After weeks of dramatic headlines about the coming fiscal cliff and how any deal to avert it would affect taxpayers, the majority of people may be able to rest easy: Most taxpayers will see little or no tax changes in 2013 as a result of the American Taxpayer Relief Act. However, taxpayers above certain levels of income will see higher tax rates. Additionally, certain provisions in the 2010 Affordable Care Act are becoming effective for the first time in 2013, bringing about a combination of changes that will affect some taxpayers at differing levels of income. There are three points at which you will see an increase in tax rates or a reduction in certain other tax benefits.
If you earn $200,000 (single) or $250,000 (married filing jointly)
Under the 2010 healthcare law, taxpayers with income over $200,000 (single) or $250,000 (married filing jointly) will have two new taxes.
First, earned income exceeding these thresholds will be subject to an additional 0.9% tax, on top of the current Medicare tax of 1.45%. (The current rate of 1.45% will still apply to wages below these levels.)
Second, taxpayers above that threshold will also have a new tax of 3.8%. The tax will apply either to your net investment income (i.e., interest, dividends, capital gains, after-tax annuity income, and rents and royalties) or the amount by which your modified adjusted gross income (MAGI) exceeds the threshold amount—whichever is less.
For example, a married couple filing jointly in 2013 with $325,000 of MAGI — $100,000 of which is net investment income — will pay the 3.8% surtax on $75,000 (i.e., the amount of net investment income that exceeded the applicable $250,000 threshold).
If you earn $250,000 (single) or $300,000 (married filing jointly)
There are two relevant items for taxpayers in this income bracket.
The first is the phase-out of itemized deductions (which you may see referred to as “Pease limitations” named after the Congressman who first proposed this type of phase-out). Under this provision, itemized deductions will be reduced by 3% of the amount by which your adjusted gross income (AGI) exceeds the $250,000/$300,000 threshold, but not beyond 80% of your total deductions. For instance, if you are single and earn $275,000 per year with $5,000 worth of itemized deductions, then $750 (3% of the $25,000 that you earn over the threshold for individuals) would be disallowed, leaving you with $4,250 in deductions. Certain itemized deductions (for medical expenses, investment interest and casualty or theft losses) will not be limited and are not subject to phase-out. However, the medical expense deduction is now available for amounts paid in excess of 10% of AGI rather than the previous 7.5% of AGI.
The second item is the personal exemption phase-out (which you may see referred to as “PEP”). Personal exemptions (i.e., the $3,900 in 2013 that you can claim for yourself, your spouse, and any dependents) will be phased out by 2% for each $2,500 of AGI that exceeds $250,000 (for singles) or $300,000 (for married couples filing jointly). For example, if a married couple with no dependents has a combined AGI of $400,000, they could claim personal exemptions of $1,560. $6,240 or 80% (2% for every $2,500 over $300,000) of their possible $7,800 will not be allowed.
If you earn $400,000 (single) or $450,000 (married filing jointly)
For taxpayers in this bracket, the top rate of 35% for personal income tax has increased to 39.6% on taxable income above the threshold level. Capital gains and dividend tax rates also increase from their current amounts (0% or 15%) to 20%. (This is in addition to the new Medicare tax of 3.8% on capital gains and other forms of passive income mentioned above.)
How should you respond?
An advisor can help you develop the best approach for your particular circumstances. In general, however, thinking about your current and future income can help you determine appropriate strategies.
If you are currently in a higher income tax bracket than you anticipate you will be in the future, you may wish to:
If you are currently in a lower income tax bracket than you anticipate you will be in the future, it may make sense to accelerate income as much as possible:
For those affected by the new taxes, there is a lot to consider. Contact your advisor to discuss how best to manage your finances in light of these changes.
For more information on the provisions of the American Taxpayer Relief Act, please see “The fiscal cliff deal and you: Understanding gift and estate taxes” and “The fiscal cliff deal and you: January 31 deadline for IRA charitable gifts.”
The tax information contained herein is not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Taxpayers should seek advice based on their own particular circumstances from an independent tax advisor.
The material presented above is for informational purposes only and the statements made represent TIAA-CREF's interpretation of applicable law. It is presented with the understanding that TIAA-CREF (or its affiliates, distributors, employees, representatives and/or insurance agents) is not engaged in rendering legal or tax advice.