In the last half of 2012, the American taxpayer waited nervously for Congress and President Obama to come to some kind of compromise in order to prevent the country from hurtling over the looming fiscal cliff. They were able to do so in the nick of time in the form of the American Taxpayer Relief Act, which substantially updated several major sections of the tax code. Of course, one of the biggest provisions of the act was to raise taxes for just over three-quarters of all taxpayers. But the wealthy were hit the hardest by far, and their tax bills have been increased several times more than those of the lower or middle classes. Single taxpayers with adjusted gross incomes of at least $400,000, Head of Household filers with at least $425,000 and married taxpayers who file jointly with at least $450,000 of income now face much higher tax rates on several different kinds of income. The tax hikes are, however, worse in some areas than others.
Tax Rate Increase
One of the most direct increases in the tax on the wealthy comes in the form of a rate increase on total taxable income. The rate for the top tax bracket has reverted from 35% back to 39.6% as it was under the Clinton Administration. This rate applies to all taxpayers with incomes at or above the levels mentioned above.
Taxpayers in the top tax bracket no longer receive the same break on long-term capital gain income as those in the lower brackets. Wealthy taxpayers must now pay a 20% rate on all long-term gains, which is 5% higher than the rate assessed for those in the lower brackets. This rate also applies to all qualified dividends (which are eligible for capital gains treatment) that are paid outside of an IRA or other tax-deferred retirement plan. But an additional 3.8% tax for Medicare has now been layered on top of these increases, and this tax must be paid by all unmarried taxpayers with adjusted gross incomes (AGIs) of at least $200,000 and married taxpayers who file jointly with AGIs of at least $250,000. Those in this category will, therefore, pay a total tax of 18.8% on long-term gains and qualified dividends, while those in the top tax bracket are effectively taxed at a rate of 23.8% on long-term capital gains and a whopping 43.4% on short-term gains. These increases will likely make tax-free instruments such as municipal bonds and bond funds more appealing for investors in this category. The act also contains a provision that allows taxpayers to convert their traditional 401(k) balances (including all pretax contributions) into a Roth 401(k) at any time. The amount that is converted must be reported as taxable income for that year, however, which may negate the value of this strategy in some cases. The value of tax-deferred vehicles such as cash value life insurance and annuities will also increase, and those who are eligible to participate in employer-sponsored retirement plans would probably be wise to increase their contributions to the maximum level if they have not done so already. This is because there is a distinct possibility that Congress may reduce the tax rates again at some point in the future before distributions are taken. Holding shares of individual stocks can also defer income, and sophisticated investors and business people will continue to be able create separate trusts and corporations to hold their portfolios and reduce their income tax bills.
Another major form of tax increase for the wealthy comes in the form of reduced deductions that are commonly available for low and middle class filers. The income thresholds for both itemized deductions and personal and dependency exemptions begin at a lower level than for investment income; the thresholds for single, head of household and married filing jointly taxpayers are $250,000, $275,000 and $300,000 respectively. Filers with incomes above these levels will have their exemptions reduced by 2% for every $2,500 or fraction thereof by which they exceed the threshold and their itemized deductions will be reduced by 3%.
Joe is single and has an adjusted gross income of $288,000 in 2013. He has no dependents and reported $50,000 of itemized deductions. His personal exemption for 2013 is $3,900. His income exceeds the $250,000 threshold by 15.2 increments of $2,500 ($288,000 - $250,000 = $38,000 / $2,500 = 15.2). Because partial amounts of this increment count the same as a full one, his personal exemption will be reduced by 32% (16 increments x 2%). His itemized deductions will be reduced by 48% (16 x 3%). He will only be able to deduct $26,000 of his itemized deductions and $2,652 of his personal exemption ($50,000 x 52% and $3,900 x 68%).
However, there is a cap on the reduction of itemized deductions of 80%. Even a taxpayer with an AGI of $1.7 million can still deduct 20% of his or her itemized deductions.
It's not all Bad
Although the American Taxpayer Relief Act has resulted in a substantial tax hike for the wealthy, there are still several ways that they can reduce their taxable income in 2013. The act extended several major deductions through 2013, such as the $500,000 Section 179 Expensing deduction, the $100,000 donation of a distribution from a traditional IRA to charity, and the exclusion of any gain from the sale of qualified small business stock that was held for at least five years. The unified credit limit for estate taxes has also been preserved, and the COLA adjustment has raised this amount to $5.25 million per person in 2013, although estate tax rates have also risen from a maximum rate of 35 to 40%. Most of these tax breaks are currently set to expire at the end of 2013, however, and it remains to be seen whether Congress will extend them into 2014 or beyond.
The Bottom Line
Congress has raised and lowered taxes in the U.S. over the decades in response to both public sentiment and economic need. The recent tax increases on the rich may last for some time or they may be overturned by the next presidential administration. For more information on how the new legislation has affected the taxation of the wealthy, consult your tax advisor.