Originally published in New Hampshire Business Review - November 2012.
Although there is much uncertainty over tax rates due to the
expiration of the Bush tax cuts and the upcoming debate in Congress
about extending them, taxes for high income individuals will
certainly rise in 2013 as the revenue-raising provisions of the
Patient Protection and Affordable Care Act of 2010
("PPACA", otherwise known as "Obamacare") come
into effect. The PPACA is expected to raise $210.2 billion
through 2019 by increasing the Medicare payroll tax for high income
taxpayers and adding a new tax on their investment income.
Medicare Payroll Tax Increase. First, the tax increase.
Currently, Medicare Part A (hospital insurance) is funded primarily
by a payroll tax on wages from employment and self-employment.
Employers and employees each pay 1.45% of covered wages and the
self-employed pay 2.9% of their net earnings from self-employment.
Under the PPACA, the employee portion of the hospital insurance tax
(as well as the self-employed individual's hospital insurance
tax) is increased by 0.9% on wages in excess of $200,000 for an
individual filing as single or head of household, $250,000 for a
married couple, or $125,000 for a married individual filing a
separate return. For example, an employee filing a joint return
will pay hospital insurance tax of 1.45% on wages up to $250,000
and 2.35% on wages above that.
This tax increase will affect employers as well. Under current law,
each employer is required to withhold its employee's share of
the tax and is liable for that tax if it fails to withhold.
Starting in 2013, the employer will be required to withhold the
extra 0.9% only on amounts that it pays over $200,000, even though
the tax may apply to lesser amounts if the employee has other
sources of earned income such as a spouse or second job. The
employer need not consider the spouse's wages when determining
what amount to withhold. This is an administratively simple
solution for the employer, but employees may find that they need to
increase their withholding or make additional estimated tax
payments in order to avoid incurring penalties for underpayment of
estimated tax.
New Medicare Tax on Investment Income. Now for the new
tax. In addition to increasing payroll taxes for high income
taxpayers, the PPACA extends the hospital insurance tax to apply to
the net investment income of individuals, estates and trusts. For
an individual, the tax is 3.8% of the smaller of net investment
income or the excess of modified adjusted gross income (adjusted
gross income increased by certain foreign earned income) over
$250,000 for a married couple or surviving spouse, $125,000 for a
married individual filing a separate return, or $200,000 for anyone
else. In other words, taxpayers are subject to the tax on all of
their investment income only if their modified adjusted gross
income exceeds the applicable amount by at least the amount of
their net investment income.
This new tax also applies to trusts and estates. For trusts and
estates, the tax is on the smaller of undistributed net investment
income or the excess of adjusted gross income over the dollar
amount at which the highest income trust and estate tax bracket
begins ($11,650 plus an adjustment for inflation).
Net investment income includes interest, dividends, annuities,
royalties, rents and most net gains from disposition of property
that is not held in the taxpayer's active trade or business and
income from passive activities. Notably, the tax does not apply to
income from most businesses conducted by a sole proprietor,
partnership or S-corporation, interest on tax-exempt bonds,
veteran's benefits, or the excluded capital gain from sale of a
principle residence.
Overall Effect. Although the payroll tax increase and the
new tax on investment income may sound burdensome for those in the
highest tax bracket, many commentators have cautioned that they
must be put in historical context. The trend in the post-war era
has been downward from a high point of over 90% for ordinary income
and 35% for long-term capital gains. Over the last 25 years, top
rates on ordinary income have hovered between 31 and 39.6% and top
rates on long-term capital gains have been between 15 and 28%. The
top marginal rate for individuals is currently 35% for ordinary
income and 15% for long-term capital gains. The PPACA will
make the top marginal rate on long-term gains 18.8%. Depending on
Congressional action (or lack thereof), if the Bush tax cuts are
allowed to expire, the top marginal rate on ordinary income will
increase from 35% to 39.6% (which could increase the top rate on
dividends to 43.4% (39.6% plus 3.8%)), and the top marginal rate on
long-term capital gains will increase from 15% to 23.8% (20% plus
3.8%).
Tax Planning. Whether one considers the new taxes
historically low or painfully high, careful tax planning this year
may result in tax savings for those who are able to recognize
income this year rather than in later periods. In particular,
taxpayers considering appreciated selling capital assets, like
second homes, homes with built-in gains greater than the exclusion
for primary residences, or stocks, may wish to consider timing
these sales to make 2012 rates applicable. Likewise, taxpayers who
are considering converting a regular IRA, 401(k) or 403(b) to a
Roth IRA would do well to make those rollovers effective in 2012.
Generally, taxpayers who are in the highest income bracket would do
well do check in with their tax advisors soon about potential
planning opportunities.
Catherine Hines is a shareholder at McLane, Graf, Raulerson
& Middleton where she is an attorney in the Tax
Department.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.