Many people, especially higher-income types, will pay higher taxes next spring. Don't be surprised that your returns take a bigger bite from your 2013 income.
Most of the media coverage focused on the rolling back of a two percentage point cut in the payroll tax and the increase in the top tax rate to 39.6%. In truth, there are many small changes to the tax code that essentially nickel and dime the highest income earners.
By taking a little here and a little there, Congress ensured that high-income earners pay a lot more income tax in 2013. So much for that taxpayer relief promised in the title of the bill. Here’s how they did it:
Increase in top rate and squeeze in the 35% bracket. Not only does the bill increase the rate on the highest incomes ($400,000 single or $450,000 married filing joint), it also creates an extremely narrow 35% bracket. The 33% bracket ends at $398,350 for single and married filing joint taxpayers. This means there’s a tiny $1,650 range in the 35% bracket for single filers.
This means that it’s only a tiny jump from paying 33% or 39.6%. The gap for married couples filing jointly is $50,000 greater, but it’s still a very narrow band.
Raising the rate on capital gains and dividends. Taxpayers in the highest bracket now pay 20% on long-term capital gains and qualified dividends (essentially those held for longer than 61 days – nonqualified payouts get taxed as ordinary income). This is an increase from 15%. While minor, this has implications for the investments these individuals hold in taxable accounts. You can offset this with more municipal bonds and low or no dividend-paying stocks.
Return of the Pease Limitations. The ceiling on your deductions is lower now. Pease limitations reduce itemized deductions such as charitable contributions, mortgage interest, state, local and property taxes for single filers with adjusted gross income (AGI) greater than $250,000 ($300,000 for joint filers). The reduction is the lesser of 3% of AGI above the threshold or 80% of the itemized deductions otherwise allowable.
Personal exemption phase-outs are back. The personal exemption of $3,900 for each member of the household falls for singles filers with AGI greater than $250,000 (or $300,000 for married couples filing jointly). The personal exemption drops by 2% for every $2,500 or portion thereof above the threshold. So if you are single and your AGI is $252,500, you can only deduct $3,822 for each family member.
Additional taxes in the Patient Protection and Affordable Care Act. Don’t forget, the new taxes for Obamacare kick in this year. That imposes an additional 0.9% Medicare tax on individual incomes above $200,000, or $250,000 for married joint filers. And there is no inflation adjustment for this written into the law. Finally, the health law levies a 3.8% Medicare tax on investment incomes above those same thresholds, also not adjusted for inflation.
These changes bring small increases in the tax bills for high-income earners. Taken as a whole, though, it’s like a death by 1,000 cuts. Most likely, the highest income earners will see a substantial increase in their 2013 taxes. The new rules have implications for allocating taxable investment portfolios, as well. Now is the time to review your portfolio to see if you need to make changes to offset these new taxes.
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Blair Hodgson DuQuesnay, CFA, CFP, is the founder and CEO of Ignite Investments and Planning, a registered investment advisor domiciled in the state of Louisiana. She regularly posts her financial insights on her blog, http://ignitemyplan.com/blog/
Ignite Investments and Planning does not provide tax advice. You should consult with your CPA or tax professional regarding your individual tax situation.
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