Recent tax law changes will impact many taxpayers in 2013, even those who don’t meet the government’s various definitions of “high-income.”
As has become customary in the last couple of years, Congress waited until the eleventh hour to pass new tax legislation - in this case, the American Taxpayer Relief Act of 2012 (ATRA), signed into law on Jan. 2, 2013. Had Congress not acted, the tax component of the “fiscal cliff” would have taken effect, resulting in higher income tax bills for all taxpayers.
For income tax purposes, Congress has defined high-income taxpayers as single individuals, heads of households and married couples filing jointly who have taxable incomes of at least $400,000, $425,000 and $450,000, respectively. Under ATRA, all taxable income above these thresholds is now subject to a maximum federal rate of 39.6 percent on ordinary income, which includes wages, interest income, business income and short-term capital gains. ATRA also increased the tax rate on long-term capital gains (realized upon the sale of investments held for more than one year) and qualified dividends for these top earners from 15 percent to 20 percent.
For those with taxable incomes below the aforementioned amounts, ATRA made the once-temporary Bush-era marginal income tax rates permanent. These include the 15 percent rate on long-term capital gains and qualified dividends for most taxpayers. Further, taxpayers in income tax brackets of 15 percent or lower will continue to enjoy long-term gains and qualified dividends completely free of federal tax.
ATRA replaced the top federal income tax rate for estates and trusts, formerly 35 percent, with the new 39.6 percent rate. Because tax brackets for estates and trusts are compressed compared with brackets for individuals, the top rate applies to any taxable income in excess of $11,950 that remains in a trust or estate.
The tax rate increases described above are straightforward. Much less so is the revival of limitations on itemized deductions and the personal exemption phaseout, both of which had been temporarily eliminated under the Economic Growth and Tax Relief Reconciliation Act of 2001. The reinstatement of these provisions will result in higher tax bills for many individuals and families below the top 39.6 percent tax bracket.
Itemized deductions and personal exemptions are subtracted from a taxpayer’s adjusted gross income (AGI) to determine his or her taxable income. The reinstated provisions limit the total amount of itemized deductions (such as mortgage interest, property taxes, and charitable contributions) and personal exemptions that households may claim after their AGIs exceed certain thresholds. The thresholds for 2013 are $300,000 for married couples filing jointly and surviving spouses, $275,000 for heads of households, $250,000 for unmarried individuals and $150,000 for married taxpayers filing separately. These will be adjusted for inflation annually.
The “Pease” limitation, named after the late Rep. Donald Pease, D-Ohio, reduces a taxpayer’s itemized deductions by 3 percent of his or her AGI above the threshold, but not by more than 80 percent of total itemized deductions. For a married couple with adjusted gross income of $425,000 and $50,000 in itemized deductions, their allowed deductions would be reduced by $3,750, resulting in additional income tax of about $1,240.
The personal exemption amount for 2013 is $3,900. A family of four’s exemptions could total as much as $15,600 of untaxed gross income. Under the phaseout, however, the total amount of exemptions a taxpayer may claim is reduced by 2 percent for every $2,500, or portion thereof, by which her AGI exceeds the applicable threshold. Assume that the married couple mentioned in the previous example has two young children. Their personal exemptions will be reduced to zero under the phaseout, resulting in additional income tax due of about $5,150. Although they would not be subject to the 39.6 percent income tax rate (their taxable income, $378,750, is below the applicable threshold), they would see their tax bill increase by as much $6,390, assuming their AGI and deductions stayed constant between 2012 and 2013.
The Patient Protection And Affordable Care Act
In addition to the tax law changes that took effect under ATRA, a Medicare surtax on earned income and net investment income now affects high-income taxpayers. This surtax is imposed under the Patient Protection and Affordable Care Act to help pay for health care reform. However, the definition of a high-income taxpayer has a much lower threshold under the Affordable Care Act than under ATRA.
Unmarried employees and self-employed individuals with earned income above $200,000 (above $250,000 for married couples filing joint tax returns and above $125,000 for married couples filing separately) will pay an additional 0.9 percent on wages surpassing that threshold. Employers are responsible for withholding this additional Medicare tax once an employee’s wages and compensation reach $200,000 for the year. However, the employer is not responsible for taking into account any compensation the employee may earn outside of the company, or the wages of the employee’s spouse, when determining its withholding requirement. In either of these cases, the taxpayer must be aware of her exposure to the surtax and either request that additional taxes be withheld from her compensation by filing a Form W-4, Employee’s Withholding Allowance Certificate, or remitting the additional tax by making estimated tax payments. The self-employed or their tax preparers will also need to factor in the additional tax when computing quarterly estimated tax payments for 2013. Otherwise, they may incur underpayment penalties and interest charges.
The Affordable Care Act also imposes a 3.8 percent tax on unearned net investment income. The act broadly defines unearned investment income to include interest, dividends, annuities, royalties, rents and capital gains that are not derived in the ordinary course of trade or business. The tax will apply to the lesser of net investment income or the modified adjusted gross income (MAGI) amount exceeding the $200,000/$250,000 thresholds established for earned income. For example, an unmarried taxpayer has $230,000 of MAGI, including $50,000 of net investment income. She would pay health care tax of $1,140 on $30,000, the amount of investment income that pushes her MAGI above the $200,000 threshold, rather than the entire $50,000. Combining the tax law changes of ATRA and the Affordable Care Act, taxpayers subject to the 39.6 percent income tax rate will now pay top effective tax rates of 23.8 percent on long-term capital gains and qualified dividends and 43.4 percent on short-term gains and other investment income. An increase in tax rates of 8.8 percent and 8.4 percent, respectively, is quite significant. These rates also apply to trusts and estates.
