Fiscal Cliff Tax Legislation - What's It Mean to Me? - Part II

Posted By Jay Kaufman || 9-Jan-2013

For Clients, Advisors and Community: In this article (briefly delayed by technical glitches), I review the implications of the income tax changes in the legislation. I have chosen not to restate that which has been published in the general news, but rather some interesting tidbits related to the new law.

Increased Brackets. We have a “progressive” income tax system. This means that the rate of income tax increases as an individual or couple’s income goes up. Thus, their “bracket” is the highest rate at which the next dollar of income is taxed.

The individual bracket rates of 10, 15, 25, 33 and 35 percent are maintained. There is an additional 39.6 percent bracket which applies to income at $400,000 (singles) and $450,000 (married) and to increase the capital gain rate to 20% up from 15%.

  • Interestingly, President Obama initially proposed a level of $250,000 for the higher rate based on adjusted gross income. The new law level of $400,000/450,000 for the highest tax rates is based on taxable incomewhich is the bottom line of the tax return. The figures can be very different. This will save the taxpayer.

Affordable Care Act Surcharge. Starting this year, higher income taxpayers are subject to a surcharge of 3.8% on net investment income (not salary, net investment income). To make things more confusing, here the $200,000 (single) and $250,000 (married) thresholds apply (not the $400,000/450,000 thresholds). This is the case because the surchase was part of the health care act, not the fiscal cliff legislation. The 3.8% surtax applies to capital gains whether long term or short term. Hence, the highest long term capital gain rate becomes 23.8% and the highest short term capital gain rate becomes 43.8%.

Exemption Limitations. The Act phases out exemptions in at least two ways. First, itemized deductions for higher income taxpayers (the so-called “Pease Limitation”) are reduced by 3% once their attains a certain threshold ($300,000 for married couples and surviving spouses, $275,000 for heads of households, $250,000 for unmarried taxpayers and $150,000 for married taxpayers filing separately). Itemized deduction cannot be reduced by more than 80%

Second, the personal exemptions are phased out, but at slightly higher incomes that would have been the case in the past. The exemptions would have been phased out, for example at $267,000 for married couples before the legislation. The limit was increased to $300,000 for a married couple in the legislation.

Avoiding the Net Investment Income Surcharge: Most of our clients own their businesses through “pass through” entities (An “S” corporation or partnership where all of the profits and losses of the business “pass through” to the owners’ personal income tax return. The business itself is not taxed separately). As a result, the profits of the business are taxed on their personal income tax return. I suspect that business owner clients will have increased interest in putting money in tax-qualified retirement plans to avoid the higher brackets and the surcharge on net investment income. There are two benefits. First, is that the contribution is deductible, reducing current taxable income and perhaps putting them in a lower bracket. Second, monies withdrawn from the plan will not be subject to the 3.8% surcharge because by definition they are not net investment income.

Roth IRAs. I also predict that, despite higher brackets, we will see more Roth IRA conversions. There are many benefits. The biggest is that once the conversion tax is paid and the funds have been in the account for five years, there is no more tax on gains within the account and on withdrawals from the account. In addition, there are no “required minimum distributions” from the account.

More to come? It’s likely that this is just interim legislation. I think that there is more to come as the Congress deals with the debt ceiling and other tax issues. It’s possible that much of this may yet change as Congress considers the debt ceiling and potentially major tax reform. Stay tuned.

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