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When is 20% really not 20%? Hint: when it's more. Taxpayers fortunate enough to be in the highest income tax bracket are keenly aware of the 2013 tax-rate increases. If asked, the majority of these taxpayers most likely would say that the maximum tax rate on long-term capital gains is 20%. This is correct in theory, perhaps, but it is wrong in practice. That's because the newly imposed 20% capital gains tax doesn't account for the additional Medicare surcharge that was introduced this year with the Patient Protection and Affordable Care Act and which is applied to capital gains and dividend income of high-earning investors.
The additional 3.8% can make a difference in tax planning, and investors should be aware of it when estimating their tax liability. This article provides some information and guidance to help determine the maximum capital gains tax rates for investors in various tax brackets.
The American Taxpayer Relief Act of 2012 created an additional long-term capital gains tax rate for single individuals with taxable income in excess of $400,000 and married couples with taxable incomes of more than $450,000. As of January 1, 2013, the new 20% rate was added to the existing 15% rate. Similar to previous years, taxpayers in the lowest two marginal tax brackets are not subject to capital gains taxes. The 15% and 20% long-term capital gains rates also apply to qualified dividend income (QDI). QDI is generally dividends received from domestic corporations or qualified foreign corporations that meet certain holding period requirements. Mutual fund shareholders receive QDI from the investments held in their funds. It should be noted that short-term capital gains are treated as ordinary income and generally taxed at the higher, marginal income tax rate.
In addition to the increased long-term capital gains tax, an additional levy on high-income earners was introduced with the Affordable Care Act, which took effect on January 1, 2013. The act requires certain high-income earners—generally defined as taxpayers with adjusted gross income in excess of $200,000 if unmarried or $250,000 if married—to pay an additional 3.8% on net investment income, including dividends and capital gains. The so-called Medicare surcharge is applied to the lesser of investment income or the amount in excess of the $200,000/$250,000 gross income threshold. For example, a couple with gross income of $260,000, which includes $15,000 of investment income, would pay a 3.8% Medicare surcharge on $10,000, the amount by which their gross income exceeded the cap, as opposed to the higher investment income amount of $15,000.
The Taxing Task of Tallying Taxes
When determining the potential tax implications of an investment, a taxpayer should consider both taxes: capital gains taxes and the Medicare surcharge. The maximum "all-in" tax rate of 23.8% may be simple to compute (20% + 3.8%); however, for individuals and couples with taxable income less than $400,000 and $450,000, respectively, determining the all-in tax rate can become tricky. This is because the capital gains tax rate is based on taxable income and the Medicare surcharge is based on modified adjusted gross income (MAGI).1 Table 1 combines the two and presents the all-in tax rate based on the most likely combination of taxable income and modified adjusted gross income levels. For example, a married couple in the 33% marginal income tax bracket most likely has modified adjusted gross income of more than $250,000; therefore, their all-in capital gains tax rate is 18.8% (15% capital gains rate plus 3.8% Medicare surcharge).
Source: Internal Revenue Code Sections 1(h), 1411 and Rev. Proc. 2013–15.
For illustrative purposes only and not intended to provide tax advice. Speak to your tax advisor regarding your particular situa tion.
The interplay between the determining factor for applying the Medicare surcharge (modified adjusted gross income of more than $250,000 if married) and the maximum 20% capital gains rate (taxable income of more than $450,000 if married) produces some interesting results. Taxable income is computed by subtracting deductions and exemptions from adjusted gross income. Since your adjusted gross income will be greater than your taxable income, taxpayers in the highest 20% capital-gains tax bracket also will be subject to the 3.8% Medicare surcharge. This is because gross income will always be in excess of $250,000 if taxable income is greater than $450,000.
When combining the new 20% capital gains rate with the Medicare surcharge as reflected above, it's evident that there are four tax rates applicable to capital gains and qualified dividend income: 0%, 15%, 18.8%, and 23.8%. There is no 20% all-in capital gains tax rate.
Tips to Minimize the Tax Bite
The 2013 tax rates applicable to long-term capital gains and qualified dividends generally have increased. However, the tax rates typically associated with capital gains—0%, 15%, and 20%—do not account for the Medicare surcharge. When combined with the surcharge, the all-in tax rates are 0%, 15%, 18.8%, and 23.8%. There is no 20% all-in rate. These all-in rates should be used for tax-planning purposes. Investors are advised to consult with their financial and/or tax advisors for tax-planning opportunities.
Glossary of terms
Adjusted gross income (AGI) is a measure of income typically used as a starting point to determine certain deduction, credit, and other tax benefits that are limited based on income. AGI is generally calculated as your gross taxable income minus certain "above-the-line" deductions, such as alimony and deductible retirement plan contributions.
Modified adjusted gross income (MAGI) used to determine the Medicare surcharge is determined by taking the adjusted gross income and adjusting for certain foreign income earned.
Deductible contribution is a contribution to a qualified retirement plan that may be deducted from an individual's overall income to reduce the adjusted gross income on which taxes are calculated.
Net investment income subject to the Medicare surcharge includes dividends, interest, annuities, rents, royalties, and capital gains. Distributions from qualified plans, such as an IRA, are not included in net investment income for the purpose of computing the Medicare surcharge.
A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.
A SEP IRA, or simplified employee pension plan, is a retirement plan specifically designed for self-employed people and small-business owners. When establishing a SEP IRA plan, business owners and any eligible employees can establish a separate SEP IRA; employer contributions are then made into each eligible employee's SEP IRA.
A SIMPLE IRA is an IRA-based plan that gives small-business employers a simplified method to make contributions toward their employees' retirement and their own retirement. Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions and the employer can make matching or nonelective contributions. All contributions are made directly to an individual retirement account (IRA) set up for each employee (a SIMPLE IRA). SIMPLE IRA plans are maintained on a calendar-year basis.
Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.
This information, including all linked pages and documents, is not intended to be tax advice and cannot be used to avoid any tax penalties. This material is provided for general educational information only and is not intended to cover every aspect of U.S. tax law. Investors should speak to their tax advisor regarding their particular situation.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial and/or tax advisor prior to making an investment decision.
Some Risks to Consider: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. The income derived from municipal securities may be subject to the alternative minimum tax. Any capital gains realized may be subject to taxation. Federal, state, and local taxes may apply. There is a risk that a bond issued as tax-exempt may be reclassified by the IRS as taxable, creating taxable rather than tax-free income. In addition, bonds may be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks.
Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.
Taxable equivalent yield is the pretax yield that a taxable bond needs to possess for its yield to be equal to that of a tax-free municipal bond. It does not reflect state and local income taxes or the alternative minimum tax, if any, and will vary based on each investor's tax bracket.