How expiring tax cuts and new provisions will increase tax rates in 2013

Steve Magovac, CPA, MT, Associate Director in Tax, SS&G

If nothing changes by end of the year, more of your income in 2013 will go toward taxes, says Steve Magovac, CPA, MT, an associate director in tax at SS&G.

“With the tax cuts that are expiring at the end of 2012, everyone is going to be facing a tax hike in 2013, from those with moderate incomes up to the highest-income individuals,” says Magovac.

Smart Business spoke with Magovac about how the expiring tax cuts and new tax increases will impact your income in 2013.

What can taxpayers expect in 2013?

President Bush implemented tax cuts in 2001 and 2003 tax bills and President Obama extended them through 2012. If nothing is done legislatively, come 2013, those tax cuts are going to expire and tax rates are going to go up. The 10 percent tax bracket would disappear and move up to 15 percent for income levels below $35,350 for filing single.  All other tax bracket rates would increase, with 39.6 percent being the highest bracket for income levels making over $388,350.

Currently, the maximum tax rate on long-term capital gains and qualified dividends is 15 percent, with lower income filers having a 0 percent tax rate. The expiring provisions would remove the capital gains rate back to a maximum of 20 percent, and qualified dividends would resume being taxed at the ordinary rates, as high as 39 percent.

With other expiring provisions, we’ll see the return of the ‘marriage penalty,’ limitations on itemized deductions and personal exemptions for high-income earners, reduction in the child tax credit to $500 and tougher eligibility requirements, loss of the American Opportunity Credit for eligible higher education expenses, the temporary 2 percent reduction in the employee share of FICA tax rate, and many others.

What new laws will impact taxes?

In 2011 and 2012, many employees and self-employed individuals benefited from a 2 percent Social Security reduction that is withheld from payroll checks. In 2013, the rate will revert back to 7.65 percent. In addition, as a result of the health care act, there will be an additional hospital insurance tax. This payroll tax of 0.9 percent will be paid by wage earners who make $250,000 or more if married and filing jointly, $125,000 if filing separately and $200,000 if single or head of household. This new tax does not apply on income earned up to the limits but kicks in on income above the set amounts.

Another tax being rolled out in 2013 is the Medicare contribution tax. This 3.8 percent tax will be paid by those individuals at the same income limits as the hospital insurance tax. The Medicare contribution tax is on net passive income — investment income, interest and dividends, royalties, rents, capital gains, annuities, etc. — in which high-income individuals will pay an additional 3.8 percent on that income over those levels. For example, if you are married filing jointly and your total income is $260,000, with $20,000 of it from interest, only $10,000 will be subject to that 3.8 percent tax.

What other changes are coming in 2013?

As part of the health care act, the medical expense deduction that currently applies to medical expenses over 7.5 percent of adjusted gross income will increase to 10 percent making that even more difficult to receive a medical deduction.  In addition, under current law, you can put an unlimited amount — up to your earned income — in a medical flexible spending account. Beginning in 2013, that limit will decrease to $2,500 as a result of the government’s efforts to raise funds to supplement public health insurance.

In addition, some education benefits are going to decrease and some, such as the American Opportunity Credit, disappear at the end of 2012. The student loan interest deduction is also changing, reverting to an older law in which that deduction is only available for the first 60 months of repayment. Finally, the Section 179 and bonus depreciation limits are also changing; Section 179 is decreasing from $500,000 in 2011 to $125,000 in 2012 down to $25,000 in 2013, and bonus depreciation is decreasing from 100 percent in 2011 to 50 percent in 2012 and is eliminated in 2013.

How will these changes impact the way high-net-worth individuals think about tax planning?

Typically, people try to accelerate deductions and defer income into future years. However, if no new legislation changes are made to the expected 2013 tax code, it may be a better idea to reverse your thinking. If tax rates are going to increase next year and you know you are going to have a higher income, you may want to accelerate some of that income and take deductions instead in 2013, when the rates might be higher. One tax planning idea is if a Roth conversion is a worthwhile option, consider converting in 2012 rather than 2013.

There is a lot of uncertainty right now and it’s a guessing game what new legislation will be in place in 2013, if any. However, as of now, there is nothing good coming in 2013. The rules as they are now written show a large tax increase in 2013 for high-net-worth individuals. With the tax rate increasing to 39.6 percent, plus the additional 3.8 percent on the Medicare portion and the 0.9 percent additional payroll tax, high-net-worth individuals will be paying a tax rate of more than 44 percent.

If the economy is still fragile in late 2012, there may be a possibility of more favorable tax provisions passing to stabilize and improve the economy. But in my opinion, with the tax laws as they are, someone is going to be footing the bill, and that is more likely than not going to be higher-income individuals.

This year, it will be more important than ever for high-net-income individuals to work very closely with their tax advisers. You should be thinking about it now, but it’s really difficult to put anything into motion yet because it’s practically impossible to predict what will happen in 2013.

Steve Magovac, CPA, MT, is an associate director in tax at SS&G. Reach him at (330) 668-9696 or [email protected]

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