The start of 2013 unfortunately brings with it the need to integrate into your clients' tax planning some new threshold amounts that have been added to the Tax Code. In addition to reviving a handful of extender provisions with their various adjusted gross income thresholds, the American Taxpayer Relief Act of 2012 also introduces new starting points for either direct or indirect tax increases.
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The threshold amounts examined in this month's column are the gatekeepers to the new 39.6 percent income tax rate, the new 20 percent maximum tax on net capital gain, the 3.8 percent net investment income surtax, and the indirect tax increases caused by revived versions of the Pease limitation on itemized deductions and the personal exemption phaseout, or PEP, limitation.
39.6 PERCENT TAX RATE
Perhaps the most important new thresholds for 2013 involve the rate bracket amounts that begin the 39.6 percent rate. The threshold amounts are keyed to taxable income and are: $450,000 for married individuals filing joint returns and surviving spouses; $425,000 for heads of households; $400,000 for single individuals; and $250,000 for married individuals filing separate returns. The applicable threshold dollar figures are subject to an adjustment for inflation in calendar years after 2013.
For those within the new 39.6 percent range, above-the-line deductions and exclusions -- and strategies to maximize them -- now become ever more valuable. Likewise, personal exemptions and itemized deductions have become more valuable, although these below-the-line deductions now run up against the newly revived PEP and Pease limitations.
Fortunately, the threshold amounts for the 39.6 percent have not followed the Obama administration's initial proposal, which would have added additional complexity to planning to avoid the top rate bracket. That proposal had keyed the 39.6 percent rate bracket (and a 36 percent bracket when it was in play) to an inflation-adjusted AGI amount that was then reduced by the standard deduction and specified personal exemptions.
20 PERCENT CAPITAL GAINS RATE
The new top capital gains rate of 20 percent applies at a threshold of $450,000 for joint filers and surviving spouses, $425,000 for heads of households, $400,000 for single individuals, and $225,000 for married individuals filing separate returns. These are the same threshold amounts that determine the start of the 39.6 percent rate. However, the correct computation can get complicated rather quickly depending upon certain combinations of taxable income, net capital gain, gain from collectibles and unrecaptured depreciation.
Although a similar computation for the new 20 percent rate was and still is required to determine the 0 percent capital gain rate for those in the 15 percent or lower income tax bracket, the 0 percent rate involved far fewer taxpayers and, because of their relatively low income, far fewer variables. Beginning in 2013, the capital gains rates for individuals are:
- A capital gains rate of 0 percent applies to the adjusted net capital gains if the gain would otherwise be subject to the 10 or 15 percent ordinary income tax rate;
- A capital gains rate of 15 percent applies to adjusted net capital gains if the gain would otherwise be subject to the 25, 28, 33 or 35 percent ordinary income tax rate; and,
- A capital gains rate of 20 percent applies to adjusted net capital gains if the gain would otherwise be subject to the 39.6 percent ordinary income tax rate beginning after Dec. 31, 2012.
Adjusted net capital gain for this purpose is net capital gain from capital assets held for more than one year, other than collectibles gain and unrecaptured Code Sec. 1250 gain, which carry their own rates.
Determining the capital gain rate when ordinary income exceeds the threshold amounts is relatively easy. In that situation, all net capital gain is taxed at 20 percent. For example, the individual who has $475,000 of ordinary income has all net capital gain taxed at 20 percent.
If ordinary income is below the threshold amount (and assume no gain on collectibles or unrecaptured 1250 gain is involved), the amount of net capital gain taxed at 20 percent is the excess of ordinary income and capital gain beyond the threshold. For example, if joint filers have $375,000 in ordinary income, then their first $75,000 in net capital gain is taxed at 15 percent, with any excess beyond $75,000 taxed at 20 percent because of their $450,000 threshold amount.
PEASE AND PEP THRESHOLDS
The American Taxpayer Relief Act revived the "Pease" limitation on itemized deductions. The Pease limitation, named after the member of Congress who sponsored the original provision, reduces the total amount of a higher-income taxpayer's otherwise-allowable itemized deductions by 3 percent of the amount by which the taxpayer's AGI exceeds an applicable threshold. However, the amount of itemized deductions is not reduced by more than 80 percent. Certain items, such as medical expenses, investment interest, and casualty, theft or wagering losses, are excluded.
The "applicable threshold" levels of adjusted gross income that now apply are: $300,000 for married couples and surviving spouses; $275,000 for heads of households; $250,000 for unmarried taxpayers; and $150,000 for married taxpayers filing separately. The dollar amounts are adjusted for inflation for tax years after 2013.
The personal exemption is $3,900 in 2013, up from $3,800 in 2012. However, the pre-2010 personal exemption phaseout has returned in 2013. Similar to the Pease limitation, the exemption is subject to a phaseout that begins with adjusted gross incomes of $150,000 ($300,000 for married couples filing jointly). It phases out completely at $211,250 ($422,500 for married couples filing jointly). Taxpayers with AGI over the threshold amount reduce their otherwise allowable deduction for personal and dependency exemptions by 2 percent for each $2,500 or fraction thereof by which the adjusted gross income exceeds the threshold amount ($1,250 for married taxpayers filing separately).
3.8 PERCENT NII SURTAX
For tax years beginning after Dec. 31, 2012, under the Patient Protection and Affordable Care Act of 2010, a net investment income surtax applies. The NII surtax on individuals equals 3.8 percent of the lesser of:
- Net investment income for the tax year; or,
- The excess, if any, of the individual's modified adjusted gross income for the year over the threshold amount. The threshold amount in this case is: $250,000 in the case of a taxpayer filing a joint return or a surviving spouse; $125,000 in the case of a married taxpayer filing a separate return; and $200,000 in any other case. Modified adjusted gross income for these purposes is AGI without the foreign earned income exclusion or offset.
While net investment income includes capital gains and losses, it also includes passive income and income from certain financial instrument trades and businesses, as well as rents. Given that the threshold amounts are lower for the 3.8 percent tax than the 20 percent maximum tax on net capital gains, capital gains subject to the 20 percent tax invariably will also be subject to the additional 3.8 percent surtax, while net capital gain subject to the 3.8 percent surtax will not necessarily be subject to the maximum 20 percent rate.
The American Taxpayer Relief Act makes a valuable change to the treatment of retirement savings and opens up an important planning opportunity, but one with the potential of impacting one or more of the new threshold amounts. Generally, participants with 401(k)s and similar plans have been allowed to roll over funds to designated Roth accounts in the same plan subject to certain qualifying events or age restrictions. The American Taxpayer Relief Act lifts most restrictions, and now allows participants in 401(k) plans with in-plan Roth conversion features to make transfers to a Roth account at any time. Those making such conversions as a result may be recognizing a large amount of income that may push them into a higher income, capital gain or net investment income surtax threshold bracket. Timing conversions, doing them over a period of years, and/or reducing capital gain recognition events during those years are strategies now worth considering.
Likewise, the American Taxpayer Relief Act has extended, through Dec. 31, 2013, the provision allowing tax-free distributions from individual retirement accounts to public charities, by individuals age 701/2 or older, up to a maximum of $100,000 per taxpayer each year. Taking advantage of this provision for charitable giving may also help reduce exposure to one or more of the threshold amounts as well.
Avoiding or minimizing exposure to the new threshold amounts for higher-income taxpayers should now be included on any due diligence check sheet used within the overall tax planning process. While ultimately the decision may be made that realization of certain income is best not postponed from a transactional perspective, careful monitoring of an individual's income against various threshold amounts can at least help give the individual the opportunity to consider alternative paths.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.