s a wealth advisor earning $375,000 at Morgan Stanley, with a five-bedroom brick home, a minivan, a son in private school, and three younger kids to follow. “My dad never made more than $25,000 a year,” says the burly, outgoing Kwon, 39. “When I was a kid, this was the top neighborhood in Peoria. I never thought I could live here.”

For all his blessings, Kwon gets really steamed when politicians and pundits claim that he and other Americans in his income group aren’t shouldering their “fair share” in taxes and should pay more. Nor does he appreciate being branded as “rich” when it’s far from certain he’ll ever build the kind of lavish nest egg the truly wealthy enjoy, especially after the current market meltdown. “I’m not a trust-fund baby,” says Kwon. “Raising taxes for people at my income level is like being punished for success, for working hard.” Kwon’s total tax bill is already more than $100,000, and the bite is taking an ever-rising share of his raises and bonuses, not to mention his wife’s income as a photographer. Kwon fears that America risks killing the incentive for people like him by shrinking the rewards for logging extra hours or starting a business, diminishing the dream that brought his father from Korea.

The Kwon family has plenty of company, representing an income group comprising five million households that earn between $250,000 and $500,000 a year and pay a large chunk of it back in taxes. These folks aren’t America’s hedge fund managers, investment bankers, or CEOs—who boast net worths in the multimillions and qualify as rich right now. Instead, these are the doctors, consultants, and attorneys, the marketing managers and CIOs, the owners of real estate agencies and security firms. They write the contracts, inspire the sales teams, and integrate computer systems. They own many of America’s small businesses. A man aspiring to join this cohort, nicknamed Joe the Plumber, has put a face on a big issue in the presidential campaign: Whether it’s fair or wise to raise taxes on the powerful job engine of America’s corner stores, maintenance firms, and yes, plumbing contractors.

“I try to save 25% to 30% of my income every year. I’m a financial advisor, so I practice what I preach. … When I was young, I thought the well-to-do in Peoria had perfect lives. Now I know they’re just hard-working people supporting their families.”

Bill Kwon is a financial advisor. His wife, Kira, is a freelance photographer. They live in Peoria, Ill., and their household income is $375,000.

This is the world of the HENRYs, an acronym we’ll use to describe people whose financial situation can be summed up by the phrase “high earners, not rich yet.” (I coined the term for a Fortune story in 2003 on the alternative minimum tax, or AMT, the bane of the HENRYs.) Put simply, the HENRYs are the bulwark of the professional and entrepreneurial class that drives the economy. Look in the mirror, Fortune reader, and you’ll probably see a HENRY.

They are relentless strivers. Aspiring HENRYs played by the rules and did everything right: They won the best grades in high school, got accepted at good colleges and grad schools, and worked daunting schedules as medical interns or associates in law firms. They’re an upwardly mobile group: Most HENRYs used their talent and grit to advance from the middle class, and those who got a hand from affluent parents are determined to do even better for their kids.

“These high earners may come from privileged, upper-middle-class backgrounds or be the children of immigrants,” says Phillip Cook, a financial advisor in Torrance, Calif. “What they have in common is that they worked incredibly hard to build their careers and work incredibly hard to move ahead.” Now this group of superachievers is being targeted as a cash machine. Barack Obama, the Democratic presidential nominee, has pledged to pay for middle-class tax cuts and credits by raising taxes on the HENRYs. “It’s time for folks who make over $250,000 a year to pay their fair share,” Obama has declared regularly on the campaign trail.

Obama and the congressional Democrats frequently refer to households earning over $250,000 as the “rich” and the “wealthiest Americans.” But whether the HENRYs are truly “rich,” or ever will be, is debatable. In Fortune’s interviews with two dozen HENRYs from Charlotte to Concord, Calif., what emerged was a portrait of families a world away from the private jets, luxury vacation homes, and heated garages with Bentleys and Porsches lined up headlight to headlight that typically represent America’s vision of “rich.”

Kelly Lynch, the owner of a commercial maintenance company in Redondo Beach, Calif., is raising two kids with her partner, Jill Fenske, on a household income of $400,000. She’s saving $800 a month for the children’s college fund and $4,000 a month for retirement—a number that someday might make her rich. “If I blew my money like other people, I’d feel rich,” says Lynch. Her views on taxes are befitting a born entrepreneur: “I think it would be unfair if someone tried to raise my taxes,” says Lynch. “I don’t think people should be penalized because they earn more.”

