February 21, 2013
2013 Will Hit Higher-Income Taxpayers Hard - Be Prepared
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On December 22, 2017, The Tax Cuts and Jobs Act was signed into law. The information in this article predates the tax reform legislation and may not apply to tax returns starting in the 2018 tax year. You may wish to speak to your tax advisor about the latest tax law. This publication is provided for your convenience and does not constitute legal advice. This publication is protected by copyright.
Now that Congress has passed the American Taxpayer Relief Act of 2012 (ATRA) and avoided the so-called “fiscal cliff,” higher-income taxpayers need to brace for higher taxes. There are numerous provisions in the ATRA that don’t provide the higher-income taxpayer any relief, and when these are combined with the provisions of the 2010 Affordable Health Care Act, higher-income taxpayers will feel a significant increase in taxes for which they need to prepare.
Virtually all of the increases are based on a taxpayer’s filing status and income, and even individuals who don’t perceive themselves as higher-income taxpayers may be surprised if they have a substantial gain from the sale of stocks, sale of a home or rental, sale of a business, the exercise of stock options, and just about any other event that would inflate income for the year or generate investment income.
So here are the things to watch for in 2013:
Virtually all of the increases are based on a taxpayer’s filing status and income, and even individuals who don’t perceive themselves as higher-income taxpayers may be surprised if they have a substantial gain from the sale of stocks, sale of a home or rental, sale of a business, the exercise of stock options, and just about any other event that would inflate income for the year or generate investment income.
So here are the things to watch for in 2013:
- Personal Exemption Phase-out – For tax years beginning after 2012, ATRA reinstated the Personal Exemption Phase-out (PEP), which had been suspended in 2010 through 2012. It is interesting to note that the reinstated phase-out thresholds are higher than in previous years, thus requiring significantly higher income before the phase-out begins to take effect. The otherwise allowable exemption amounts are reduced by 2% for each $2,500, or part of $2,500 ($1,250 for married filing separately), that the taxpayer's AGI exceeds the amount shown in the table below for the taxpayer's filing status.
Example: Ralph and Louise have an AGI of $412,500 for 2013 and two children for a total of four exemptions totaling $15,600 (4 x $3,900). The threshold for a married couple is $300,000; thus, their income exceeds the threshold by $112,500. Dividing $112,500 by $2,500 equals 45. So 90% (45 x 2%) of their $15,600 exemption allowance is phased out, leaving them with a reduced exemption deduction of $1,560 ((100-90) x $15,600). Assuming Ralph and Louise are in the 33% federal tax bracket, the phase-out costs them an additional $4,633 ($15,600 x 90% x 33%).
Planning Tips – Taxpayers subject to the phase-out should consider relinquishing the exemption of a dependent child to the other parent, in cases where the parents are divorced or separated. Where a taxpayer is party to a multiple support agreement, the taxpayer may want to allow another contributing member of the agreement who is not hit by the phase-out to claim the dependent’s exemption. - Itemized Deduction Phase-out – The itemized deduction phase-out referred to as the “Pease” limitation, which, like the personal exemption phase-out, had been suspended for 2010 through 2012, is reinstated for 2013 and later years. The AGI threshold amounts are the same as the exemption thresholds shown in the table above. Like the exemption phase-out thresholds, the reinstated itemized deduction phase-out thresholds are higher than they were in earlier years, thus requiring significantly higher income before the phase-out begins to take effect. For taxpayers subject to the “Pease” limitation, the total amount of their itemized deductions is reduced by 3% of the amount by which the taxpayer's adjusted gross income (AGI) exceeds the threshold amount, with the reduction not to exceed 80% of the otherwise allowable itemized deductions.
Not all itemized deductions are subject to phase-out. The following deductions are not subject to the phase-out:
- Medical and dental expenses
- Investment interest expense
- Casualty and theft losses from personal use property
- Casualty and theft losses from income-producing property
- Gambling losses
Thus, a taxpayer who is subject to the full phase-out still gets to deduct 20% of the deductions subject to the phase-out and 100% of the deductions listed above.
