With less than 2 months remaining in the year, it is high time to begin looking at your 2013 tax picture. Most Americans will be in the same boat as last year (as to tax rates), but there are a number of tax changes to deal with for a great number of folks. So, whether you’re looking at your own taxes or you’re a professional getting ready to assist clients, you’d better start now. The changes in the tax law, while not voluminous in the mainstream, are significant. This article is designed only to brief the reader; anything that might affect you deserves greater study and analysis.
Tax Rates: Who wins, who loses?
Beginning in 2013, we now have a new top income tax rate of 39.6% (think back to the Clinton era), while last year’s top rate was 35%. The new rate applies to taxable income in excess of $400,000 (single), $450,000 (joint returns and surviving spouses), $425,000 (heads of household), and $225,000 (married filing separately). Please note the application of this rate is to taxable income, not gross income. Taxable income, generally, is your total income less your itemized deductions and personal exemptions. Some of the other changes below are not based on taxable income, so watch for the nuances.
Net Investment Income Tax
As we reported to you earlier this year in our article, The New Tax Twins: 2013’s Medicare Nightmare, there are two new Medicare surtaxes in effect for 2013: a 3.8% tax on net investment income above a threshold amount, and a .9 percent additional tax on wages and self-employment income above a threshold amount. For both taxes, the threshold amount is $200,000 for individuals, $250,000 if married filing jointly, or $125,000 if married filing separately. While there are various estimates out there, the new 3.8% tax could affect roughly 4.2% of all taxpayers (Tax Policy Center estimates). We’ll briefly readdress how these taxes are calculated.
For the 3.8% tax, you perform a two-prong test: 1) is your income in excess of the thresholds above? If yes, then 2) you will pay the 3.8% tax on the smaller of: a) your excess income over the threshold amount or b) your net investment income. Net investment income, generally, is comprised of interest, dividends, rents, royalties, capital gains, and income from passive investments. As is typical with any provision in the tax code, there are a great number exceptions to this new law, way too many to list here. But, make sure you understand them because they can make or break you as it relates to this tax.
The .9% Medicare tax is also subject to the threshold amounts above, but with a strange twist. Basically, under the new law, your employer is required to begin withholding an additional .9% of Medicare tax from your wages on the first dollar over $200,000, regardless of your overall tax situation. That’s the essence of the tax. That said, the twist: let’s say you are married, and one spouse has wages of $205,000, while the other spouse has wages of $20,000. You have no other income. The spouse with the W-2 of $205,000 will have had the additional .9% Medicare surtax withheld on the $5,000 in excess of the $200,000 threshold. However, because your total income is below the threshold amount to be subject to this tax ($250,000), the additional Medicare taxes withheld will be refunded when you file your income tax return. Good to get the money back, but not so good in giving an interest-free loan to the Treasury.
More taxes, more complexity.
Capital Gains and Dividends: Good News for 99%; Bad News for 1%
Yes, there actually is good news, and that is, the existing tax rates on capital gains and dividends (max rate of 15%) will remain in effect for all taxpayers that don’t reach the new 39.6% tax bracket. But, if you fall into the new 39.6% rate, you get to cope with a new 20% rate for capital gains and dividends beginning in 2013.
Medical Expenses
In years prior to 2013, medical and related expenses that exceeded 7.5% of your income were deductible as an itemized deduction. This was a tough target to hit as many of you know. Now it’s going to be even tougher. Beginning in 2013, the floor to deduct any medical-related expenses has been increased to 10% of your income. So, if your income is $100,000, your out-of-pocket costs will have to exceed $10,000 to take this deduction. The one exception to the new floor is this: between 2013 and 2016, if you OR your spouse reach age 65 in any one of the years in this range, your floor goes back down to 7.5% of income. A grandfather clause, of sorts.
Personal Exemptions (PEP) and Itemized Deductions (Pease)
Ever hear of PEP and Pease? If you have, it’s been a long time since you’ve had to deal with these villains. After a 12 year hiatus, the 2012 “Fiscal Cliff” negotiations reinstated the (PEP) reduction in personal exemptions and the (Pease) reduction itemized deductions (your mortgage interest, tax, and contributions). This will affect taxpayers with adjusted gross income over $250,000 (single), $300,000 (joint returns), $275,000 (head of household), and $150,000 (married filing separately). While one can hope the withholding tables were eventually adjusted to anticipate these reduced deductions, this should be analyzed closely (remember, the 2012 filing season was delayed up to 6 weeks because the IRS did not have the necessary time to correct tax forms or update tax tables due to the late timing of the legislation).
Other Things to Consider Before the End of the Year
Below are a few additional items to be considered before the end of the year to determine if it could help your tax situation. These strategies should be adopted only if they make sense in the context of your total financial picture, not just to save tax dollars. Make sure you consult with your tax advisor before considering any of these strategies.
Shifting Income into the Current Tax Year
Depending on your projected income for this year and next, it may make sense to accelerate income into 2013. If your income in 2014 is going to be higher than this year, you should contemplate moving income into 2013, if possible, to even out the effects. The following are a few thoughts to consider:
- Selling those investments with gains from your investment portfolio; and
- take IRA distributions this year rather than next year (but not before you’re eligible!).
Shifting Income to 2014
In contrast to accelerating income in 2013, it may make sense to defer income into the 2014 tax year or later years, if possible. Some options for deferring income include:
- if you work at a company where year-end bonuses are paid, ask your employer to pay the bonus in January 2014 (if you are self-employed, this strategy takes on greater complexity);
- if you are considering selling assets or investments that will generate a gain, postpone the sale until 2014;
- if your income falls within the established range for deductibility, consider making an IRA contribution, and
- if your employer has a 401(k) plan, max out your deferrals before the end of the year.
Deferring Deductions into 2014
Similar to the discussion above about accelerating income into 2013, if you’re expecting a substantial increase in taxable income in 2014, you may want to explore the benefit of deferring deductions into 2014. For instance:
- to the extent that you will receive a deduction, consider postponing year-end charitable contributions, property tax payments, and medical and dental expense payments until next year; and
- consider postponing the sale of any property or investment that might generate a loss.
Accelerating Deductions into 2013
Conversely, if you anticipate that your income will decrease next year, you should consider tactics to accelerate certain deductions into the current tax year to offset the higher income this year. Options include:
- consider prepaying your property taxes in December (if you pay AMT, this may not be advisable);
- if you owe state income taxes, consider making up any shortfall in December rather than waiting until your return is due (if you pay AMT, this may not be advisable);
- consider making your January mortgage payment in December (to get the additional interest deduction);
- if you lump your contributions at the end of the year, consider making 2013 and 2014 contributions this year; and
- sell some or all of your loss stocks (only under certain circumstances).
Author’s note: In defining a solid tax plan, the issues addressed above are only a small portion to be considered. Always consult with your tax pro before considering these or any other tax strategies.
Needless to say, given the law changes, planning for this year and next has become more important than it has been in the past few years. But get ready, it’s here.