Year-end tax planning strategies for the higher-income individual take on renewed importance for 2013 as the result of recent changes. Many of these individuals are subject to higher tax rates on a number of fronts for the first time in 2013. New rates include a higher maximum income tax bracket of 39.6 percent, a 20 percent capital gains rate, a 3.8 percent net investment income tax triggered by a general adjusted gross income threshold, and a 0.9 percent Additional Medicare Tax on compensation income. Trying to avoid some of these new tax rates, or at least some of their full impact, also creates challenges as income is sought to be deferred into 2014 and deductions accelerated in 2013.
YEAR-END WAGE WITHHOLDING
Many higher-income individuals are only suddenly waking up to the fact that they will be owing significantly more tax for 2013 than for 2012 because of rate increases and deduction limitations. The increase in the highest-income tax bracket from 35 to 39.6 percent; the increase in the highest capital gains rate from 15 to 20 percent; and the new 3.8 percent net investment income tax and the 0.9 percent Additional Medicare Tax on compensation, along with increased restrictions on the full use of certain itemized deductions and personal exemptions and a general run up of the stock market in general, may add up to a hefty increase in the amount of tax that many individuals should have been paying as estimated tax starting back in the first quarter 2013.
Underpayment penalties for these initial quarters cannot be reduced by mailing in the difference at this time. However, since wage withholding is deemed to apply ratably over the entire calendar year, increased wage withholding for the remainder of 2013 to minimize the shortfall is one strategy worth considering.
Care in increasing employer withholding for the balance of 2013 must be taken, however. Both the employer and employee must follow certain rules to achieve the proper result. First, wage withholding can only be done prospectively; an employer cannot send in a check for retroactive withholding. Second, a Form W-4 must be filed with the employer before increased wage withholding may take place. An employer cannot act on its own; nor can it act only on verbal instructions.
A final point to consider is the restriction on taxes withheld on supplemental wages that are greater than $1 million (for example, year-end bonuses). Withholding for those supplemental wage payments can only be done at the 39.6 percent rate; no more or no less -- therefore curtailing some plans to accelerate a bonus to solve a shortfall in estimated tax.
ADDITIONAL MEDICARE TAX
Taxpayers considering additional withholding to accommodate a shortfall in estimated tax should be especially mindful of restrictions in withholding for the new Additional Medicare Tax. Starting in 2013, the Additional Medicare Tax increased the employee-share of Medicare tax by an additional 0.9 percent of covered wages in excess of certain "higher income-level" threshold amounts. A similar tax is assessed against self-employment income in excess of the threshold amounts. The Additional Medicare Tax is not imposed until an individual's covered wages, compensation and/or self-employment income exceed the threshold amount for the taxpayer's filing status. The threshold amounts are: $200,000 for single individuals (and heads of household); $250,000 for married couples filing a joint return; and $125,000 for married individuals filing separate returns.
An employer is required to collect the Additional Medicare Tax with respect to wages earned for duties performed by the employee for the employer only to the extent that the employer pays wages to the employee in excess of $200,000 in a calendar year. In fact, the employer is not allowed to withhold more. This restriction applies without regard to the employee's filing status or other wages/compensation. Individuals who receive wages from more than one employer, and who expect those wages to exceed the threshold amounts, should consider increasing their withholding or making estimated tax payments.
Especially apropos for year-end planning, the IRS has also cautioned that if an employee has amounts deferred under a non-qualified deferred compensation plan, and such compensation is taken into account as wages for FICA under a special timing rule, the non-qualified deferred compensation will also be taken into account under the special timing rule to determine the employer's obligation to withhold Additional Medicare Tax.
In implementing strategies for balancing taxable income for 2013 with 2014 to keep at a level tax bracket from year to year, inflation once again should be factored into planning. Most increases for 2014 are minimal (approximately 1.5 percent overall), but benefits can add up. In addition, two recent changes are notable for planning for 2013 and the start of 2014: a permanent Alternative Minimum Tax "patch" and the inflation-adjusted unified gift and estate tax exemption.
Permanent AMT "patch." The American Taxpayer Relief Act "patched" the AMT by increasing the exemption amounts and allowing nonrefundable personal credits to the full amount of the individual's regular tax and AMT. Additionally, ATRA provides for an annual inflation adjustment to the exemption amounts. The 2014 AMT exemption amounts are: $82,100 (up from $80,800 in 2013) for married filing jointly and qualified widow(er)s; $52,800 (up from $51,900 in 2013) for single and head of household; and $41,050 (up from $40,400 in 2013) for married taxpayers filing separately.
Unified gift and estate tax exemption. One inflation-based increase between 2013 and 2014 is particularly significant because of its dollar size: The unified estate and gift tax exemption rises from $5.25 million to $5.34 million. At the existing permanent 40 percent rate, that translates to a $36,000 tax savings simply because of inflation. Estate plans, especially those using the maximum exemption for gifting appreciating assets out of a potential estate as soon as possible, should consider an early January 2014 gift of $90,000 over and above the annual gift tax exemption ($14,000 or $28,000, depending upon a split-gift election).
Aside from solving a potential estimated tax shortfall through increased wage withholding, use of traditional year-end tax planning that accelerates certain deductions can also effectively reduce estimated tax penalties. At the time this article was written, Congress was a long way off in deciding whether to extend a handful of provisions that are expiring at the end of 2013. Expiring provisions on the individual side include, among others, the deduction of state and local sales taxes in lieu of state and local income taxes; the teachers' classroom expense deduction; exclusion of cancellation of indebtedness on principal residence; parity in transit fringe benefits; the mortgage insurance premium deduction; and tax-free IRA distributions, up to $100,000, to charity by individuals age 70-1/2 or older.
Odds are that most if not all of these provisions will be extended for 2014, but only retroactively by legislation sometime during 2014. Accelerating expenses that may qualify for one of these expiring tax break into 2013, however, does provide a degree of protection in case a budget-conscious Congress is persuaded that some of the extenders are not worth the revenue loss.
Once December rolls around, it's usually too late to implement many "year-end" tax strategies as effectively as if begun earlier in the year. For the wage withholding and other remedies recommended in this column, those who started early have a distinct advantage. Nevertheless, action now by many taxpayers, especially those in the highest tax brackets, either in recovering some estimated tax penalty exposure or otherwise generally reducing a tax liability for 2013 that most likely will be significantly higher than it was in 2012, should still yield some good results.
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 part of Wolters Kluwer.
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