Will Rogers once said, “The only two things in life that are certain are death and taxes; but at least death doesn’t get worse every time Congress gets together.” Now that you have just sent your check to Washington for your 2012 Federal Income Tax, what lies ahead for 2013 and 2014 could be even more troubling for many. Provisions under two major tax acts, the Patient Protection and Affordable Care Act (PPACA) signed into law in 2010 and The American Taxpayer Relief Act of 2012 are likely to have significant impact on the personal income taxes paid by higher income Americans – much more than the seemingly modest increases in the marginal tax brackets for “wealthy Americans.” Below are seven provisions scheduled to go into effect in 2013 that will potentially increase your tax bill next year.
0.9% additional Hospital Insurance (Medicare) tax on high income taxpayers.
Under current law, an employee is liable for a Medicare Hospital Insurance (HI) tax equal to 1.45% of his or her covered wages. Self-employed individuals are subject to a HI tax of 2.9% of net self-employment income. Beginning in 2013, taxpayers with incomes above certain thresholds will pay an additional HI tax of .9%. For an employee, the additional .9% effectively increases the HI tax from 1.45% to 2.35% on income in excess of the applicable threshold. For self-employed taxpayers, the additional, tax of .9% effectively raises the HI rate to 3.8% of net self-employment income in excess of the applicable threshold. Also, for self-employed individuals, the additional .9% HI tax is not deductible.The thresholds are $250,000 in case of a joint return (the earnings of both spouses are considered) or a surviving spouse, $125,000 in the case of a married individual filing a separate return, and $200,000 for any other taxpayer.
3.8% unearned income Medicare contribution.
The new legislation imposes a 3.8% unearned income Medicare contribution tax on individuals, estates, and certain trusts. For individuals, the tax is 3.8% of the lesser of net investment income or the excess of modified adjusted gross income over a threshold amount. This threshold is $250,000 in the case of a joint return or a surviving spouse, $125,000 in the case of a married individual filing a separate return, and $200,000 in any other case. Investment income, generally, refers to (1) income from interest, dividends, annuities, royalties and rents; (2) gross income from a business to which the tax applies (such as income from “passive” activities); and (3) the net gain from the disposition of certain property. The term does not include distributions from IRAs and other qualified retirement plans.
Threshold for itemized deduction of unreimbursed medical expenses generally increased to 10%.
Under current law, an individual is allowed an itemized deduction for regular tax purposes1 for unreimbursed medical expenses to the extent that such expenses exceed 7.5% of Adjusted Gross Income (AGI). Beginning in 2013, the new legislation increases the threshold for the itemized deduction for unreimbursed medical expenses from 7.5% of AGI to 10% of AGI. However, for the years 2013, 2014, 2015, and 2016, if either a taxpayer or spouse is age 65 before the end of the taxable year, the threshold remains at 7.5%.
New Tax Brackets and an additional 39.6% bracket for “high-income” earners.
The former 10%, 15%, 25%, 33%, and 35% brackets are made permanent. A 39.6% rate will apply to taxable incomes above $450,000 (Married filing joint); 425,000 (Head of Household); $400,000 (Single); and $225,000 (Married filing separately).
20% Capital Gains Tax Rate for High Income Earners
For taxpayers in the 39.6% bracket, a 20% tax rate will apply to long-term capital gains and qualified dividends. For those in the 25%, 28%, 33%, or 35% brackets, a 15% rate will apply. For those in the 10% or 15% brackets a 0% rate is applicable.
Personal and Dependent Exemption Phase-Out.
This provisions requires taxpayers whose income exceeds certain limits to phase-out their personal and dependent exemptions. For 2013 these limits are: $300,000 for Married filing joint; $275,000 for Head of Household; $250,000 for Single; and $150,000 for Married filing separately. The thresholds are subject to adjustment for inflation.
Itemized Deductions Phase-Out
Taxpayers whose incomes exceed specified limits must reduce certain, otherwise deductible, items on Schedule A. The same threshold amounts applicable to the personal exemption phase-out (see above) apply to the itemized deduction phase-out. These threshold amounts will be subject to adjustment for inflation in future years.
What should you do now?
Schedule a meeting with your CPA. Because there are many other provisions of these major tax acts, just how they will ultimately impact you depends on many factors. The best thing you can do over the next few months is to schedule a meeting with your CPA or tax advisor to do some advance calculations as to how your tax liability might change. Don’t wait too long to do this as it could result in you needing to increase your tax withholding or estimated payments.
Implement a tax efficient investment plan. Your investment plan should be tweaked to minimize taxable investment income and high-turnover capital gains distributions. This will be a major theme for the next few years as investors seek to maximize after-tax returns on their portfolios and thus avoid some of these new taxes.
Tax rates will likely not head lower until our federal budget deficit and overall debt picture has improved. Nevertheless as Federal Judge Learned Hand once remarked,
“Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.”