The American Taxpayer Relief Act of 2012 (ATRA12) prevented higher taxes for many taxpayers but those in the top two tax brackets will experience an increase in taxes in 2013 and beyond without careful planning. This year taxes will increase on the upper income taxpayers in four areas:
- Tax Brackets – The top tax bracket rises to 39.6%, and applies to income in excess of $400,000 for single taxpayers ($450,000 for couples). The thresholds are indexed for inflation after 2013 like all the other tax brackets. It’s important to keep in mind tax brackets are based upon taxable income after all deductions, not Adjusted Gross Income (AGI).
- Capital Gains and Dividends – ATRA12 increases the tax rate to 20% for any long-term capital gains that fall in the new top tax bracket (the new 39.6% bracket with the $400,000 / $450,000 thresholds noted above). Qualified dividend treatment is now tied to the long-term capital gains rate. In effect, the top tax rate for qualified dividends has risen to 20%.
- Deduction Phase-outs – The phase-out of itemized deductions and personal exemptions is back. The phase-out for itemized deductions (Pease limitation) reduces all itemized deductions by 3% of excess income over an AGI threshold. The AGI threshold in ATRA12 is $250,000 for single taxpayers ($300,000 for married couples). ATRA12 also restores the personal exemptions phase-out (PEP). PEP reduces personal exemptions by 2% of the total exemptions for each $2,500 of excess income over the AGI threshold used the Pease limitation.
- Obamacare Taxes – This tax applies to the smaller amount of a taxpayer’s net investment income or their modified adjusted gross income (MAGI) over the threshold. The threshold for single taxpayers is $200,000 and $250,000 for married taxpayers filing jointly. MAGI is the number on line 22 of the 2012 IRS form 1040. Distributions from qualified retirement accounts are not subject to the tax, but the taxable income from non-qualified deferred annuities is considered investment income and subject to the tax. Other taxable investment income is – passive rental income, royalties, other passive activity income. Income excluded from the tax are – wages, municipal bond interest, life insurance proceeds, social security & veterans benefits, sale of a principal residence and income from an active interest in a business.
Five Strategies to Minimize the Impact
- Taxpayers who will become subject to the additional investment income tax can move some of their investments to minimize the impact of the tax. Start by reviewing your portfolio to make sure those investments generating the most income are held in a tax-deferred or tax-free account like a Roth IRA. Income from municipal bonds is currently exempt from tax and can be kept in a taxable account. Passively managed stock funds are generally more tax efficient and should also be held in a taxable account. Gains realized on investments in retirement accounts are also not subject to the additional 3.8% tax therefore income oriented investments like REITs should be held in retirement accounts.
- The tax treatment of life insurance was left unchanged in ATRA12. Higher taxes will also make life insurance a much more attractive investment vehicle in 2013 and beyond. While the primary purpose of life insurance is to provide income for an insured’s beneficiaries upon his or her death, certain types of life insurance policies can also function as tax-preferred investment vehicles.
- If protecting your income from taxation is a priority, a new look at the tax-free, municipal bond market should be considered. Muni bonds pay interest that is exempt from federal income tax as well as the state income tax of the state where it was issued. This tax exemption results from the theory of reciprocal immunity: States do not tax federal government bond interest and the federal government does not tax interest of state and local government issues. Municipal bond interest is not subject to the new 3.8% Obamacare tax. This interest is excluded from AGI and will trigger the phase-out of deductions.
- Making contributions to an employer sponsored plan is a great way for high income taxpayers to shelter income and reduce AGI. The Internal Revenue Service announced cost-of-living adjustments affecting dollar limitations for retirement-related plans in 2013. The elective deferral (contribution) limit for employees who participate in 401(k), 403(b), most 457 plans and the federal government’s Thrift Savings Plan increased from $17,000 to $17,500. The catch-up contribution limit for employees aged 50 and over who participate in 401(k), 403(b), most 457 plans and the federal government’s Thrift Savings Plan remained unchanged at $5,500.
- Finally, be sure to review currently held security positions trading below your cost before the end of the year. This situation is called an unrealized loss. Unrealized losses are not tax deductible. To use the loss for tax purposes, the position must be sold, creating a realized loss. The technique of creating these losses for tax planning is called tax-loss harvesting. The federal tax code says that capital losses can be used to offset capital gains. If losses exceed gains, the taxpayer can take a $3,000 loss against other income. Any excess loss can be carried forward into future tax years. This is yet another way to reduce your AGI and potentially save some more of your itemized deductions.
While Congress acted to prevent widespread tax increases for most taxpayers, the reality is that even lower-income taxpayers will see at least slightly higher taxes in 2013. High-income and small-business-owner taxpayers will see the most pronounced increases and will want to take even stronger steps to plan for these changes in 2013.
- Taxpayers with income greater than $200,000 will likely see a significant increase in taxes this year if they don’t start planning now.
- There are four areas of potential tax increases affecting high income taxpayers.
- Planning for a lower tax bill should begin with a review of your investments and where they are held.