“Making $400,000 sounded like a lot of money coming out of high school. Now I feel more like we’re making $100,000 instead of $400,000. If I were rich,I’d have an ocean view and take longer vacations.” 

Kelly Lynch is the CEO of a maintenance company. Her partner, Jill Fenske, is a chemical engineer. They live in Redondo Beach, Calif., and their household income is $400,000.

Sure, it’s hard to weep for families that earn more than 98% of American households, especially when median family income stands at $50,000 and the middle class is getting pummeled by falling home and stock prices. Unlike millions of Americans, most HENRYs don’t need to worry about making the next mortgage or credit card payment. Still, HENRYs are getting a bad rap from those who lump them in with America’s conspicuously wealthy.

While there’s no consensus definition of how much wealth or income makes someone rich in America, here’s a reasonable proposal: Many Americans would consider a family wealthy if it enjoyed either a large net worth today, something on the order of $3 million, or an income big enough to pay for a luxurious lifestyle—with enough left over to save for a comfortable retirement. The $3 million figure would generate around $200,000 in income, plenty to retire on tomorrow. If a couple in their 30s, 40s, or 50s has the option to stop working and live on their ample savings—call it “take this job and shove it” money—they can definitely be classified as rich. The HENRYs don’t rate as rich by either standard. They’re mostly two-income families. And even with two incomes they don’t earn enough for luxurious lifestyles, and their savings don’t remotely approach the take-this-job level.

Hit hard by taxes

The reason the HENRYs are strapped for both lifestyle and nest egg is twofold: First, they already face a large and rising burden for federal, state, and property taxes plus the knife of the AMT. “Taxes are by far my biggest expense,” says Kwon. Second, the HENRYs invest heavily in a distinct set of high-grade staples that, in effect, defines them. They’re all about the kids: saving for private colleges, paying for day care—practically a must, because Mom and Dad are both working—and providing dance, tennis, or gymnastics lessons. These might be seen as luxury items by middle-class workers, but they’re absolute necessities to the HENRYs. The big tax bite and what they consider investments in their kids chew up most of the HENRYs’ incomes, leaving little for either extravagant living or, in many cases, saving for an affluent retirement. Indeed, the HENRYs consider themselves “well off” and “successful” but nowhere near “rich.”

“Wealthy people are those who have lots of cash reserves and don’t have to go to work,” says John Selden, 35, a dentist in Charlotte with a family income of $350,000. Adds David Twa, county administrator of Contra Costa County in California (salary: $250,000): “I feel middle class. To me, rich is people with golf-club memberships.” Tony Molino, 50, an attorney in Rancho Palos Verdes, Calif., speaks for legions of HENRYs: “I’ve worked 50 to 60 hours my entire life, and I don’t have a lot left over at the end of the month. I’m comfortable, but when Joe Biden talks about sucking it up, getting patriotic, and paying more taxes, I get livid.”

“It would be nice if I could look up at 55 and see I don’t need to work anymore. Now, I don’t think anybody can be that certain.” 

Dr. John Selden is a dentist. His wife, Dr. Kymberly Selden, is a pediatrician. They live in Charlotte, and their household income is $350,000.

The HENRYs interviewed by Fortune indulge in virtually none of the toys that brand families as rich. “I eat fast food and take my kids to soccer,” says Kwon. Marie Hoffman, a realtor in Hermosa Beach, Calif., keeps hearing about what affluent Americans are supposed to be buying and swears it’s not her. “I see $1,400 dresses advertised in Oprah’s magazine, and I can’t imagine anyone buying a sheath to wear to work at that price,” marvels Hoffman.

Of course, how far those mid-six-figure salaries stretch depends heavily on where the HENRYs live. A $300,000 paycheck goes a lot further in Peoria or Wichita than in Manhattan or San Francisco. “If I lived somewhere else, like Indiana where I grew up, I’d own a minor-league team,” jokes Hall Davidson, 59, of Hollywood Hills, Calif., who produces educational videos and whose family income is just over $250,000. Twa, who relocated from St. Paul to Northern California for his job, is getting a salary increase from $144,000 to $250,000, partly to compensate him for the far higher cost of housing. Even so, he can’t afford what most Americans think of as a luxury home. For the HENRYs, a $1.5 million mini-mansion with $9,000 a month in mortgage and property tax payments would be a budget buster. As a result, HENRYs who live in areas with high housing prices own modest homes.

