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
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.