Ordinary Income Tax
Rates
The
Bush era tax cuts that were extended in 2010 are set to expire at the end of
this year. If that happens and Congress takes no action, rates for most
taxpayers, on both ends of the income spectrum, would increase. For instance,
right now those who pay tax at the lowest rate pay just 10% in federal income
tax. That number would jump to 15% next year. Similarly, the very highest
income tax rate one can pay in 2012 is 35%. The highest rate in 2013, if
nothing changes, will be 39.6%.
Sources
of income that are subject to ordinary income tax rates include your salary,
self-employment income, alimony, interest, short-term capital gains and the
portion of your Social Security included in gross income.
Capital Gains
If
you hold a capital asset for longer than one year, you get a special tax break
on any profit when you sell it. Instead of having the profits subject to
ordinary income tax rates, you get to pay tax at long-term capital gains rates,
which are more favorable. Like the ordinary rate increases we’re set to see in
2013, the changes in the long-term capital gains rates will impact you, no
matter what end of the income spectrum you happen to be on. Currently, if your
marginal ordinary rate (the highest ordinary income tax rate you pay tax at) is
10% or 15%, you don’t pay any tax on long-term capital gains. If nothing
changes, that nice 0% rate (sure can’t beat that) will become up to 10% next
year. At the other end of the spectrum, the maximum long-term capital gains
rate is 15% (a savings of almost 60% when compared to the top ordinary rate of
35%). Barring Congressional action between now and next year, the top long-term
capital gains rate will be 20%.
Long-term
capital gains rates apply to the profits on capital assets held longer than one
year. Capital assets include stocks, bonds and real estate, including any
portion of your primary residence that is not excluded from income.
Qualified Dividends
The
economy generally runs better when people are investing their money in
businesses and not just leaving it in the bank. In an effort to encourage more
people to invest in businesses, Congress created a special tax break for
“qualified dividends,” which are simply dividends that have met certain
criteria outlined in the Tax Code. Once again, if nothing changes, taxpayers of
all income levels will be hit harder in 2013. The current tax rates for
qualified dividends are the same as long-term capital gains rates. If you are
in the 10% or 15% marginal ordinary income tax bracket you pay a 0% tax rate on
qualified dividends. If you are in one of the higher brackets, you pay a 15%
rate.
The
rate on qualified dividends isn’t simply scheduled to increase next year. Oh
no… it’s much worse. Qualified dividends, as things stand now, won’t even exist
next year. Instead of getting a tax break, dividends will be taxed at ordinary
income tax rates at whatever marginal bracket you happen to be in, just like
your interest is now.
FICA
In
2011 Congress passed what was widely referred to as the “payroll tax holiday.”
In essence, it was a one year reduction, from 6.2% to 4.2%, in the amount of
FICA (Social Security) taxes taken out of a worker’s paycheck. Self-employed
persons received a similar break. The tax break was popular enough that is was
later extended through the end of 2012. To this point, Congress has taken no
action to further extend this deadline, so workers can expect to see more money
taken out of their checks for FICA beginning January 1st.
Once
again, taxpayers at all ends of the spectrum will feel the pinch. The 6.2% FICA
rate scheduled to be in effect for 2013 is a flat rate, meaning those who earn
$10,000 salaries will pay the same 6.2% rate that those making $100,000 will.
Those with substantial earned income will not only see their FICA tax rate
increase, but more of their income will be subject to the tax. In 2012, only
the first $110,100 of earned income was subject to the tax. In 2013, up to
$113,700 of earned income will be subject to the tax. As a result, those with
high income could pay nearly $2,500 more in FICA tax next year.
The
FICA tax is assessed on earned income, both from wages and self-employment. You
cannot reduce your FICA tax with deductions on your return.
3.8% Health care
Surtax
As
if it’s not bad enough that nearly all the rates on various types of personal
income are set to increase next year, we’re going to add a brand new tax to the
mix as well. If you are a high-income taxpayer, beginning in 2013, you may be
hit with an additional 3.8% surtax on all or a portion of your “net investment
income.” This 3.8% surtax only applies if your net investment income is above
your applicable threshold. If you are married and file a joint return, the
threshold is $250,000. If you are single, the threshold is $200,000.
The
3.8% surtax will be assessed on the lesser of the amount of income you are over
your applicable threshold or your total sum of investment income. Investment
income includes capital gains, interest, dividends, taxable distributions from
non-qualified (not retirement account) annuities and rental income (unless that
is your business). Earned income, as well as IRA and other retirement account
distributions, are not net investment income, but could increase your total
income, causing other net investment income to become subject to the surtax.
0.9% Medicare
Surtax
Is
all your income earned income? If so, you don’t have to worry about the 3.8%
surtax on net investment income, but that doesn’t mean you’re out of the woods
either. Beginning in 2013 certain higher earners will be hit with an additional
0.9% Medicare Tax (we wrote a Tuesday article about this tax). The thresholds
for the new Medicare surtax are the same as the thresholds for the 3.8%
healthcare surtax, except here, the only income considered is earned income.
Married couples who file a joint return and have combined earned income above
$250,000 will be hit with the 0.9% surtax on any excess above that amount. If
you are a single filer, you’ll be affected in a similar manner, but on earned
income exceeding $200,000.
Earned
income includes both wages (salary from an employer) and self-employment
income.