Example: Ralph and Louise from the previous example, who had an AGI of $412,500 for 2013, exceed the threshold for a married couple by $112,500. Thus, they must reduce their itemized deductions subject to the phase-out by $3,375 (3% of $112,500) but not exceeding 80% of the deductions subject to the phase-out. For 2013, Ralph and Louise had the following itemized deductions:
The phase-out is the lesser of $3,375 or 80% of $24,000. Thus Ralph and Louise’s itemized deductions for 2013 will be $32,625 ($24,000 - $3,375 + $12,000). Assuming Ralph and Louise are in the 33% federal tax bracket, the phase-out will cost them an additional $1,114 ($3,375 x 33%)
Planning Tip – Conventional thinking is to maximize deductions. However, where taxpayers are not normally subject to phase-out and have a high-income year because of unusual income, it may be appropriate, where possible, to defer paying deductible expenses to the year following the high-income year, or perhaps pay and deduct the expenses in the preceding year. - Ordinary Income Tax Rate Increase – Beginning in 2013, the ATRA retained the graduated tax marginal rates that are adjusted annually for inflation, and added a new top rate of 39.6% (previously the top rate was 35%). Thus, higher-income taxpayers who fall within this new bracket will be subject to an additional 4.6% tax on their income above the threshold for this new bracket. The thresholds are:
- $450,000 for joint filers and surviving spouses;
- $425,000 for heads of household;
- $400,000 for single filers; and
- $225,000 for married filing separately.
Example: Jack and Sally who are filing jointly have an ordinary taxable income of $600,000. Their income above $450,000 will be subject to the 39.6% tax rate. Thus, they will see a tax increase of $6,900 (($600,000 - $450,000) x 4.6%) as a result of the new tax bracket. - Capital Gains and Dividends – Beginning in 2013, ATRA permanently increased the top rate for long-term capital gains and qualified dividends to 20% (up from 15%) for taxpayers with incomes exceeding the following for 2013 (inflation adjusted for future years):
- $450,000 for joint filers and surviving spouses;
- $425,000 for heads of household;
- $400,000 for single filers; and
- $225,000 for married filing separately.
This results in an increase of 5% (20% – 15%) in capital gains rates for higher-income taxpayers.
Example: Howard, a single individual, retired this year and sold his rental, which he had owned for a long time, for a profit of $700,000. Even though his income is generally in a lower-income tax bracket, the profit from the sale itself pushed his income above the $400,000 threshold for single taxpayers, and to the extent his income exceeds the $400,000 threshold, he will be subject to the increased capital gains rate. Had Howard’s other taxable income been $50,000, then he would have had a total income of $750,000, of which $350,000 exceeds the 20% long-term CG rate threshold. As a result, Howard pays the 20% rate on $350,000. That is an increase of $17,500 ($350,000 x 5%) over what he would have paid in 2012.
Caution – Generally, sales that are subject to long-term capital gains rates are also investment income subject to the 3.8% unearned income Medicare contribution tax that is part of the Affordable Care Act discussed later in this article.
Planning Tip – If Howard had utilized an installment sale, he could have spread the gain over multiple years and possibly avoided the higher CG rate. He might have also utilized a tax-deferred exchange to defer the gain into other real estate property. - Increased Hospital Insurance Tax – As part of the Affordable Health Care Act, beginning in 2013, the Hospital Insurance (HI) tax rate (currently at 1.45%) will be increased by 0.9% on individual taxpayer earnings (wages and self-employment income) in excess of compensation thresholds for the taxpayer's filing status. Married taxpayers must combine their incomes subject to HI tax when computing this additional tax. Thus, for wages the HI tax rate will be 1.45% up to the income threshold and 2.35% (1.45 + 0.9) on amounts in excess of the income threshold. The hospital insurance portion of the self-employed tax rate will be 2.9% up to the income threshold and 3.8% (2.9 + 0.9) on amounts in excess of the threshold. The income thresholds where this increase begins are $250,000 for married taxpayers filing jointly, $125,000 for married taxpayers filing separately, and $200,000 for all other taxpayers.
