On January 1, 2013, we may awake on New Year’s Day to find a Tax Code that looks very different from the day before. If Congress fails to act (imagine that!), the combination of various expiring provisions and new taxes scheduled to take effect as part of the Health Care and Education Affordability Act of 2010 (referred to by some as the “Health Care Act” or “Obamacare”), taxes will be going up significantly, especially for taxpayers with incomes in excess of $250,000. Here’s a summary of these tax changes:
Health Care Tax on “Net Investment Income.” As part of the Health Care Act, in 2013 there will be a new tax equal to 3.8% of “net investment income.” In general, this tax applies to married taxpayers with incomes in excess of $250,000 ($200,000 for single taxpayers). “Net investment income” generally refers to income from sources like interest, dividends, annuities, royalties, and capital gains. It’s worth noting that interest on tax-exempt bonds, and excluded gain from the sale of a principal residence that are excluded from gross income are not considered net investment income for purposes of the additional tax. Qualified retirement plan and IRA distributions are also not considered investment income.
Income Tax Rates. For 2013, the top income tax rate will be 39.6%. However, all tax brackets will change under the 2013 revision. For example, in 2012, the 28% tax bracket begins when the income of a couple filing jointly reaches $142,701. In 2013, for the same couple, the 28% bracket will begin when their income reaches approximately $58,000.
Capital Gains. In 2012, the top rate on long-term capital gains is 15%. In 2013, the top rate on capital gains will increase to 20%.
Dividends. Under current law, most dividends are taxed in a similar fashion to capital gains, with the top tax rate on dividend income being equal to 15%. In 2013, dividends will be taxed the same as other “ordinary” income. Therefore, the top tax rate on dividends could increase to 39.6%.
Itemized Deductions. Under current law, the prior limitations on itemized deductions (e.g. the common “Schedule A” deductions for things like state taxes, mortgage interest, and charitable contributions) were phrased out completely. In 2013, these limitations return, providing that itemized deductions are reduced by an amount equal to 3% of adjusted gross income over a certain threshold, but not in excess of 80% of the itemized deductions.
Estate & Gift Taxes. Under a December 2010 compromise between Congress and the Obama Administration, the estate tax exemption was increased to $5 million ($5,120,000 under 2012’s inflation adjustment) with a top rate of 35%. In 2013, the estate tax exemption will revert to $1 million, and the top rate will increase to 55%. The current gift tax exemption in 2012 is $5,120,000, and the top gift tax rate for gifts exceeding the exemption amount is 35%. In 2012, similar to the estate tax, the gift tax exemption amount will drop to $1 million, and the top gift tax rate will rise to 55%.
Payroll Taxes. On Feb. 22, 2012, President Obama signed the “Middle Class Tax Relief and Job Creation Act of 2012” into law. It extended the 2-percentage-point payroll tax cut through the end of 2012 (earlier legislation had extended it for only the first two months of 2012). Thus, the 2-percentage point payroll tax reduction will expire at the end of 2012. For 2013, this tax is scheduled to revert back to its prior level of 6.2%.
The Bottom Line. Unless Congress acts, taxes will increase in 2013. While there is a possibility of a “Lame-Duck” Congress passing curative legislation after the November elections, I would not count on it this time around. Therefore, one might actually consider accelerating income and making larger estate planning gifts in 2012.