Return of Exemption
Phase-outs
The
loss of personal exemptions is yet another way your tax bill might be a higher
in 2013. Under the current law, there is no limit to the amount of income you
can have in order to claim personal exemptions. To put it another way, in 2012,
even Bill Gates and Warren Buffet can claim personal exemptions. Unless
Congress takes action to extend this benefit, the same will not be true next
year. Married couples filing a joint return will begin to see their personal
exemptions phased out at around $260,000. Single filers will start to see their
exemptions phased out at about $175,000 of income (although the President’s
budget calls for that number to be closer to $210,000).
In
general, you are allowed a personal exemption for yourself and, if you are
married and file a joint return, one for your spouse as well. If you claim any
dependents, such as a children, you can generally claim an exemption for them
as well. An exemption for the same person cannot be claimed on multiple tax
returns.
Estate Tax
I
hope you’re sitting down for this one. If nothing changes between now and next
year things in the estate tax area are about to get bad… real, real bad.
Beginning in 2013, there will be three major changes to the estate tax law, and
all of them could cause you to pay more taxes. A lot more. The first major
change to the estate tax is that the exemption amount is scheduled to drop from
the current $5,120,000 all the way back down to $1,000,000. In other words,
right now, as long as the total value of your taxable estate is less than
$5,120,000 you will owe no federal estate tax, but next year, if your taxable
estate value exceeds just $1,000,000 your estate will be subject to federal
estate tax.
The
second big change to the estate tax law beginning in 2013 is that the rate,
itself, is scheduled to increase. As noted above, right now the first $5.12
million you leave to someone other than your spouse can generally pass
completely estate tax free. However, if you happen to have an estate with a
total value in excess of that amount and you pass away in 2012, any excess
would only be hit with a maximum estate tax rate of 35%. In contrast, for
deaths occurring on or after January 1, 2013, the maximum estate tax rate is
set to increase to 55%! Yep, that’s right. A whole lot more of your estate
could be hit with a tax that’s a whole lot higher.
The
final big change to the estate tax law that’s scheduled to take place in 2013
and could cause you to pay a lot more in tax is the loss of “portability.” In
essence, portability is simply a way to transfer any exemption you have
remaining after your death to a surviving spouse without the need for any
sophisticated estate planning. If you are married, this can effectively double
the amount of assets you can pass estate tax free to children, grandchildren,
etc. to $10.24 million. At that number, very few estates should be hit with
estate tax. In the past, preserving one’s exemption for a surviving spouse was
impossible and the only way to make use of the exemption at the time of the
first spouse’s death was to give assets immediately to someone other than the
surviving spouse or to use of a special type of trust, known as a credit
shelter, or A-B trust. For those passing away in 2013 or later with estates in
excess of $1 million, credit shelter trusts may once again become a critical
planning vehicle.
The
only good news in this area is that it seems like both Republicans and
Democrats agree that the estate tax laws for 2013, as scheduled now, seem a
little harsh. Though they disagree on the extent of the relief they want, the
fact that there is common ground might be cause for optimism that at least some
facet of the estate tax law (e.g. the rate or exemption) will be made more
palatable.
Gift Tax
The
current lifetime gift tax exemption is $5.12, just like the estate tax
exemption. The two exemptions are actually unified, meaning that any amount you
give away during life that eats into your lifetime gift tax exemption will
reduce the amount you can transfer after death estate tax free. For instance,
if you gifted $2 million to a child last year and pass away before the end of this
year, you can still pass $3.12 million ($5.12 current exemption - $2 million
gifted in life). Like the estate tax exemption, the gift tax exemption is
scheduled to drop to $1 million. Therefore, if you have a large estate, making
a large gift before the end of 2012 should be a topic of conversation between
you and your tax and/or financial advisor.
Note:
In 2012 you can gift $13,000 per person before using any of your lifetime
exemption. In 2014 that amount is increasing to $14,000.
The
gift tax issues for 2013 also mirror the estate tax issues in other ways. For
instance, like the estate tax, the gift tax rate is scheduled to increase from
the current maximum of 35% to 55%. The gift tax exemption is also portable in
2012, a feature that is set to be eliminated beginning in 2013.
GST Tax
The
Generation Skipping Transfer, or GST, tax is one of the taxes you pretty much
want to do anything possible to avoid (I said avoid, not evade! I know this
seems bleak, but don’t go getting any funny ideas on me now.) The GST tax is an
additional tax on top of either estate or gift tax, when you transfer property
down more than one generation. Most commonly, this comes into play when you are
gifting (during life) or bequeathing (after death) your assets to a grandchild
or great grandchild, although gifts to non-relatives 37 ½ years or more younger
than you would also be hit with the tax.
Under
the current law, the GST exemption is $5.12 million. Sound familiar? That means
you can give/leave up to $5.12 million to a grandchild completely transfer
(gift/estate and GST) tax free. That opens the door for some serious legacy and
multi-generation planning opportunities. Those opportunities are not going to
stick around forever though. As it stands now, the GST exemption is scheduled
to go back down to $1 million in 2013.
Note: Unlike the
estate and gift tax exemptions, the GST tax exemption is not portable.
The
current GST tax rate is also a “favorable” 35%. Beginning in 2013, that rate,
like the estate and gift tax rates, is scheduled to go back up to 55%. That
55%, if nothing changes, could be imposed along with a 55% estate or gift tax.
It’s also worth remembering that transfer (estate, gift and GST) taxes are
imposed not on the recipient(s) of the assets, but rather, on the donor.
