Income Taxes After the Cliff – Did Your Rate Go Up?
The threat of a significant increase in 2013 tax rates put this most recent year end into overdrive as taxpayers attempted to conclude transactions in 2012 to lock in historically low tax rates. For many taxpayers, the threat of higher rates did not come to pass under the American Taxpayer Relief Act of 2012 (“ATRA”).
The 2013 income tax rates remain the same as the 2012 rates except for the creation of a new 39.6% tax bracket. Married taxpayers encounter the new tax rate with taxable income of $450,000 or more. Single taxpayers reach the new tax rate on taxable income of $400,000 or more. This is a new marginal tax rate and only taxable income over these threshold amounts is subject to the new rate.
Capital Gain Rates: Taxpayers subject to the new 39.6% rate will also see their rate on long-term capital gains increase from 15% to 20%.
Dividends: Dividends will be taxed at the same rates as the taxpayer’s capital gains, so married taxpayers with taxable income in excess of $450,000 and single taxpayers with income in excess of $400,000 will pay a 20% tax rate on their qualified dividend income in contrast to 15% for other taxpayers.
Reduction of Exemptions and Itemized Deductions: Prior to 2001 the personal exemptions and itemized deductions of higher income taxpayers were reduced based on their level of income. ATRA restores this reduction for certain higher income taxpayers.
The income threshold for these limitations is not the same as the higher income threshold for the new increased tax rates. For purposes of this limitation, the amount of adjusted gross income is $300,000 for a joint return and $250,000 for a single taxpayer. After 2013, these amounts are adjusted for inflation.
If income exceeds the threshold, itemized deductions are reduced by 3% of the amount of adjusted gross income over the threshold but not more than 80% of itemized deductions. This does not apply to all itemized deductions, and medical expenses, investment interest, casualty losses and gambling losses are not subject to reduction.
The personal exemption phase-out has the same threshold and reduces the total of all personal exemptions claimed on the return by 2% for each $2,500 of adjusted gross income over the threshold.
To illustrate, assume that a married couple has $600,000 of adjusted gross income, $100,000 of itemized deductions and two personal exemptions of $3,800 each. Itemized deductions are reduced by 3% of $300,000, which is the adjusted gross income over the threshold amount, or $9,000. The taxpayer can only deduct $91,000 of their $100,000 itemized deductions. The personal exemptions are reduced by 2% for each $2,500 or portion of $2,500 over the threshold amount. Three hundred thousand dollars divided by $2,500 equals 120, so the taxpayers’ personal exemptions are reduced to zero.
While the reduction in personal exemptions and itemized deductions may not translate into large dollar amounts by themselves, this is a further incentive for high-income taxpayers to carefully plan the timing and amount of their income to the extent possible.
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