While the results of the presidential election have been determined, the tax landscape is less than settled. Absent any legislative changes, taxpayers are looking at significant modifications in federal taxation beginning in 2013.
“Taxpayers need to be aware of the changes and know how they will impact them. Year-end tax planning becomes critical,” says John T. Alfonsi, managing director at Cendrowski Corporate Advisors.
Smart Business spoke with Alfonsi about what business owners and individuals should know about the anticipated changes.
What are some of the changes individuals will be experiencing in 2013?
Plenty of changes will occur by virtue of the expiration of the Bush-era tax cuts primarily enacted by the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs Growth Tax Relief Reconciliation Act of 2003. For starters, tax rates will revert back to the former brackets, with the top marginal rate rising from 35 percent to 39.6 percent. Capital gain rates will also change. Currently, long-term capital gains are taxed at a maximum rate of 15 percent. Beginning in 2013, that maximum rate goes up to 20 percent.
What about dividend income?
Dividend income is currently taxed at the same rate as long-term capital gains, or a maximum of 15 percent. All dividend income will be taxed at ordinary income rates beginning in 2013. Accordingly, individuals in the top tax bracket will see their dividend income go from being taxed at 15 percent to 39.6 percent.
Are tax rates the only thing affected?
No, deductions are impacted, as well. For example, overall itemized deductions are currently not subject to any limitations. Beginning in 2013, we revert back to prior law, where higher-income taxpayers must reduce their total itemized deductions by 3 percent of the amount in excess of a threshold amount of adjusted gross income; total itemized deductions cannot be reduced by more than 80 percent, however. Personal exemptions are another deduction that will be impacted. Currently, there are no restrictions on the amount of personal exemptions a taxpayer can deduct in arriving at taxable income. After 2012, however, personal exemptions will be limited for higher income taxpayers — the amount is reduced by 2.5 percent for each $2,500 by which the taxpayer’s adjusted gross income exceeds applicable thresholds.
Are there any new taxes individuals should be aware of?
Absolutely. There are two specific taxes higher income individuals need to consider. First, the employee portion of the hospital insurance payroll tax will increase by 0.9 percent — from 1.45 percent to 2.35 percent — on wages over $250,000 for married individuals and $200,000 for unmarried individuals. The employer portion will remain at 1.45 percent. The other new tax is the Medicare contribution tax on unearned income of higher-income individuals. This tax was enacted as part of the Patient Protection and Affordable Care Act, better known as ‘Obama Care.’ The tax is 3.8 percent on the lesser of an individual’s net investment income or the amount of adjusted gross income in excess of certain thresholds — $250,000 for married individuals and $200,000 for unmarried individuals. For purposes of this tax, investment income includes interest, dividends, and income and net gains from passive activities and ‘trader’ activities, such as hedge funds.
To illustrate the impact of these changes, let’s assume a married individual has an adjusted gross income of $700,000, which is made up of wages and salary of $500,000, dividend income of $100,000 and $100,000 long-term capital gain, both from investment partnerships. Further, assume the taxpayer has gross itemized deductions of $50,000 and four personal exemptions. Taxable income will increase by approximately $35,000 solely because of the limitation on itemized deductions and personal exemptions. The total federal income tax liability will increase from approximately $151,500 to $206,000 as a result of the higher tax brackets, dividend income being taxed at ordinary income rates and the new Medicare contribution tax on the dividend and long term capital gains income. This is a 36 percent increase in the federal income tax liability without any change in gross income. This also ignores the impact of the additional $2,250 hospital insurance payroll tax on the wages.
What can taxpayers do to minimize the potential tax increase?
Tax planning becomes important. Conventional wisdom suggests you should defer income and accelerate deductions. But in a period of increasing tax rates, there are no steadfast rules; each situation needs to be looked at individually. For example, with the higher tax rates in 2013, you may want to defer any charitable contributions from 2012 to 2013 as you get a potentially bigger benefit at the higher rate. But the taxpayer needs to consider the limitation on itemized deductions that will apply in 2013, but not in 2012. This ignores, of course, the impact of the alternative minimum tax, which presents its own set of issues, concerns and tax planning. Accelerating capital gains into 2012 may be a planning opportunity to take advantage of the 15 percent rate and avoid the Medicare contribution tax on such income.
Do you have any other tax planning tips?
Taxpayers looking to make significant gifts as part of their estate plan should consider taking advantage of the $5 million lifetime gift exclusion, which expires at the end of 2012. Beginning in 2013, the lifetime gift tax exclusion decreases to $1 million. Further, estate and gift tax rates are scheduled to increase from a maximum of 35 percent to 55 percent. Of course, all of this becomes moot if new legislation is enacted to avoid the ‘fiscal cliff’ we are facing.
John T. Alfonsi is managing director at Cendrowski Corporate Advisors. Reach him at (866) 717-1607 or [email protected]
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