Implications of the 2013 'fiscal cliff' deal: ATRA raises taxes on investment income.
Because the law includes numerous complex tax rules with many caveats, taxpayers will need CPAs' help to understand the changes that result from the legislation. This discussion reviews the major tax changes for 2013, analyzes the components of tax increases for high earners, and provides some insights into how tax planning might be more important now than ever before. In addition, this analysis will primarily focus on the tax on investment income.
The Legislation's Effect on Taxes
One net effect of the deal will be higher taxes on the wealthy; The ATRA increases the top marginal tax rate to 39.6% for single filers with taxable income above $400,000 ($450,000 for married couples filing jointly, $425,000 for head of household, and $225,000 for married filing separately). Specifically, the act makes permanent the 10%, 15%, 25%, and 28% income tax brackets from the Bushera tax cuts. It also retains the 33% and 35% income tax brackets from the Bushera tax cuts for taxable income under $400,000 for single taxpayers ($450,000 for a married couple filing jointly, $425,000 for head of household, and $225,000 for married filing separately). Another significant tax impact on higher earners is the increase of the top rate on capital gains and dividends to 20%, up from the prior maximum of 15%. This top rate on capital gains will apply to taxpayers within the marginal income tax bracket of 39.6%.
Furthermore, the ATRA revives the personal exemption phaseout (PEP) and the Pease limitation on itemized deductions; both provisions apply to high earners and were eliminated from 2010 through 2012. The thresholds of the reduction on personal exemption and itemized deductions are $250,000 for single filers, $275,000 for head of household, and $300,000 for married couples filing jointly. The PEP reduces the value of each personal exemption from its full value by 2% for each $2,500 above the thresholds, based on the filing status. The Pease provision cuts itemized deductions by 3% of adjusted gross income (AGI) above the thresholds, but not by more than 80%.
Mother important change was made to the Alternative Minimum Tax (AMT). Unlike the income tax, which has a progressive tax rate system, the AMT has a rate that acts more like that of a flat tax because its statutory marginal rate only includes two-tier rates--26% and 28%. Because the AMT was not indexed for inflation before ATRA, it affected taxpayers with lower real incomes over time. For years since the Bush administration, Congress passed a series of one-year "patches" on AMT exemptions in order to minimize the AMT's impact on middle-class taxpayers. The fiscal cliff deal made the AMT patches permanent and indexed the AMT to inflation.
New Medicare Taxes
It is fair to say that all working Americans will pay more taxes this year. The Social Security tax rate paid by employees returns to the full 6.2% in 2013, up from the 4.2% rate for 2011 and 2012.
The tax increase is not only due to the passage of the fiscal cliff deal, but also to the new Medicare taxes that took effect on January 1, 2013. A new 3.8% Medicare surtax is levied on the lesser of net investment income or the excess of modified adjusted gross income (MAGI) over certain threshold amounts ($200,000 for individuals, $250,000 for married filing jointly, and $125,000 for married filing separately). In addition to the 3.8% Medicare surtax, there is an extra 0.9% Medicare payroll tax increase for higher earners whose income is more than $200,000 (individuals) or $250,000 (joint filers); this 0.9% tax also applies to self-employment earnings.
Tax Increases on Investment Income
In 2013, wealthy taxpayers receiving a significant portion of their income from investment will face tax increases on that investment income, a result of two major changes in 2013: the aforementioned 3.8% Medicare surtax on investment income and the top rate of 20% on long-term capital gains and dividends. Using available IRS tax return information, the authors estimated the tax increases attributable to family incomes from $250,000 to $700,000 in $50,000 increments. In order to simplify the analysis, the unified average percentages were applied to different income levels. For example, based on available IRS tax return information, the estimated average ratio of investment income to total family income is 8%, which has applied to all income levels from $250,000 to $700,000. (Information about IRS data is available at http://www.iis.gov/uac/Tax-Stats-2).
As shown in the Exhibit, it is important to pay attention to the attributes of two strata of total family income, which are visualized as two gray bars: 1) total family income between $260,000 and $280,000, and 2). total family income between $620,000 and $660,000. If family income is in the first gray region--"investment"--the tax increase is mainly attributed to the 3.8% Medicare surtax. This is levied on all investment income, including interest, capital gains, dividends, rental income, and royalties.
For example, IRS data indicate that an average ratio of investment income to total income could be approximately 8% for families within a $250,000--$300,000 income range; this corresponds to an average tax increase of $800. Thus, families with total income in the investment gray region might want to take steps--such as increasing contributions to a 401(k) plan, using a flexible spending account, or opening an individual retirement account (IRA)--to reduce or avoid the 3.8% Medicare surtax.