In the L.A. suburbs, Tony Molino, his wife, Barbara, and 7-year-old daughter share a three-bedroom Cape Cod-style home that he bought 20 years ago for $388,000. His monthly payment for taxes and mortgage: $3,100. The HENRYs hold down their housing costs so that they can lavish money on what they consider the ultimate staple, their kids’ education. Selden, the North Carolina dentist, and his wife, Kym, a pediatrician, spend $1,680 a month for day care for their two children, ages 6 and 3. That number will rise by $1,000 when their third child arrives early next year. They’re also putting away $750 a month per child – that will be $27,000 a year – for college. John and Kym want to send the kids to her alma mater, Duke. They figure it will cost a total of $500,000 per child when their kids are ready to attend in 2020 and 2023. “I had no idea I’d have to accumulate that kind of money for college,” says Selden. “I thought that money would be going into savings.”

Even at the upper end of the HENRY group, our cover subjects, Lindsay Mayer and her husband, Zach, a Dallas attorney, feel stretched on $500,000 a year. Lindsay, a senior manager at telecom provider Avaya, has also started her own small business on the side, investing $60,000 to launch a company called Maelee Baby that markets stylish diaper totes. Once again, their biggest expense outside of taxes and their mortgage is the children. The Mayers pay $2,200 a month for child care for their two kids. “Child care is the real killer,” says Lindsay. “We’ve achieved so much. We can’t understand why we’re still worrying about money.” The last ten days of each month, she and her husband invariably remind each other to watch expenses. “It baffles us that we have to say that to each other,” she says.

“We don’t ever expect to see Social Security. We’re not spending a lot of money on extra stuff. We’d have to watch spending even more if taxes go up.”

Lindsay Mayer is a senior manager at a telecom company. Her husband, Zach, is an attorney. They live in Dallas, and their household income is $500,000.

Folks like the Seldens and the Mayers are a fat target for tax increases because they prospered mightily—far more than the middle class—from the recent boom. From 2002 to 2006 the total income of the HENRYs, who earn $250,000 to $500,000, rose by 34%, vs. 22% for households earning between $64,000 and $109,000. During that period companies wrested far more productivity from their midlevel employees and were extremely cautious about adding new factory workers, secretaries, or salesmen, a major reason that profits exploded. But it was a great time for executives in fields from natural resources to financial services, not to mention real estate. “That was a golden period,” says David Tysk of Ameriprise Financial, who has 200 clients who fit the HENRY profile. “High earners could always move to another good job across town with a good income.”

Now, however, the HENRYs are suddenly fearful for their jobs and distressed by their shrinking portfolios. They operate without the safety net that the rich enjoy. “How quickly things change,” says Tysk. “Local companies that were hiring in the good times, like UnitedHealth and ADC Telecom, are now laying off high earners.”

Now that the government needs more revenue for bailouts and stimulus packages, is it fair or efficient to burden the HENRYs with even bigger tax bills? The case in their favor: As the HENRYs go, so goes the struggling economy. Their stats tell the story.

For the 2006 tax year, 3.1 million HENRYs accounted for about 10% of all U.S. personal income, yet they contributed 17.3% of all federal income taxes. That’s almost as much as the 12 million families and individuals who earned between $100,000 and $200,000. (The Tax Policy Center estimates that HENRYs now number five million and will pay 24% of federal incomes taxes in 2008.)

How HENRYs feel about tomorrow is crucial for the sales of new cars, PCs, and toys. According to estimates by the American Affluence Research Center, the HENRYs control as much as 15% of the $9 trillion in U.S. consumer spending. An even more important point: The HENRYs are crucial to America’s economic health because so many of them own small businesses. The debate over their future is now a major issue in the presidential campaign, courtesy of the unlikely and now overexposed folk hero nicknamed Joe the Plumber (full name: Samuel J. Wurzelbacher). He confronted Obama when the candidate was campaigning in Joe’s suburban Toledo neighborhood, telling the nominee that he wants to buy a plumbing company but is worried that Obama will raise taxes on small business. Obama responded, in part, that “when you spread the wealth around, it’s good for everybody,” which the McCain campaign attacked as socialism. “The whole premise behind Senator Obama’s plans is class warfare—let’s spread the wealth around,” declared McCain.

