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Prepare for Higher Taxes in 2013
2012 may be well go down as the year when taxes were at their lowest point for a generation or more. For more than a decade now, Congress and Presidents have supported a multitude of temporary tax cuts. Some of these tax cuts have been extended once, twice, or even more than twice. As I review the landscape, it seems inconceivable to me that all of the ‘temporary’ tax cuts will be extended for 2013. Along with new taxes scheduled to begin next year as a result of the Affordable Patient Act (new health care law), it is a near certainty that some, or all of us will see some level of tax increases in 2013. What follows is a summary of different taxes that could be higher next year.
Payroll Taxes: This has been in the headlines quite a bit lately. For 2011 all workers have received a 2% payroll tax cut in the form of a lower tax on employee Social Security taxes paid. Normally, earned income is subject to a 6.2% Social Security tax on income earned up to $106,800 (2011) and $110,100 (2012). Last year the Social Security tax was reduced to 4.2%. In December, Congress agreed to a two month extension and just this past week it was officially extended for the remainder of 2012. Given the back-and-forth in Congress on the ‘temporary’ nature of this tax cut I would expect this tax cut to have a difficult time being extended once again. Especially since the politicians will no longer be up for re-election before this tax cut expires.
Planning Strategy: Since this applies to earned income there is very little planning that could be done, especially for wage earners who already earn more than $110,100. If you earn just under this amount and can somehow ‘move’ earned income from 2013 into this year, you may wish to do that if it is an option.
Additional Medicare Payroll Tax: the Medicare payroll tax applies to all earned income (unlike the Social Security tax). This tax is currently 2.9% and is paid half by the employee (1.45%) and half by the employer (1.45%). Starting next year, the payroll tax for the employee portion will be going up by .9% for those who have earned income above $250,000 (joint filers) or $200,000 (single filers). It is important to note that this extra .9% only applies to the income over these thresholds. So, if you are married and your earned income is $250,000 or less, this new additional tax will not apply to you. If your earned income is $275,000, then the .9% Medicare tax will apply only to the $25,000 over the limit. You would then pay an additional $225 in this example.
Stealth Tax Trap: for those of you who earn less than the limits listed above, do not let your guard down. These limits are NOT indexed for inflation. So each year, more and more workers will be paying this extra tax. For example, let’s say you are married and file a joint return and you have $225,000 in earned income this year. Let’s also assume that your income will increase by 3% per year in the future. In four years time your income will now exceed $250,000 and you will be ‘eligible’ for this additional Medicare tax on earned income.
Planning Strategy: like the payroll tax cut that will expire, this extra tax is difficult to plan for since no one wants to intentionally earn less money in the future. If there is some ability to ’shift’ earned income forward into 2012, then one should explore this possibility.
Medicare Surtax on Unearned Income: this is the one that is getting a lot of attention in financial planner circles. Starting in 2013 a new Medicare surtax of 3.8% will apply to all unearned income (interest income, dividend income, capital gain income) for those who have adjusted gross income above $250,000 (joint filers) or $200,000 (single filers). If your adjusted gross income is below these thresholds, then this new surtax does not apply. Let’s see the impact using an example: adjusted gross income is $300,000. Of this amount $225,000 is earned income and $75,000 is unearned income. In this example, the $50,000 over the $250k limit (joint filers) will be subject to this new 3.8% surtax. The taxpayer would then have to pay an extra $1,900 in taxes ($50,000 times 3.8%).
Let’s say the total income was the same, but $275,000 was earned income and $25,000 was unearned income. In this example, only the unearned income, or $25,000, is subject to the new surtax.
Stealth Tax Trap: once again, the limits for this new tax are NOT indexed for inflation. Eventually, many who will not initially pay this tax will pay it in the future.
