Unpleasant Surprises are in Store for Many 2013 Tax Return Filers

Taxpayers are currently obtaining their 2013 tax information and organizing their financial data this month.  Many taxpayers are vaguely aware of the major tax increases that took effect a year ago.  But for higher income taxpayers, the reality of writing larger checks to the U.S. Treasury won’t hit until their tax returns are completed over the next two months.  Listed below are the various ways your taxes will increase for 2013 and for future tax years.  These increases underscore the need for year-round tax planning.

·       The top ordinary income tax rate is now 39.6% instead of 35.0%.  The new tax rate bracket begins when taxable income exceeds $450,000 for joint; $400,000 for single; $425,000 for head of household; and $225,000 for married filing separately statuses.  These thresholds are indexed for future inflation.

·       The top long-term capital gain tax rate is now 20% instead of 15%.  The new tax rate begins when taxable income exceeds $450,000 for joint; $400,000 for single; $425,000 for head of household; and $225,000 for married filing separately statuses.  These thresholds are indexed for future inflation.

·       A brand new income tax of 3.8% is imposed upon net investment income.  This complicated new tax was enacted as part of the Affordable Care Act (Obamacare).  Investment income is defined broadly for this purpose and includes the business income of pass-through entity owners who do not materially participate in the business.  The tax applies to individuals having modified adjusted gross income over $250,000 for joint; $200,000 for single; $200,000 for head of household; and $125,000 for married filing separately statuses.  These thresholds are NOT indexed for future inflation.
In addition, this new tax applies to income tax returns of estates and trusts when adjusted gross income exceeds the start of the top income tax bracket for estates and trusts, which is only $11,950 in 2013.  Unlike for individuals, this threshold is indexed for future inflation.

·       Itemized deductions are reduced by a percentage of AGI.  The amount of the reduction is 3% of the excess of adjusted gross income over $300,000 for joint; $250,000 for single; $275,000 for head of household; and $150,000 for married filing separately statuses.  These thresholds are indexed for future inflation.  The effect of the loss of itemized deductions is equivalent to an increased income tax rate of 1.2%.

·       Personal exemptions are reduced by a percentage of AGI.  The total amount of personal exemptions are reduced by 2% for each $2,500 (or portion thereof) by which adjusted gross income exceeds $300,000 for joint; $250,000 for single; $275,000 for head of household; and $150,000 for married filing separately statuses.  Personal exemptions are totally phased out once AGI exceeds these thresholds by $122,501.  These thresholds are indexed for future inflation.  During the phase-out range, the effective marginal tax rate increase is roughly one percentage point per exemption.

·       Medicare tax rate increases 0.9 percentage points.  Taxpayers having wages and self-employment income above certain thresholds will be assessed an additional Medicare tax on their income tax returns.  Employers are only required to withhold the extra tax when compensation exceeds $200,000.  Because the extra tax applies on a combined basis for joint return filers, insufficient tax will have been withheld on dual income couples.  The threshold amounts are 250,000 for joint; $200,000 for single; $200,000 for head of household; and $125,000 for married filing separately statuses.  These thresholds are NOT indexed for future inflation.