By Lawrence F. Byerly, JPS Shareholder
More tax changes and developments have occurred or come into play in 2013 than in any year in recent memory, and these changes impact virtually every individual taxpayer. While several 2013 law changes work to increase taxes for some, many “time-tested” tax-saving techniques continue to apply. Careful year-end planning is particularly important this year, using strategies that may help lower your taxable income and postpone the payment of your taxes to later years.
This article highlights some of the more significant tax law changes and planning opportunities available to individuals, which include utilizing existing tax breaks currently scheduled to expire after 2013. By acting timely, you may still obtain those benefits. We caution you that some of the tax planning strategies suggested in this letter may subject you to the alternative minimum tax (AMT). Therefore, a particular planning strategy must be evaluated by calculating its impact on your overall tax liability. JPS is ready to help you with appropriate planning opportunities.
THE BIG NEWS ABOUT TAX RATES AND NEW TAXES
Tax Rate Changes:
Effective for 2013, in addition to the permanent extension of the so-called “Bush-era tax cuts” for lower and middle income taxpayers, the American Taxpayer Relief Act (ATRA) reinstated the 39.6 percent tax bracket for taxable incomes in excess of $450,000 for married couples filing joint returns, $225,000 for married filing separate returns, $400,000 for single filers, and $425,000 for heads of households.
ATRA permanently retains the maximum long-term capital gain and qualified dividend rates at 15 percent for lower and moderate income individuals (and the 10 percent and 0 percent tax rates in certain lower taxable income ranges). However, beginning in 2013, for individuals with taxable income in excess of the 39.6 percent bracket thresholds, their long-term capital gains and qualified dividends will
be taxed at a new 20 percent rate. For planning, consider taking current and/or using carry-forward capital losses to offset 2013 short-term capital gains if the losses would keep those gains (taxed as ordinary income) from pushing you above the 39.6 percent threshold. In recognizing long-term gains, such losses could similarly be used to offset those gains to preserve the lower capital gains rate before reaching the threshold.
The Affordable Care Act (ACA) imposes a new .9 percent additional Medicare tax on individuals whose total W-2 wages and/or self-employment income exceeds $250,000 (combined) for married couples filing jointly, $125,000 for married filing separately, and $200,000 for single and head of household. For planning, since the tax becomes part of the total income tax, additional withholding or increased estimated tax payments may be needed to avoid penalty for underpayment of estimated income tax.
Another new tax imposed by the ACA, worthy of more discussion than is available in this limited space, is the 3.8 percent net investment income tax (NIIT) on higher-income taxpayers. With limited exceptions, “Net Investment Income” generally includes interest, dividends, annuities, royalties, rents, “passive” income (as defined under the “passive activity” loss rules), long-term and short-term capital gains, and income from the business of trading in financial securities and commodities. The 3.8 percent NIIT applies as a surtax to individuals with modified adjusted gross income (MAGI) exceeding $250,000 for married filing jointly, $125,000 for married filing separately, and $200,000 for single and head of household. The 3.8 percent NIIT is imposed upon the lesser of an individual’s modified adjusted gross income (MAGI) in excess of the threshold, or the net investment income.
In planning for the NIIT, consider that “Net Investment Income” generally includes net income from the business activity of a “passive” owner, unless that income constitutes self-employment income subject to the 2.9 percent Medicare tax. A “passive” owner is one who does not “materially participate” in the business as determined under the traditional “passive activity loss” rules. Subject to certain limited exceptions, rental income is generally deemed to be “passive” income. Prior passive losses may be used to offset current passive income. Note that tax-exempt bond interest, gain on the sale of a principal residence eligible for exclusion from income (i.e., up to $500,000 on a joint return), and distributions from qualified retirement plans are not subject to the 3.8 percent NIIT. The 3.8 percent NIIT also does not apply to earnings in a tax-deferred annuity (TDA) contract until the income is distributed. Investments generating tax-exempt income will become more attractive now because that income will not be included in MAGI, thus reducing the chance that the taxpayer will exceed the income thresholds for the 3.8 percent NIIT. And, of course, such interest is exempt from regular income tax.
