There are big tax changes waiting just around the corner on Jan. 1. Of course, being an election year some of those changes may end up changing, specifically the planned expiration of the Bush tax cuts, but we know at the very least (now that the Supreme Court has ruled) that the tax increases due to the Affordable Care Act will come to pass. Here are some things to know, so you can plan accordingly.
First let me start with a tax that is not coming: a new tax on all home sales. This one has been making the rounds on the Internet for months, and while it applies in some very specific circumstances, it is not a new tax on all home sales as the warnings imply. This rumor is a blanket application of the new investment income surtax, and in reality will not apply to the vast majority of home sellers.
The Affordable Care Act includes a 3.8 percent Medicare contribution tax on investment income — interest, dividends, rents, royalties, passive activity income, or net gain from disposition of property. This tax will apply to the lesser of investment income or adjusted gross income over $200,000 for singles and $250,000 for joint filers.
In other words, if you have an adjusted gross income of $260,000 and it is solely from wages with no investment income (assuming you file jointly), you would not owe this additional tax (but wait, there’s more). However, if your income from wages was only $150,000 of that adjusted gross income, and investment income made up the remaining $110,000, you would owe the surtax on the amount over $250,000, or $10,000. Going back to the home sale question, in most cases a married couple would have to have more than a $500,000 profit in order for the sale to impact the tax return at all. Anything beyond that $500,000 would be considered investment income, included in the adjusted gross income, and anything above $250,000 would then be subject to the surtax. You can see that it would take a large income and a large profit together before the surtax would come into play.
The expiring Bush tax cuts also have an impact on investment income. Currently, some dividends are taxed as “qualified,” meaning they are taxed at the same rates as capital gains; either 0 percent for those in the 0, 10, and 15 percent tax brackets or 15 percent for everyone else. As of Jan. 1, we are scheduled to return to the taxation of all dividends as ordinary income, at whatever your tax bracket may be. Marginal tax rates are also scheduled to return to the pre-Bush tax cut numbers.
Many people, especially retirees, were receiving dividends tax free, but will now see the tax go up to match their tax bracket (10 percent or 15 percent), assuming they have taxable income at all. High earners (the $200,000 singles/$250,000 joint filers) in the 35 percent tax bracket now could see their dividends taxed at potentially 43.4 percent (new 39.6 percent bracket plus the 3.8 percent Medicare tax) versus the current 15 percent. That’s close to triple the rate.
Capital gains were also taxed at 0 percent for taxpayers in the 0, 10, and 15 percent brackets, and all others were capped at 15 percent. Unless Congress rules otherwise, as of Jan. 1, they will be taxed at either 10 percent for those paying 0 percent before, or 20 percent for all others (slightly lower rates may apply to property held for five or more years) and 23.8 percent for those subject to the Medicare surtax. If this will be a significant impact for you, consider harvesting some investment gains prior to the end of 2012 to get the lower tax rate, if it makes investment sense too of course.
High earners without investment income will not get off completely. The Affordable Care Act created an increase in the Medicare payroll tax from 1.45 percent to 2.35 percent on wages and income from self-employment in excess of $250,000 for taxpayers married filing jointly; $200,000 for single taxpayers. Employers will be required to withhold the additional tax beginning at $200,000 for everyone, married or not. Taxpayers subject to this tax will need to make sure enough is being withheld and make additional estimated payments if not. Interestingly, self-employed taxpayers will not be able to deduct one half of this tax from their adjusted gross income, as they are with the existing self-employment tax. Taxpayers with nonqualified stock options should be aware of this when exercising, as the tax may be triggered.
Some more goodies from the Affordable Care Act: beginning in 2013, healthcare flexible spending account contributions will be limited to $2,500. These accounts allow for pretax contributions and tax free withdrawals to pay for qualified medical expenses, including tuition for special needs children. Currently there is no federal limit, although some employers impose a cap. For those itemizing deductions, the “floor” or minimum amount of medical expenses you must incur before getting a tax deduction will increase from 7.5 percent of adjusted gross income to 10 percent. Taxpayers age 65 before the end of 2012 can continue to use the 7.5 percent floor through 2016. It may pay to see the doctor this fall rather than waiting until next year if you will have enough medical expenses to take the deduction. Finally, taking non-qualified distributions from health savings accounts will be more expensive, too; the penalty will go from 10 to 20 percent.
Should the Bush tax cuts in fact expire, we will see marginal tax rates rise. The 10 percent bracket will be eliminated and combined into the 15 percent bracket; the 25 percent rate will go to 28 percent; 28 to 31 percent; 33 to 36 percent; and 35 to 39.6 percent. For joint taxpayers with $50,000 in taxable income (all wages), taxes will go from $6,630 in 2012 to $7,500 in 2013. That’s an 11 percent increase. We’ll need to add another 2 percent to that, too, because the payroll tax cut we’ve enjoyed for the past two years is set to expire. Note, too, that for families with eligible children, the child tax credit is scheduled to revert to $500 from its current $1,000. The marriage penalty will make a comeback; the standard deduction for married filing jointly, which is now twice the single deduction, will be reduced, and tax brackets will be adjusted so that couples move up in bracket sooner than double the single rate. If you have control over the timing of your income and it looks like the tax cuts will in fact expire, it may be advantageous to accelerate your income and take advantage of today’s rates.