2013 Individual Income Tax law Changes

Much has been made of the “fiscal cliff” that is looming at the end of 2012. The “fiscal cliff” refers to the numerous expiring tax cuts and mandatory spending cuts that are expected to negatively impact the economy. In this blog, we’d like to explain these expiring tax cuts, as well as the additional tax increases coming as a result of health care reform, that are set to take effect on January 1, 2013.

Expiring Tax Cuts

In both 2001 and 2003, President Bush enacted a series of tax cuts. These tax cuts were set to expire at the end of 2010, however, Congress extended them until the end of 2012. These tax cuts are generally referred to as the Bush tax cuts. Key elements of the Bush tax cuts include:

• A lowering of the individual income tax rates from 15%, 28%, 31%, 36%, and 39.6% to 10%, 15%, 25%, 28%, 33%, and 35%. Please note that these individual tax rates also apply to taxpayers that have business income from a sole proprietorship, S corporation, or partnership.
• A lowering of the top long term capital gains rate from 20% to 15%.
• A lowering of the top individual rate on dividends from 39.6% to 15%.
• A gradual reduction of the phase out of itemized deductions for higher income taxpayers.
• A gradual reduction of the phase out of personal exemptions for higher income taxpayers.
• A doubling of the child tax credit from $500 to $1,000.
• A gradual reduction in estate taxes.

Without congressional intervention, these taxes will revert back to their 2001 and 2003 levels. There are varying opinions on how to address these expiring tax cuts. President Obama has recently proposed eliminating the tax cuts for single taxpayers with greater than $200,000 in income and married taxpayers with greater than $250,000 in income. Under this proposal, the top two individual tax rates of 36% and 39.6% would be restored for these filers, along with the limitation on itemized deductions and personal exemptions. The capital gains and dividend tax rates would revert back to their pre-Bush tax cut level for these filers as well. While the Republicans would generally like the cuts extended for all taxpayers. Any action by Congress, however, is expected to be delayed until after the November elections in a lame duck session. Once the elections are over, there will likely be some compromise regarding the $250,000 threshold level. Although they have since backed off of their comments, both Senator Charles Schumer (D-NY) and House Minority Leader Nancy Pelosi (D-Calif.) have recently called for a temporary extension of the Bush tax cuts to families earning up to $1 million a year.

Additional Tax Increases Due to Health Care Reform

Now that health reform has been upheld by the Supreme Court, a series of tax hikes will take effect in 2013. These tax hikes are addition to any potential tax increases that may result from the expiration of the Bush tax cuts explained above.

Under the Affordable Care Act (generally referred to as “Obamacare”), beginning in 2013, there will be an additional 0.9% Medicare tax on wages of an employee or earnings of self-employed individuals. For single filers, this additional tax applies to wages or self-employment income received during the year in excess of $200,000. If an employee or self-employed individual files a joint return, then the tax applies to all wages and earnings in excess of $250,000.

Also beginning in 2013, there will be a 3.8% surtax on unearned income of higher-income individuals. Unearned income includes such items as dividends, interest, capital gains, and passive income. This surtax applies to the lesser of either (1) net investment income or (2) the excess of modified adjusted gross income over the threshold amount ($250,000 for joint filers and $200,000 for single filers).

Planning

Due to the significance of these tax changes, careful tax planning will be essential. As an illustration, let’s assume that President Obama’s proposal for the Bush tax cuts passes Congress. When you factor in the 3.8% surtax as a result of health care reform, a higher income taxpayer in 2013 would have an actual top tax rate of 23.8% on long term capital gains and 43.4% on dividends. That’s much higher than the 15% maximum tax rate now.

Disclaimer: The information on this blog should not be used without the guidance of a professional tax adviser. Although the information contained here is presented in good faith and believed to be correct, it is not intended as tax advice.

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