The next critical income region depicted in the Exhibit--"capital gains"--falls between $620,000 and $660,000. Families with income in this range will see tax increases due to the rise of the top capital gains tax rate (from 15% to 20%). An average estimated tax increase of $4,000 is expected for this income range. Such families should use comprehensive tax planning to minimize their taxes, including careful arrangement of their sources of income, as briefly discussed in the following section.
2013 Tax Planning for Married Couples
In the past, more than 80% of families with income greater than $100,000 filed joint returns, a practice that has generally made good fiscal sense. A married couple would typically pay more in taxes by filing separately; due to the characteristics of the 2013 fiscal cliff deal, however, filing separately might actually mitigate the tax hike in certain cases, such as the following:
* To avoid the 3.8% Medicare surtax on investment income
* To avoid exceeding the thresholds of the top tax rate, which can trigger a capital gain tax increase.
The 3.8% Medicare surtax is levied on the lesser of net investment income or the excess of modified adjusted gross income (MAGI) over the thresholds of $250,000 (married filing jointly) and $125,000 (married filing separately). For example, consider a husband and a wife who reside in a common-law state. Their taxable income is $210,000 if they file jointly; if they file separately, the husband's taxable income is $110,000 and the wife's taxable income is $100,000 (including $40,000 royalty income on a property that the wife inherited from her parents). Their joint MAGI is $280,000. (If they file separately, the husband's MAGI is $155,000, and the wife's MAGI is $125,000.)
Because the 3.8% Medicare surtax is applied on investment income when MAGI exceeds the threshold of $250,000 (married filing jointly) and $125,000 (married filling separately), they will need to pay a surtax of $1,140 if they choose to file jointly if they file separately, however, they do not need to pay the surtax because the wife's MAGI falls below the threshold. It is worth noting that a married couple with different taxable incomes filing separately will normally pay more taxes than those filing jointly (i.e., "the tax bracket loss"); however, in this case, the couple will save $1,140 when they choose to file separately, because they are in the same tax bracket.
Surprisingly, the tax filing status strategy can also be useful to families with a much lower income. For example, consider a family that has a taxable income of $120,000, including a long-term capital gain of $45,000 earned by the husband, who has a taxable income of $60,000 when he files separately. This family can save $1,064 in taxes if husband and wife file separately, because a part of the long-term capital gain qualifies for the 0% tax rate.
A Mixed Outcome
There was a great deal of media attention surrounding the implications of the 2013 fiscal cliff and tax increases especially dominated headlines. After all, the fiscal cliff deal is about increasing taxes and generating more revenue to offset the national debt and spending; however, it might offer a much more moderate tax provision on the wealthy compared to the rates prior to the Bushem tax cuts, primarily the Economic Growth and Taxpayer Relief Reconciliation Act of 2001 (EGTRRA). Although EGTRRA included a sunset provision that expired at the end of 2010, it was extended by Congress to December 31, 2012. If Congress did not extend
the provision again or pass new legislation, the rates prior to the Bushem tax cuts--including marginal tax rates of 15%, 28%, 31%, 36%, and 39.6%--would have revived.
In pushing for the passage of the fiscal cliff deal, President Obama asserted that it must protect the middle class from higher taxes. In reality, however, the tax outcome for the middle class will be mixed. First, the tax on investment income will have a significant impact on the middle class. Second, the PEP and Pease limitations will likely reduce middle-class tax-payers' deductions. Third, the AMT will remain a threat for some middle-class taxpayers. In sum, the effects of the fiscal cliff deal are not limited to the wealthy; rather, middle-class taxpayers will be economically affected as well.
In the past, only about 5% of married couples filed separately; however, due to the provisions in the fiscal cliff deal, filing separately might actually mitigate the tax hike in certain cases. Thus, the authors expect to see an increase in the number of married couples who file separately in 2013.
The tax increase is not only due to the passage of the fiscal cliff deal, but also to the new Medicare taxes that took effect on January 1, 2013.
In sum, the effects of the fiscal cliff deal are not limited to the wealthy; rather, middle-class taxpayers will be economically affected as well.
Yi Ren, PhD, is an assistant professor in the department of accounting at the University of Scranton, Scranton, Pa.
Dong Xiao, PhD, is a research associate at Northeastern University, Boston, Mass.
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|Title Annotation:||federal taxtion; American Taxpayer Relief Act of 2012|
|Author:||Ren, Yi; Xiao, Dong|
|Publication:||The CPA Journal|
|Date:||Mar 1, 2013|
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