Small Tax Changes for 2013 Could Cost You Big

The Affordable Care Act of 2010 and the American Taxpayer Relief Act of 2012 created several small taxes on high-income taxpayers that went into effect for 2013. When you first learned about the laws that created Obamacare three years ago and averted the fiscal cliff in January, respectively, you might recall hearing a laundry list of seemingly “small” tax changes that were parts of these landmark laws.

While these taxes might not have seemed like much individually, there is a good chance you’ll notice the cumulative effect when you get your tax bill in April if you made more than $200,000 as an individual or $250,000 as a couple.

To help you see what these new taxes might mean for you, let’s take a look at how they will affect three sets of taxpayers at different income levels.

Medicare Tax Increase on Earned Income

Income threshold: $200,000 individuals; $250,000 married couples

A 0.9% increase of the Medicare tax applies to earned income greater than $200,000 for individuals and $250,000 for married couples. Previously, workers paid 1.45% in Medicare tax on all of their wages, salaries, commissions, or other forms of earned income. But starting in 2013, any dollar earned above those amounts is taxed at 2.35% for Medicare.

Keep in mind that the increase only applies to earnings above the thresholds. The first $200,000 of earnings for individual filers and $250,000 for married couples is still taxed at the previous rate of 1.45%.

Impact in Bedrock:

Barney and Betty have $350,000 in earned income, so $100,000 of their earnings will be subject to the 0.9% tax increase, resulting in $900 of additional taxes compared with 2012. Fred and Wilma earned $650,000 as a couple, so they would have $400,000 subjected to the increased tax. This results in $3,600 of additional taxes compared with 2012.

But with Fred and Wilma, the timing of when they pay this tax can be tricky. Fred makes $150,000 at this job, and Wilma makes $500,000 at her job. Because Wilma’s salary is greater than $200,000, her employer should automatically increase her withholding to account for the 0.9% tax increase. All employers are supposed to start withholding for the new tax at $200,000, whether the employee is single or married. Because Fred’s salary is less than $200,000, his employer won’t increase the withholding rate on his paychecks throughout the year.

As a result, when Fred and Wilma’s accountant computes the tax they owe as a married couple, the Flintstones will have to pay an additional $900 (0.9% x $100,000) that wasn’t collected throughout the year.

Medicare Surtax on Investment Income

Income threshold: $200,000 individuals; $250,000 married couples

Individuals earning more than $200,000 and couples earning more than $250,000 are now subject to a new Medicare surtax of 3.8% on investment income, such as interest, dividends, capital gains, and rental income. If your non-investment income (basically your earned income) is greater than the threshold, the tax is calculated by taking 3.8% times the amount of investment income. But if your non-investment income is just below the threshold and adding in your investment income puts you over the threshold, then the 3.8% only applies to the amount by which your total income exceeds the threshold.

Impact in Bedrock:

The Flintstones and the Rubbles don’t have any investment income, so the tax doesn’t apply to them. But Fred’s former boss, Mr. Slate, does. Now that Mr. Slate is retired from the rock quarry, his only source of income is $250,000 in rental income from an apartment complex that he owns in Bedrock. Because his investment income is more than the amount by which his MAGI exceeds the threshold for individuals ($250,000 – $200,000 = $50,000), the 3.8% tax is applied to Slate’s MAGI above the threshold. As a result, Slate owes $1,900 more (3.8% x $50,000) than he did in 2012.

Itemized Deduction Limits

Income threshold: $250,000 individuals; $300,000 married couples

The biggest headlines from the American Taxpayer Relief Act were the increase in the top marginal tax bracket from 35% to 39.6% (affecting individuals earning more than $400,000 and married couples earning more than $450,000) and the increase in the tax rate on capital gains and dividends from 15% to 20% for people in this highest tax bracket.

But the law also effectively increases tax rates for taxpayers at much lower income levels ($250,000 for individuals and $300,000 for couples) by limiting their ability to use the personal exemption and itemized deductions.

Starting in 2013, a taxpayer’s ability to claim itemized deductions is reduced by 3% of the amount of income that exceeds the thresholds. The reduction is limited to 80% of the amount of the total itemized deductions, which is a confusing way of saying that no matter how much the taxpayer earns, he will still be able to claim at least 20% of the itemized deductions.

Impact in Bedrock:

Barney and Betty’s income of $350,000 exceeds the threshold by $50,000, so their itemized deductions are reduced by $1,500 ($50,000 x 3%). Because the Rubbles are in the 33% tax bracket, the new limits will increase their tax bill by $500 in 2013 compared with 2012.

Fred and Wilma’s income of $650,000 exceeds the threshold by $350,000, so their itemized deductions are reduced by $10,500 ($350,000 x 3%). Because the Rubbles are in the 39.6% tax bracket, the itemized deduction limits will increase their tax bill by $4,150 in 2013 compared with 2012.

Personal Exemption Limits

Income threshold: $250,000 individuals; $300,000 married couples

Starting in 2013, a taxpayer’s ability to claim personal exemptions is reduced once income exceeds those thresholds. Each personal exemption is worth $3,900, and you get to claim it for yourself, your spouse, and any dependents. The calculation for the reduction is a bit tricky: the exemption gets reduced by 2% for each $2,500 increment that income exceeds the threshold. Unlike the limits on itemized deductions, the personal exemptions can get phased-out completely.

Impact in Bedrock:

Barney and Betty’s income exceeds the threshold by $50,000, or 20 increments of $2,500. As a result, they will lose 40% of their personal exemptions (20 increments x 2%). The Rubbles can claim four personal exemptions (assume they have two kids), so the 40% reduction takes the value of those exemptions from $15,600 to $9,360. Because the Rubbles are in the 33% tax bracket, this $6,240 reduction will cost them approximately $2,050 in additional taxes in 2013 compared with 2012.

Because Fred and Wilma’s income is so far above the thresholds, their personal exemptions are completely phased out. They lose the entire $15,600 of their four exemptions, which will add approximately $6,175 to their tax bill compared with 2012 because they are in the 39.6% tax bracket.

Taxpayers who are affected by the alternative minimum tax (AMT), however, won’t feel the sting of the lost personal exemptions. The AMT doesn’t allow for deductions for personal exemptions.

Adding It All Up

The table below shows the total impact of these four new taxes for Bedrock’s most famous residents.

Don’t Fall Victim to Sticker Shock on April 15

As you can see, these four new taxes can add up to a big difference when high-income taxpayers go to file their taxes next spring. Because some of these tax increases won’t be withheld from your paychecks during the year, there’s a good chance you will owe additional taxes once your accountant calculates your tax bill. And this can come as quite a shock if you didn’t owe any taxes last year and your income didn’t increase from 2012 to 2013.

Filing your 2013 tax return as early as possible in 2014 can help you avoid this sticker shock and keep you from getting caught in a cash crunch on April 15. Learning what your tax bill will be as early as possible will give you time to round up the cash you need to pay the IRS by the tax deadline.

You also might consider having your accountant run your numbers this fall to give you an idea of what you might owe next spring.

At Eilts & Associates, we are available to help you understand what these new taxes will mean for you. Contact us (773.252.6171 or bart@eiltscpa.com) to set up a time to review your withholding and income and help you prepare for your upcoming tax bill.

#Individuals

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