Planning Strategy: there’s a bit more that can be done here since it involves unearned income. I think we will see more and more people using tax-exempt investments like municipal bonds in their taxable portfolios to help minimize the impact of this new tax. Depending on how much other tax rates go up (dividends and capital gains), we may see an entire shift in asset location and the use of tax-advantaged portfolios. One pitfall of restructuring one’s portfolio is the potential trigger of capital gains taxes. If one would have to incur a large gain this year simply to avoid a partial tax increase on unearned income in the future, one needs to balance the potential liability in the years ahead versus incurring a higher tax this year. November’s election may help provide some guidance in this area.
Comment on the new Medicare taxes: since these taxes are part of the healthcare law, it seems that these are the most likely taxes to go forward next year barring a total Republican takeover in Washington. It should also be noted that even if the Republicans win Congress and the White House, repealing the health care law will be nearly impossible. To do so, the Republicans would need a ’super-majority’ of 60 in the US Senate. Given that they currently hold a minority position of 47 that would seem highly unlikely in just about any scenario for the upcoming election. If President Obama is re-elected, then it is a sure thing that these taxes will go into effect next year.
Capital Gains Taxes: these are scheduled to go up next year under current law. In President Obama’s budget he is calling for a 20% rate on long-term capital gains for those who are in the top two tax brackets. (Primarily those above $250k once again- are you noticing a theme?) Currently the rate is 15% for those in the top four income tax brackets. (0% for those in the bottom two brackets.) Republicans oppose higher taxes on capital gains. My guess is that if Obama wins, he will likely be in a position to get this increase through, but the Republicans may be able to delay the implementation for a year or two. A Republican in the White House will almost certainly mean that any increase that occurs as a result of current law lapsing would be retroactively reversed.
Planning Strategy: if it becomes apparent after the election that these rates are going up and your income puts in in the cross-hairs of this tax increase, then shifting your taxable investments to tax-free municipal bonds would be one method to limit exposure to this in the future. We also may see folks ‘harvesting gains’ later this year and effectively resetting their cost basis on investments. This will be quite strange to see folks intentionally creating taxable income now to avoid a higher tax in the future.
Dividends: the current tax rate on ‘qualified’ dividends is 15% for those in the top four tax brackets. This is scheduled to revert to the taxpayers top marginal tax rate next year. President Obama’s budget assumes this as well. Republicans will certainly fight this. My guess is that they settle on a 20% rate for those in the top tax brackets as a compromise. A Republican victory in the presidential election will likely mean the rates on qualified dividends stay at 15%.
Planning Strategy: again, this will depend on the election results. If it looks like dividend taxes are going up to the top marginal tax rate, then folks will really be looking hard at tax-advantaged investments like municipal bonds.
Regular Income Taxes: yes, good old-fashioned regular federal income tax rates are scheduled to go back to the pre-Bush tax rates of the Clinton era. President Obama wants to make the current rates permanent for everyone in the bottom four tax brackets. He wants to see the top two tax brackets go back to 39.6% and 36.0% respectively from their current 35% and 33% rates. Republicans oppose this. If Obama wins, I’m thinking that a deal will be struck during the lame-duck session on this issue along with capital gains and dividends. If they do not strike a deal, then the new Congress will have to deal with this early next year.
Planning Strategy: if your top marginal tax rate is in the top two brackets and you expect to continue earning money at these levels into the future, then you may wish to consider any strategies possible to move income into 2012. If you have vested stock options that can be cashed in, you might want to do that in 2012. Again, a lot of decisions will hinge on the election but it is better to be prepared to take action now and begin thinking about these possible tax increases.
Alternative Minimum Tax: once again, Congress has not addressed the AMT issue for 2011. Most observers feel that an increased exemption, or ‘patch’, will be passed before the end of the year. But what happens in 2013 when politicians are not up for re-election? Who knows. This is just one more aspect of our tax code to be aware of that may increase your tax bill in the future.
Planning Strategy: not much can be done about the AMT now. This is one more issue that will need to be resolved after the election.
Summary: while there is not a lot of good news regarding taxes beyond this year, there is time for some planning. Those who educate themselves on what the future will bring with regards to higher taxes will best be prepared to minimize their future tax liability and take action this year.