Employers are required to withhold the additional tax once wages exceed $200,000, but only on income from that employer. Employers cannot adjust the HI withholding based upon the employee having additional employment or a spouse who also works. Thus, there will be situations where the taxpayers will be under-withheld for the year.
Example – Jack and Jill are both employed. Jack’s wages are $175,000, and Jill’s wages are $150,000. Since neither employee’s wages exceed $200,000, their employers do not withhold the additional 0.9% for HI tax on either Jack’s or Jill’s wages. When they file their joint 1040 return, they will need to include $675 (($175,000 + $150,000 $250,000) x 0.009) HI tax as part of their total tax. Jack and Jill may need to adjust their income tax withholding or make estimated tax payments to account for the extra HI tax and to avoid any underpayment penalty. - Unearned Income Medicare Contribution Tax – As part of the Affordable Health Care Act, a new tax takes effect beginning in 2013. The official name of this tax is the “Unearned Income Medicare Contribution Tax,” and even though the name implies it is a contribution, don’t get the idea you deduct it as a charitable contribution. It is, in actuality, a surtax levied on the net investment income of higher-income taxpayers.
The surtax is 3.8% on the lesser of your net investment income or the excess of your modified adjusted gross income (MAGI) over a threshold based on your filing status. MAGI is your regular AGI increased by income excluded for working out of the country; net investment income is your investment income reduced by investment expenses.
The filing status threshold amounts are:
- $250,000 for married taxpayers filing jointly and surviving spouses.
- $125,000 for married taxpayers filing separately.
- $200,000 for single and head of household filers.
Example - A single taxpayer has net investment income of $100,000 and MAGI of $220,000. The taxpayer would pay a Medicare contribution tax only on the $20,000 amount by which his MAGI exceeds his threshold amount of $200,000, because that is less than his net investment income of $100,000. Thus, the taxpayer's Medicare contribution tax would be $760 ($20,000 × 3.8%).
Investment income includes:
- Interest, dividends, annuities (but not distributions from IRAs or qualified retirement plans), and royalties,
- Rents (other than derived from a trade or business),
- Capital gains (other than derived from a trade or business),
- Home sale gain in excess of the allowable home gain exclusion,
- A child’s investment income in excess of the excludable threshold if, when eligible, the parent elects to include his or her child’s investment income on the parent’s return,
- Trade or business income that is a Sec. 469 passive activity with respect to the taxpayer, and
- Trade or business income with respect to trading financial instruments or commodities.
Planning Tips: For surtax purposes, gross income doesn't include interest on tax-exempt bonds. Thus, one can avoid the net investment income surtax by investing in tax-exempt bonds. A taxpayer can also utilize the installment sale provisions to spread gains from capital assets such as rentals and business assets over a number of years to keep the investment income under the tax threshold.
Investment expenses include:
- Investment interest expense,
- Investment advisory and brokerage fees,
- Expenses related to rental and royalty income, and
- State and local income taxes properly allocable to items included in Net Investment Income.
Do you think you will never get hit with this tax because your income is way under the threshold amounts? Don’t be so sure. When you sell your home, the gain is a capital gain, and to the extent that the gain is not excludable using the home gain exclusion, it will add to your income and possibly push you above the taxation thresholds. And, since capital gains are investment income, you might be in for a surprise. The same holds true for gains from selling stock and a second home. So when planning to sell a capital asset, be sure to consider the impact of this new surtax.
The surtax also applies to undistributed net investment income of trusts and estates, and there are special rules applying to the sale of partnership and Sub-S Corporation interests.
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