THE BIG NEWS ABOUT DEDUCTIONS
Phase-out of Itemized Deductions and Personal Exemptions for Higher-Income Taxpayers:
For many years prior to 2010, higher-income individuals were subject to a phase-out provision that reduced their personal exemptions and itemized deductions as their income exceeded certain thresholds. The phase-out was suspended from 2010 to 2012. Beginning again in 2013, ATRA permanently reinstates these phase-out provisions for individuals with adjusted gross incomes exceeding $300,000 for married couples filing joint returns, $150,000 for married filing separately, $250,000 for single filers, and $275,000 for heads of households. For planning strategies designed to reduce the chance of going over the threshold amount, note that the phase-out provisions do not apply to medical expenses, investment interest, gambling losses, casualty losses and theft losses claimed as itemized deductions.
Medical Expense Deduction:
For 2013, a medical expense deduction is available to the extent the total medical expenses exceed 10 percent of adjusted gross income (AGI), instead of 7.5 percent as it was before the change by ACA. The 7.5 percent threshold still applies through 2016 for taxpayers who are age 65 before the close of the tax year. For planning, consider accelerating as many elective medical expenses (i.e., braces, new eye glasses, etc.) into 2013 as possible if that would cause your deductible medical expenses to be above the 10 percent AGI limitation threshold. Paying your medical expenses by credit card, in the year the expense was incurred, will constitute payment for that year, even if you subsequently do not make full payment of the credit card statement.
Charitable Contribution utilizing the Required Minimum Distribution from an IRA:
A taxpayer who is at least age 70½ may have the IRA trustee make a qualifying transfer of up to $100,000 from his or her IRA directly to a qualified charity. The direct transfer to charity will count towards the required minimum distribution for the year and eliminates the distribution from both AGI and MAGI. This may, in turn, increase deductions that are otherwise reduced as your AGI increases, keep you in a lower tax bracket, and help keep your income below the applicable NIIT threshold. This tax break is scheduled to expire after 2013.
Child Tax Credit:
For 2013 and beyond, ATRA made permanent the child tax credit of $1,000 per child. Generally the credit is for children eligible to be claimed as a dependent.
Traditional Planning for Income Deferral or Acceleration of Deductions:
Although these strategies are still advisable for many, keep in mind that the new taxes and higher rates should be considered. It can be a good idea to defer income into 2014 if you believe that your marginal tax rate for 2014 will be equal to or less than your 2013 marginal tax rate. In addition, deferring income into 2014 could increase various credits and deductions for 2013 that would otherwise be phased out as your adjusted gross income increases. This classic tax planning strategy may be particularly valuable for 2013 if the deferral of income causes your 2013 taxable income to fall below the thresholds for either the new 39.6 percent tax rate or the new 3.8 percent NIIT. This strategy may also keep your 2013 income below the phase-out thresholds for any of the tax breaks that are currently scheduled to expire after 2013, such as the school teachers’ deduction (up to $250) for certain school supplies, deduction for state and local sales taxes and the deduction (up to $4,000) for qualified higher education expenses.
A Caution About Timing:
Remember that for cash basis taxpayers, as most individuals are, to be deductible for 2013, a check must be mailed and postmarked (or hand delivered) on or before December 31, 2013, or made by a credit card charge in 2013. Also, for self-employed individuals on the cash basis, consider delaying year-end billings to defer income until 2014. Note, however, that if you have already received the check in 2013, deferring the deposit does not defer the income. (Don’t defer billing if that would increase your risk of not getting paid.)
NORTH CAROLINA CHANGES TO BE AWARE OF
North Carolina has not been without some major changes during 2013, with most going into effect in 2014. N.C. taxpayers should be aware of a number of tax breaks that will expire at the end of 2013, and take them into consideration for their year-end planning. For 2014, a flat tax rate of 5.8 percent replaces the graduated rates ranging up to 7.75 percent. The net business income deduction (up to $50,000 maximum per taxpayer) is gone after 2013. Thus, one must weigh the possibility of accelerating business income into 2013, at possibly a higher N.C. tax rate after the deduction, as compared to deferring that income to 2014, all of which would be taxed at a lower rate. Also, 2014 brings a cap on the itemized deductions for home mortgage interest and property taxes, combined at $20,000. Make sure to pay your 2013 property taxes in 2013 if you will be impacted by the 2014 limitation. If income is deferred to 2014, there may not be as much mortgage interest and property tax deduction available to offset that income.
Clearly this article is a very broad overview of some of the more significant changes that will affect individual taxpayers for 2013 and beyond. It cannot be stressed too much that many of the planning techniques are now even more inter-dependent and will require careful planning and consideration of their over-all impact on your total tax situation. We at JPS are glad to help answer any questions or assist you in your year-end planning. We look forward to hearing from you.