Effective in 2013, new rules impose significantly higher taxes on higher earners, increasing the importance of tax awareness and tax planning. Under the Affordable Care Act (P.L. 111-148, 3/23/2010 and P.L.111-152, 3/30/2010, collectively) there is a higher payroll tax and a surtax on the unearned income of higher-income individuals. Under the American Taxpayer Relief Act of 2012 (P.L. 112-240, 1/2/2013), higher tax rates apply to ordinary income, capital gains and dividends, while at the same time limitations are imposed on the use of the personal exemption and itemized deductions. This article highlights these changes.
Brave new tax world. For tax years beginning after Dec. 31, 2012, the following rules apply:
Increased payroll tax for high-earning workers and self-employed taxpayers. An additional 0.9% hospital insurance tax (i.e., a component of the Federal Insurance Contributions Act (FICA) payroll tax imposed on wages) applies to wages received with respect to employment in excess of: $250,000 for joint returns; $125,000 for married taxpayers filing a separate return; and $200,000 in all other cases. The additional 0.9% tax also applies to self-employment income for the tax year in excess of the above figures.
Surtax on unearned income of higher-income individuals. An unearned income Medicare contribution tax is imposed on individuals, estates, and trusts. For an individual, the tax is 3.8% of the lesser of: (1) net investment income or (2) the excess of modified adjusted gross income over the threshold amount ($250,000 for a joint return or surviving spouse, $125,000 for a married individual filing a separate return, and $200,000 for all others). For surtax purposes, gross income doesn't include excluded items, such as interest on tax-exempt bonds, veterans' benefits, and excluded gain from the sale of a principal residence.
Higher individual income tax rates apply to higher-income taxpayers. The income tax rates for most individuals stay at 10%, 15%, 25%, 28%, 33% and 35%, as in 2012. However, a new 39.6% rate applies for 2013 for income above $450,000 for joint filers and surviving spouses; $425,000 for heads of household; $400,000 for single filers; and $225,000 for married taxpayers filing separately. These dollar amounts are inflation-adjusted for tax years after 2013.
Capital gain and dividend rates rise for higher-income taxpayers. The top rate for capital gains and dividends rises to 20% for 2013 (up from 15% in 2012) for taxpayers with incomes exceeding $450,000 for joint filers and surviving spouses; $425,000 for heads of household; $400,000 for single filers; and $225,000 for married taxpayers filing separately. In comparison, for taxpayers whose ordinary income is generally taxed at a rate below 25%, capital gains and dividends are subject to a 0% rate, and taxpayers who are subject to a 25%-or-greater rate on ordinary income, but whose income levels fall below the above thresholds, are subject to a 15% rate on capital gains and dividends. Further, the rate under the alternative minimum tax—a tax system separate from the regular tax, designed to limit certain tax benefits—also rises from 15% in 2012 to 20% in 2013 for capital gains and qualified dividends otherwise subject to the 39.6% regular tax rate.
Personal exemption is limited for high earners. There is a personal exemption phaseout (PEP) for 2013 with a starting threshold of $300,000 for joint filers and surviving spouses; $275,000 for heads of household; $250,000 for single filers; and $150,000 for married taxpayers filing separately. Under the phaseout, the total amount of exemptions that can be claimed by a taxpayer is reduced by 2% for each $2,500 (or portion thereof) by which the taxpayer's adjusted gross income exceeds the above threshold. These dollar amounts are inflation-adjusted for tax years after 2013.
Itemized deductions are limited for high earners. There is a limit on itemized deductions for 2013 (i.e., the “Pease” limitation) with a starting threshold of $300,000 for joint filers and surviving spouses; $275,000 for heads of household; $250,000 for single filers; and $150,000 for married taxpayers filing separately. Thus, for taxpayers subject to the “Pease” limitation, their itemized deductions are reduced by 3% of the amount by which the taxpayer's adjusted gross income exceeds the threshold amount, with the reduction not to exceed 80% of the otherwise allowable itemized deductions. These dollar amounts are inflation-adjusted for tax years after 2013.
While there is a real prospect that high earners will pay more taxes this year, tax practitioners and taxpayers should both keep in mind that it's almost never too late to better a taxpayer's tax situation, minimizing taxes to the greatest extent possible. Year-end tax planning may be especially productive this year because timely action could nail down a host of “extender” tax breaks—individual and business tax provisions that are due to expire at year's end.
In addition, other tax moves may prove advantageous. Many taxpayers can still better their tax position by acting now to make the most of enhanced expensing and depreciation; keep adjusted gross income (AGI) down to avoid reduction (or elimination) of the many tax breaks that phase out over higher levels of AGI; make the best tax use of losses; and take full advantage of the available tax credits.