There are at least six changes to the federal income tax laws which need to be considered in individual tax planning for 2013 and beyond:
- Increased Medicare tax for high-earning employees and self-employed [.9 percent]
- Surtax (Medicare contribution tax) on net investment income of higher-income individuals [3.8 percent]
- An increased top income tax rate of 39.6 percent [based on taxable income]
- An increased top capital gains and dividends tax rate of 20 percent [based on taxable income]
- Phase-out of personal exemptions for high-income taxpayers [based on adjusted gross income]
- Phase-out of itemized deductions for high-income taxpayers [based on a adjusted gross income]
A few weeks back an individual contacted me for tax planning purposes. The individual explained that he had an installment sale contract with a balance owing of between $300,000 and $400,000 that might get paid off during 2013. Approximately 70 percent of the contract balance represented capital gain that the individual was reporting as the balance was collected. He wanted to know the tax effect if he were to receive a full payoff in 2013. This individual is retired and files taxes jointly with his spouse. Their typical adjusted gross income (AGI) has been between $80,000 and $125,000 and 85 percent of their social security benefits are included in their AGI.
When we calculated the effect of the full collection of this installment contract the impact was enormous. Approximately $280,000 would be added to AGI if the payoff occurred. With AGI exceeding $250,000 this individual’s net investment income (dividends, interest, capital gain and more) would be subject to the new 3.8 percent net investment income surtax. This add-on tax amounted to between $6,000 and $7,000. The tax rate of 3.8 percent is applied against the lesser of net investment income or AGI exceeding the thresholds of $250,000 for joint filings, $125,000 for married filing separate returns, and $200,000 for all other filing types.
The American Taxpayers Relief Act revived the phase-outs of personal exemptions and itemized deductions. These phase-outs are both triggered at certain AGI levels. The itemized deduction phase-out begins when AGI hits $300,000 for joint filing, $275,000 for heads of households, $250,000 for unmarried taxpayers and $150,000 married filing separate returns. This phase-out trims otherwise allowable itemized deductions by 3 percent of the amount by which the taxpayers AGI exceeds the applicable threshold. Phase out is limited 80% of itemized deductions. In the case of my client, itemized deductions were reduced by $2,400. Since the taxpayers were in the 28 percent tax bracket their tax was increased by about $700 as a result. The phase-out for personal and dependency exemptions occurs at a rate of 2 percent for each $2,500 ($1,250 for separate filing by married couples) that AGI exceeds the applicable threshold. Therefore, exemptions are fully phased out at $211,250 ($422,500 for married couples filing jointly). The $280,000 bump in income as a result of the possible installment sale payoff would have put our couple well into the phase-out range. They would expect to lose about $5,200 of their $7,800 exemption deduction. Again, with a tax rate of 28 percent, their tax bill would increase by approximately $1,500.
The full collection of this installment contract would bring into play three of the six tax law changes: 3.8 percent surtax, itemized deduction phase-out, and personal exemption phase-out. We discovered that the combination of these tax law changes resulted in an effective tax rate of 27% on the additional income rather than the expected 15 percent rate applicable to the capital gain income. In addition to the taxes discussed here, this individual’s circumstances were impacted by Alternative Minimum Tax (AMT).
However, further analysis allowed us to suggest a less than full payoff that would keep AGI below the applicable thresholds and hold the effective tax rate to 15 percent on the additional income. By negotiating an installment sale principal payment that would keep AGI below $300,000 there would be no phase-out of exemptions or itemized deductions. Furthermore, by keeping AGI below $250,000 the 3.8 percent surtax would not apply.
For 2013 and beyond there should be careful monitoring of AGI and taxable income compared to the various thresholds. Circumstances other than taxes may deem it best to recognize income now rather than over time, but early tax planning with your CPA will be very helpful to your decision making process and enhance your understanding of the 2013 income tax equation.
For more information about this article, please contact Doug Parham, CPA.