2013 Tax Landscape
At the end of 2012 a number of tax laws, including rate cuts, deductions, and other provisions, will expire. The effect on each person will depend on their income and tax situation. One study estimated that the average American household would face a tax increase of $3,800 if Congress does not act to extend some, or all, of the tax breaks.
The so-called Bush tax cuts are in place through the end of 2012. That means that your income for this year will still be taxed under those rates. But beginning in 2013 those reduced rates will automatically expire unless Congress takes action. But that’s not all. The 2% Social Security tax rate reduction, often called the payroll tax holiday, is also scheduled to expire at year-end.
There’s still more. More people will be liable for the federal estate tax. And the controversial 2010 healthcare legislation, recently upheld by the Supreme Court, will impose an additional 0.9% Medicare tax on salaries and self-employment income earned by higher-income individuals as well as a 3.8% Medicare surtax on investment income earned by higher-income folks.
“The Bush Tax Cuts”
The Bush tax cuts consist of several components, including tax rates on ordinary income, capital gain income, and treatment of certain types of investment income. Should Congress fail to enact any type of legislation, the following will occur:
Higher Tax Rates. Despite the plans and promises of those who are vying to be sitting in the Oval Office come next January, without action by Congress and approval by whoever is sitting in that seat, rates will go up for everyone. Currently, the rates for the different brackets are 10%, 15%, 25%, 28%, 33%, and 35%. In 2013, the rates will be 15%, 28%, 31%, 36% and 39.6%.
Higher Capital Gains and Dividends Taxes. Right now, the maximum federal rate on long-term capital gains and dividends is 15%. Starting next year, the maximum rate on long-term gains is scheduled to increase to 20%. Dividends will no longer be treated similar to capital gains and will be subject to the ordinary rates stated above. That means, dividends could be taxed at a rate as high as 39.6%.
Return of the Itemized Deductions Phase-Out Rule. Before the Bush tax cuts, a phase-out rule could eliminate up to 80% of a higher-income individual’s itemized deductions for mortgage interest, state and local taxes, and charitable donations. The rule was gradually eased and finally eliminated in 2010. Next year, however, the phase-out will be back with full force. Those who itemize their deductions and have 2013 adjusted gross income above about $179,000 (or about $89,500 for married filing separate status), this phase-out rule will take away the benefit of a portion of otherwise allowable deductions.
Return of Personal Exemption Phase-Out Rule. Similar to the itemized deduction phase-outs, there is a similar rule that can eliminate up to 100% of a higher-income individual’s personal exemption deductions. Depending on a taxpayer’s filing status this phase-out begins to kick in anywhere from about $134,000 for married filing separate through $269,000 for those filing joint married returns. Those with single or head of household filing status will be somewhere in the middle of that range.
Marriage Penalty. The Bush tax cuts eased the so-called marriage penalty, which can cause a married couple to pay more in taxes than when they were single. Right now, the bottom two tax brackets for married joint-filing couples are exactly twice as wide as for singles. Starting next year, the joint-filer tax brackets will contract, causing higher tax bills for many folks. In addition, the standard deduction for married joint-filing couples is currently double the amount for singles. Starting next year, the joint-filer standard deduction will be less than double that for singles.
Payroll Tax Holiday
In 2012 the Social Security tax rate on the employee portion of salaries and net self-employment income was reduced 2%, saving someone a maximum of $2,202. A married couple can potentially save twice as much if they both work. The payroll tax holiday is scheduled to end on December 31, 2012. Combined with the annual increase to wages subject to Social Security tax, workers will see an immediate decrease in their take-home wages.
New 0.9% Medicare Tax on Higher-Income Individuals
This change is not because of some expiring provision, but is an element of the Health Care Act recently upheld by the Supreme Court. Starting in 2013, an extra 0.9% Medicare tax will be charged on salary and/or net self-employment income above $200,000 for an unmarried individual, above $250,000 for a married joint-filing couple, and above $125,000 for those who use married filing separate status. Self-employed individuals know that they are allowed to deduct one-half of their self-employment tax but this additional 0.9% will not qualify for the 50% deduction. This tax is subject to withholding or quarterly estimated tax payments.
New 3.8 Percent Medicare Surtax on Investment Income
Another gift from the Health Care Act is 3.8% surtax, beginning in 2013, on all or part of the net investment income, including long-term capital gains and dividends collected by higher-income individuals. This is in addition to any tax paid under the ordinary income or capital gains rate structures. In effect, the maximum federal rate on long-term gains for 2013 and beyond will actually be 23.8% versus the current 15%, and the maximum rate on dividends will be 43.4% versus the current 15%.
The new surtax applies to those with modified adjusted gross income (MAGI) over $200,000 (unmarried), $250,000 (married joint-filer), or $125,000 (married filing separate). For most people, the MAGI will be their total income before itemized deductions and personal exemptions. The surtax will apply to the lesser of your net investment income or the amount of MAGI in excess of the applicable threshold stated above. Net investment income includes gains from assets held for investment (stock, securities, real estate), interest, dividends, royalties, annuities, rents, and income from passive business activities. Net investment income also includes taxable gains from personal residence sales. There is currently a great deal of incorrect information on the internet surrounding this. The surtax applies only to taxable gains from sales of investments or real property (including residences). It does NOT apply to the total sales price. And, since up to $500,000 of gain on a sale of a residence can be excluded from taxation, many people will not be paying this surtax on sales of their homes. Those who believe they will be subject to this tax must take it into consideration for their estimated tax payments.
Tax Planning Implications
Depending on how the presidential election turns out, it’s possible that some of these changes, perhaps none of them, will take effect. The prudent approach is to plan for the worst and be prepared to make some tax planning moves after the November election results are known. We are available to work with clients to help them position income and deductions to get the best treatment.
Greg Tanner – is a Tax Principal at Wertz & Company, LLP, a Professional Services Firm located in Orange County, CA that specializes in working with entrepreneurs along their journey to success.