Act Now to Prepare for Upcoming Tax Changes

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Hourglass President Obama’s State of the Union speech repeated his call to raise taxes for America’s wealthiest. Specifically he mentioned Warren Buffett’s claim that he pays a lower tax rate than his secretary. This comment has come to be known as the Buffett rule. The President has quantified this to mean that if you make more than $1 million a year, you should not pay less than 30 percent in taxes.

A recent survey found that many millionaires would support Buffett’s view that the wealthiest should pay more in taxes, as long as it’s other rich Americans. About 71 percent of millionaires surveyed said they agree that the very wealthy ought to pay more in taxes and give more to charity. Most don’t believe that includes them. Forty-nine percent say they are “not in the same league” as Warren Buffett. According to Forbes magazine, Warren Buffett is the world’s third-richest person. The survey released by PNC Wealth Management found that most millionaires don’t consider themselves to be among the wealthiest Americans. Therefore any tax increases shouldn’t apply to them personally.

The PNC Wealth Management survey of 555 respondents included only households with investable assets of $1 million or more excluding real estate. This definition would be in line with the IRS 2008 Statistics of Income report that defines the wealthiest Americans as those having a net worth of at least $1.5 million. They represented 1.2% of the population and held 20.3% of the country’s total net worth.

When you measure by income, the 2009 figures from the IRS showed the top 1% of income earners took in 16.9% of total income that year and paid 36.7% of all income taxes. About 236,883 households earned $1 million or more in 2009. The PNC survey didn’t ask respondents what level of income or assets they believed should trigger higher taxes.

The survey asked respondents what action, if any, they would take should they be considered wealthy and subject to tax increases. Forty-one percent said they would change their investment strategy in response to tax increases. They would increase their holdings in tax-free municipal bonds and reduce portfolio turnover to limit the realization of capital gains. Almost 70 percent of respondents said they plan to increase their charitable giving or give the same amount in order to minimize the income taxes they would have to pay. Under current tax law, taxpayers generally can’t take deductions for charitable contributions of more than 50 percent of their adjustable gross income.

Higher taxes will be the source of much debate this year as the race for the Presidency heats up. Big decisions regarding tax reform will most likely be delayed until 2013 when the new Congress convenes. We unfortunately have to face the more immediate concern of expiring tax provisions enacted temporarily under the Tax Reform Act of 2010. The consensus believes this law will receive yet another short term extension. Millionaires will have to face the new Medicare tax that goes into effect in 2013. The tax will actually affect taxpayers with incomes over $200,000 ($250,000 for joint filers). This tax became law in 2010 under the healthcare reform legislation.

The new Medicare tax comes in two forms. The first part is an increase in payroll taxes. Anyone receiving a paycheck is familiar with the Federal Insurance Contributions Act (FICA) deduction that shows up your paystub. The FICA tax is 6.2% of wages (up to $110,100 in 2012). The Medicare portion of the tax is 1.45% of all wages (there is no cap). FICA tax is paid by both employers and employees and equals a total of 15.3% in taxes collected on all wages up to $110,100 and 2.9% on anything over that amount.

In 2013, the new health reform legislation increases the Medicare portion on high- wage individuals by 0.9% (to 2.35%). If you’re married and file a joint federal income tax return, the additional Medicare tax will apply to your combined wages that exceed $250,000. The additional tax applies to single filers with wages that exceed $200,000.

The second part of the new Medicare tax is a 3.8% tax on the unearned income of high-income individuals (the new tax also applies to estates and trusts). The tax is equal to 3.8% of the lesser of:

  • Your net investment income (interest, dividends, annuities, royalties and rents, capital gains, income from a passive business, or a business that trades financial instruments or commodities), or
  • Your modified adjusted gross income over $200,000 ($250,000 joint filers).

Basically you will be subject to the new 3.8% tax if your adjusted gross income exceeds the amounts listed above. Interest on tax free municipal bonds, veterans’ benefits, and any gain from the sale of your principal residence are excluded from gross income and will not be considered income subject to the Medicare tax. Distributions from a retirement plan and IRA distributions are also not subject to the new tax.

Don’t put off tax planning for 2012 until the end of the year. Look for ways to plan your income throughout the year to avoid a year end scramble. 401(k) elections, Roth conversions, and harvesting capital gains (or losses) should all be planned now to put you in the most flexible position for year-end. You will want to be able to take advantage of whatever tax rules make the final cut.

Rick’s Insights

  • The new Medicare tax starts in 2013 and will apply to investment income for couples with incomes over $250,000.
  • Tax planning should begin early in 2012 to provide flexibility if needed to take advantage of tax changes that may be enacted at year end.

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