Reducing Exposure To The Additional Tax Bite
To minimize the blow of these additional taxes, reduce your adjusted gross income. Maximizing contributions to qualified retirement plans, such as 401(k)s, Simplified Employee Pensions (SEP) IRAs, SIMPLE IRAs and cash balance plans is a great start. Consider making gifts of appreciated securities to children and other family members in the 10 and 15 percent income tax brackets, especially if you are subject to the 39.6 percent income tax rate and to an effective long-term capital gains rate of 23.8 percent. The qualified dividends paid by these securities, as well as the long-term gains realized from selling them, will be tax-free for lower-income taxpayers, increasing your gift’s value while reducing your income.
Going forward, trustees should strongly consider whether it would be more tax-effective to distribute income to trust beneficiaries in lower tax brackets. Trusts don’t have to generate much income to pay top marginal tax rates, because trust income tax brackets are so compressed. If the beneficiaries are subject to the 15 percent tax bracket or lower, and including trust distributions in their incomes wouldn’t push them into higher brackets, the trust income may escape taxation entirely. Even if the beneficiaries are in higher tax brackets but are not subject to the top tax rate, distributing the income may at least avoid exposure to the Medicare surtax. Similarly, if trustees plan to sell appreciated securities to cover trust distributions, they should consider distributing the securities directly to the intended beneficiaries so that they may sell them instead.
Federal Estate And Gift Taxes
Many estate-planning attorneys and financial advisers, including those at Palisades Hudson, were working at a frenetic pace to help high-net-worth clients establish and fund irrevocable trusts before 2012 ended. We were concerned that, without congressional intervention, the $5.12 million federal gift and estate tax exemption would be reduced to $1 million per taxpayer and that the top marginal gift and estate tax rate of 35 percent would increase to 55 percent in 2013. Instead, ATRA made permanent the $5 million exemption, adjusted for inflation annually (the figure is $5.25 million in 2013) and a maximum federal estate tax rate of 40 percent for estates of decedents dying in 2013 or later.
Under ATRA, the $5 million generation-skipping transfer (GST) tax exemption was also indexed for inflation. For 2013, the GST exemption is also $5.25 million, and amounts in excess of the exemption are taxed at a rate of 40 percent. The GST tax, however, is separate and levied in addition to the federal gift and estate tax. It applies to transfers made to grandchildren and more remote descendants.
ATRA also made portability permanent. Portability is a mechanism that allows a surviving spouse to apply any remaining exemption that her deceased spouse did not use to transfers she may make during her lifetime and upon her own death. Therefore, portability can be an effective estate-planning tool for married couples. The deceased spouse’s estate must file a federal estate tax return (Form 706) to make the portability election. It is important to keep in mind that portability does not apply to the GST tax exemption, so if the first spouse to die does not use all of his GST exemption, the remainder could be wasted without careful planning.
For 2013, the annual gift tax exclusion amount, which adjusts for inflation annually, was increased to $14,000. As a result, taxpayers can make gifts of up to $14,000 per person (and married couples may make gifts of up to $28,000 per person) without using any of their available lifetime exemption or triggering any gift taxes.
Because of the significance of the tax law changes in 2013, it is best to consult an experienced tax adviser to determine how they will impact your personal situation. Effective planning early in the year will likely save you some money come April 2014.
Other Noteworthy Tax Changes
The American Taxpayer Relief Act contains several other noteworthy tax law changes and extensions for 2013:
IRA Distributions To Charity - Through the end of 2013, taxpayers age 70 1/2 and older are allowed to distribute up to $100,000 tax-free from their traditional IRAs to public charities.
State And Local Sales Tax Deduction - The choice to claim an itemized deduction for state and local general sales taxes in lieu of state and local income taxes has been extended through 2013.
Education Credit - The American Opportunity Tax Credit has been extended through 2017. It provides qualified taxpayers with a maximum tax credit of up to $2,500 per eligible student for qualified tuition and related expenses incurred during the tax year.
Student Loan Interest Deduction - Voluntary interest payments are now deductible. You can deduct the full amount, up to $2,500 annually (subject to income phaseout limitations), even if you paid more than required. And you can now deduct interest for the entire loan term, not just for the first 60 months as under prior law.
Mortgage Insurance Premium - The provision to treat mortgage insurance premiums as deductible interest has been extended through the end of 2013.
Home Office Deduction - The self-employed and employees who are required to maintain home offices by their employers may now deduct $5 per square foot for home office expenses, up to a maximum of $1,500. This can make life a little easier for small business owners who keep poor records. However, they should still determine whether filing for a home office deduction the traditional way would provide a greater tax benefit.
Small Business Expensing - The dollar and investment limits for deducting the cost of capital assets purchased during the tax year, instead of claiming depreciation deductions over the life of the assets, has been extended through 2013. Under Internal Revenue Code Section 179, the dollar limit is $500,000 and the investment limit is $2 million this year.