The engine behind small-business growth

The HENRYs, together with high earners making more than $500,000, own 660,000 small businesses and pay $110 billion in corporate taxes, one-fourth of the U.S. total, on their personal returns. Small businesses created two-thirds of the 6.4 million new private-sector jobs the U.S. economy added between 2003 and 2007. Even so, the undeniable fact is that the HENRYs cannot completely escape America’s backlash against the rich. The earnings gap in the U.S. is greater than ever, with the top 1% of U.S. households receiving more than 22% of reported income in 2006. For voters struggling on the median income to save for their kids’ college education, the difference between a $250,000 income and $1 million is like comparing gold and platinum: It all looks pretty rich. But it’s not just an emotional reaction. The growing sentiment for putting heavier taxes on upper incomes has a rational component as well, pushed by economists who contend that people who are financially successful at this point in the post-industrial age owe a debt to the breakthroughs of the innovators who went before them and hence a greater obligation to society at large.

In a new book called Unjust Deserts, academics Gar Alperovitz and Lew Daly dispute the idea that high taxes would be a disincentive to today’s strivers, pointing out that America’s most expansive period of economic growth in the postwar era happened at a time when marginal tax rates reached 91%. Even though the HENRYs may be stretched, they’re facing a future of higher taxes no matter who’s elected President. The stark reality is that with two costly wars, a massive financial bailout, a looming recession, and ballooning deficits, the government is under intense pressure to raise more revenues.

In fact, many HENRYs accept the idea that as some of America’s most prosperous citizens, it’s their obligation to shoulder an even bigger share of the burden, especially in these tough times. “I’m happy to pay taxes, having been in government all my life,” says county administrator Twa. “Do I think we should be paying more than the people making half what we make? Absolutely.” Adds Davidson, the California video producer: “I’m fine with higher taxes. You need good roads and good schools. That’s what taxes pay for.”

How much would the candidates roll back the clock on taxes? Let’s get straight to the election headline (those of you reading this after Nov. 4 will have a better idea of what you’re facing): The HENRYs would fare notably worse under Obama than under McCain. Obama would substantially increase their capital gains levies; he also advocates a significant hike in Social Security taxes aimed smack at high earners, though he says the increase would come far in the future. By comparison with those measures, Obama’s much-discussed pledge to raise tax rates on families earning over $250,000 a year isn’t as harsh as it looks. Obama’s proposed rate increase would affect only some of the HENRYs because so many of them are already saddled with a curse that can be spelled in three letters—AMT, or alternative minimum tax.

The AMT hammers these Henrys by erasing most of their biggest deductions, including state income taxes and property taxes. And it’s almost exclusively aimed at the HENRYs, exempting most of the middle class and the truly rich. McCain, for all his talk about cutting taxes, would essentially preserve the status quo for HENRYs, resulting in more and more of them getting drawn into paying the AMT. Obama’s plan would do the same, with one important difference. Under Obama’s plan, the highest earners among the HENRYs would leave the AMT. But that’s not good news for them. They would graduate by paying even higher taxes. The dreaded parallel tax system known as the AMT might as well be called the “HENRY tax,” so precisely does it target that group.

It wasn’t intentional. The AMT was established in 1969 to force around 155 millionaires who were using tax shelters and massive deductions to avoid all federal income tax to pay their fair share. Over the years the AMT has strayed far from its original purpose of punishing a few rich tax dodgers. It has gradually become a huge cash generator for the federal budget. The Treasury projects that the AMT will raise $88 billion in 2008, and that number is expected to double by 2013. In fact, it’s now far too big to repeal without disastrously ballooning the budget deficit.

The AMT doesn’t simply eliminate the plutocratic tax shelters that the rich were using in the 1960s. It erases most of the routine deductions that reduce taxes for middle-class households. For the 2008 tax year, around 4.1 million households are expected to pay the AMT, according to the Tax Policy Center, double the number in 2002. Well over half of those payers will be HENRYs. Of families with children and with incomes ranging from $200,000 to $500,000, more than 50% will pay the AMT.

Trapped by the alternative minimum tax

The AMT traps large numbers of HENRYs in high local- and state-tax states like New York, Massachusetts, California, and Minnesota. The immense rise in property taxes across America, a legacy of the housing bubble, isn’t just hitting HENRYs when they write checks to their towns. Once the AMT applies to them, they can’t deduct the local levies on their federal tax returns. Last year John Selden’s property taxes on his $750,000 house in the Charlotte suburbs jumped from $9,000 to $12,000. A few years ago, before he was hit by the AMT, Selden saved around 30% on his property taxes because he could deduct them on his federal return. Last year the AMT forced him to effectively pay 100% of those taxes, including the $3,000 increase. Gary Seim, an engineer at Boston Scientific, and his wife, Lee Pfannmuller, a natural-resource manager for the state of Minnesota, pay around $10,000 in property taxes on their modest 2,500-square-foot house in Minneapolis. That’s twice the figure of five years ago. In effect, they’re paying an extra $3,000, courtesy of the AMT. In an Obama administration, at least some of the HENRYs would pay higher taxes because of his plan to raise the two top marginal tax rates—for the highest, from 35% to 39.6%, back to where they stood before the Bush tax cuts. HENRYs who pay slightly more under the AMT than in the regular system would be tipped back into the regular system by the Obama plan, saddling them with higher taxes.

