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Eagerly awaited 2013 tax reform never saw the light of day. Congress was preoccupied with other challenges, such as keeping the government running. Any tax reform would have needed both sides of the aisle to come together and compromise—a scenario that proved more and more improbable as the year went on. Primarily due to congressional gridlock, no major changes to the tax law occurred during 2013.
Nevertheless, previously enacted tax law changes contained in the Affordable Care Act and the American Taxpayer Relief Act of 2012 became effective January 1, 2013, and will be reflected in tax returns filed during 2014. For many, the impact of these changes will not be appreciated until they complete their 2013 tax returns this year. This article will focus on these changes and the impact on higher-income earners.
A Third Federal Taxing Regime
Many taxpayers are familiar with “regular” income taxes and the alternative minimum tax (AMT). Beginning in 2013, however, higher-income earners will also be subject to the new income tax, the net investment income tax (NIIT), also referred to as the Medicare surcharge. The new tax applies to net investment income (NII), which includes income generated from passive activities such as dividends, interest, capital gains, rents, and royalties. NII specifically excludes tax-exempt income, distributions from qualified retirement plans, IRAs, and Roth IRAs. This tax came out of the Affordable Care Act and was originally referred to as the “Medicare surcharge.” However, industry professionals now more commonly refer to it as the NIIT to distinguish it from the separate “employee Medicare surcharge,” discussed later in this article.
How Does the NIIT Work?
The new NIIT is independent of and in addition to regular income taxes and the AMT. An individual taxpayer will be subject to the new 3.8% NIIT if his or her gross income is in excess of $200,000, or $250,000 for married couples. The NIIT 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 married couple with gross income of $260,000, which includes $15,000 of investment income, would pay 3.8% in NIIT on $10,000, the amount by which their gross income exceeded the cap, as opposed to the higher investment income amount of $15,000.
Potential NIIT Pitfalls
The NIIT is subject to the estimated tax provisions. Therefore, if a taxpayer is subject to the NIIT, consideration should be given to adjusting tax withholding or estimated payments in order to account for the additional tax and avoid potential penalties for underpayment of taxes.
Also new for 2013 is an increase, to 20% from 15%, in the maximum tax rate on long-term capital gains and qualified dividend income. The maximum long-term capital gain rate is based on taxable income of more than $400,000 if single and $450,000 if married. These same taxpayers will be subject to the new marginal tax rate of 39.6% on income over the threshold.
As discussed above, taxpayers with gross income greater than $200,000/$250,000 will be subject to the NIIT. Therefore, a married taxpayer in the highest tax bracket, with more than $450,000 of taxable income, will also exceed the $250,000 gross income threshold for the NIIT. When combining the NIIT and regular capital gain tax, the "all-in" long-term capital gain rate is 23.8%. When determining the tax implications of an investment, a taxpayer should consider the NIIT and the regular tax rate on capital gains. The "all-in" tax rate for taxpayers earning less than the maximum amount is a little more difficult to compute and is highlighted in the table below. (For more details, see the article "What's Your Real Capital Gains Rate?")
In addition to an increase in the maximum income tax rate, to 39.6% from 35%, a few other tax law changes took effect January 1, 2013. Some of the more notable, lesser-publicized changes are highlighted below.
Source: Internal Revenue Code, sections 1(h) and Rev. Proc. 2013-15.
Employee Medicare Surcharge
Until now, 2.9% of all earned income was subject to Medicare tax. Employers and employees each paid 1.45%. Beginning in 2013, the employee's portion of the Medicare tax increased 0.9%, to 2.35%, on earned income over $200,000 for single individuals and $250,000 for married couples. The total employee and employer Medicare tax on earned income greater than $200,000/$250,000 will be 3.8%. This is in addition to the NIIT.
Employees are required to begin withholding the additional 0.9% on wages in excess of $200,000 regardless of marital status. This additional withholding works well if the taxpayer is single and has only one job. If the taxpayer is married or has multiple employers during the year, or if both spouses work, the taxpayer may be overpaying or underpaying the additional Medicare tax. For example, if a married couple each earns $150,000 a year, their employers will not withhold the additional 0.9% Medicare tax because the $200,000 threshold was not exceeded by either taxpayer. However, collectively, they exceeded the $250,000 married threshold; therefore, the excess over the threshold, $50,000, will be subject to the additional Medicare tax. In this scenario, consideration should be given to adjusting the withholding or making estimated payment to avoid potential underpayment penalties.
On the other hand, a dual-income married household may be eligible for a refund if, for example, one spouse earns $230,000 and the other earns $30,000. In this scenario, the employer of the spouse who earned more than $200,000 will withhold an additional 0.9% on $30,000. However, in total, the couple exceeds the threshold of $250,000 by only $10,000. In this case, the taxpayer will be eligible for a refund for the difference.
Itemized Deduction Limitation
The so-called Pease limitation reduces the amount of itemized deductions (generally mortgage interest, property taxes, state income taxes, and charitable contributions) that certain taxpayers are allowed. The reinstatement of this limitation reduces the amount of allowable itemized deduction by the lesser of 3% of adjusted gross income above the threshold or 80% of the itemized deduction. The threshold amount is $250,000 for individuals and $300,000 for married taxpayers.
For example, the itemized deduction of a married taxpayer with $500,000 in adjusted gross income will be reduced by $6,000 (the excess over the threshold of $300,000 multiplied by 3%). Assuming the highest marginal tax rate of 39.6%, this taxpayer will pay an additional $2,376 in taxes ($6,000 limitation multiplied by the marginal rate of 39.6%).
The itemized deduction limitation may also be viewed as an increase in the marginal tax rate. For example, a taxpayer in the highest rate is subject to a maximum tax rate of 39.6%. If this taxpayer's itemized deductions are also reduced by 3% of the amount over the threshold, the effect is an additional tax of 3% of the taxpayer's marginal rate of 39.6%, or approximately 1.2%. This results in a combined effective tax rate of 40.8%.
Personal Exemption Phaseout
For 2013, an exemption of $3,900 per person is generally allowed for a taxpayer and his or her spouse and dependents. The personal exemption amount for a family of four is $15,600, or approximately $6,178 in taxes for taxpayers in the highest marginal tax bracket ($15,600 multiplied by 39.6%). Beginning in 2013, the personal exemption will be phased out for individual taxpayers with adjusted gross income greater than $250,000 and married couples with income greater than $300,000. The exemption is reduced by 2% for each $2,500 over the threshold. The entire exemption will be phased out once a taxpayer’s income exceeds the threshold by $122,500.
During the last few years, there has been much talk of simplifying the tax code. However, the addition of the NIIT and other provisions has only made the tax code more voluminous and complex. All these changes add up to a larger tax bill for high-income taxpayers. Considering that the tax law is not any easier to understand and is also more expensive for higher-income earners, we highly recommend that individuals consult with their financial and tax advisors.
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.
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 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. This material is being provided as general information only and is not intended to be legal or tax advice. 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 their appropriate tax, legal, and financial advisors with respect to individual circumstances and all applicable federal, state, and local taxes.