“We’re not wealthy at all. We’re well off and successful.”

Lee Pfannmuller is a manager at a state agency. Her husband, Gary, is a biomedical engineer. They live in Minneapolis, and their household income is $275,000.

On the other hand, the McCain plan is pro-HENRY in pledging to leave the top tax rates where they are today. Hence, HENRYs already paying the AMT would stay there unless their incomes soared. (But his plan would do nothing to help HENRYs already trapped by the AMT, nor those that will fall under the AMT in the future.) McCain also favors HENRYs on capital gains: He’d leave the current 15% maximum rate in place. Obama’s plan is aimed right at the heart of the HENRYs: He’d lift the rate to at least 20% for families earning over $250,000.

Between the high taxes and expenses for the kids, the HENRYs are hard-pressed to build the large savings they’ll need for an affluent retirement. In fact, their only real chance of becoming “wealthy”—of accumulating around $3 million in today’s dollars when they retire in 20 or 30 years—is to set aside a big chunk of their income each year, usually between $40,000 and $60,000.

Passing up luxuries

Most of all, the HENRYs face daunting choices. “They can become wealthy, but they must starve themselves of luxuries to get there,” says advisor Tysk. “These people save only because they go without.” Tysk advises his clients to save 15% of their income for retirement, and believes that most of them do it—forgoing an extravagant lifestyle. Adds Barry Glassman, a financial planner at Cassaday & Co. in McLean, Va.: “For high earners, it’s all about discipline now or regret later.”

Most HENRYs view achieving a comfortable retirement as a long and difficult climb. Selden says his family has just $200,000 in savings outside of the college fund. “With how well we’re doing, I thought I’d have $1 million by now,” says Selden. He has watched his retirement and college savings accounts shrink by 25% since last year. Selden reckons he’ll save another 5% of his salary and postpone pet projects like an expansion of the playroom. “I have a lot of time” till retirement, he says, “but that doesn’t make me feel any better when I see my quarterly statements.” Tom Hume, 39, a real estate broker from Tacoma who made $275,000 last year, pays so much to put three kids through private school that he’s looking at an extremely modest retirement. At the end of each year Hume tries to put $10,000 into his 401(k), but some years he can’t even save that much. “No one is going to feel sorry for me,” says Hume, “but as we get closer to retirement, we see that the amount we can save just won’t make it. There’s no extra money in our lives.”

Kelly Lynch, the maintenance-company owner, has license plates that read “Dreeamr,” from a nickname her parents gave her in high school. The dream still lives for the HENRYs, but it’s elusive. It’s a dream that enriches us all, and that America would do well to nurture.

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Where the tax burden falls

The HENRYs really pull their weight, paying a big portion of America’s tax bill, given their percentage of all taxpayers. Source: IRS

Taxes paid by income bracket (2006)

Income bracket: $1 to $50,000
Average income: $21,000
Average taxes paid: $1,300
66% of all taxpayers fall in this graphic and pay for 8% of total taxes.

Income bracket: $50,000 to $100,000
Average income: $71,000
Average taxes paid: $6,400
22% of all taxpayers fall in this graphic and pay for 18% of total taxes.

Income bracket: $100,000 to $200,000
Average income $133,000
Average taxes paid: $17,000
9% of all taxpayers fall in this graphic and pay for 20% of total taxes.

Income bracket (HENRYs): $200,000 to $500,000
Average income: $287,000
Average taxes paid: $57,000
2.3% of all taxpayers fall in this graphic and pay for 17% of total taxes.

Income bracket: $500,000 to $1.5 million
Average income: $540,000
Average taxes paid: $187,000
0.5% of all taxpayers fall in this graphic and pay for 14% of total taxes.

Income bracket: $1.5 million to $5 million
Average income: $2.5 million
Average taxes paid: $606,000
0.1% of all taxpayers fall in this graphic and pay for 10% of total taxes.

Income bracket: $5 million and higher
Average income: $15.2 million
Average taxes paid: $3.2 million
0.03% of all taxpayers fall in this graphic and pay for 13% of total taxes.

Additional reporting by Christopher Tkaczyk.