You’ve heard that taxes are going to increase and you’re waiting for the hammer to drop. We break down the new tax brackets and regulations that will impact you in the coming year.
Last month we went through our annual ritual of filing our income tax returns. This sounds a bit strange, but I wish I could file 2012’s income tax return all over again this year, and next year, and the year after that. Why? Because last year’s tax liability was significantly lower than what you’ll be paying this year and from hereon forward. Lets take a detailed look at the tax changes so that you will know why your wallet feels lighter.
Income Tax Rates
The new tax law, called the American Taxpayer ‘Relief’ Act of 2012, now defines “rich” as making $450,000 in taxable income or more. Before this year there were six income tax brackets, but that’s been expanded to seven, with the addition of a 39.6% bracket. Here’s an estimate of how this breaks down for a married couple:
Let’s think about what this means. I’d say most of you fall into the 33% bracket, but remember you’ve got to tack on your state income tax. If we assume you pay about 5% in state income tax, then you’re paying about 38% in total income taxes on the amount of income that falls in the 33% bracket. For you evil rich EPs making more than $450,000 you’ll be at nearly 45%. Live in California or New Jersey? Try 50%.
Payroll Tax Triple Play
You’re not even close to done. For the past two years if you were an employee, you got a temporary reduction in your payroll tax (Social Security tax) and paid 4.2%. That’s now been upped back to 6.2%. There’s a cap on the amount of income that is subject to Social Security tax, but this year that amount has been increased from $110,100 to $113,700.
And to really nail it in, if you make more than $250,000 (married) in wages, thanks to Obamacare you’ll be subject to an additional 0.9% Medicare tax on top of the 1.45% you already pay as an employee. One more thing to remember is that unlike Social Security tax, there’s no cap on Medicare taxes.
Dividends and capital gains
If you own investments in taxable accounts, the rules for dividend and capital gains taxes have become more complex (imagine that). There are now three dividend and capital gains tax rates:
- 0% if you fall in the 10% or 15% income tax brackets
- 15% if you fall in the 25% to 35% income tax brackets
- 20% if you fall in the dreaded 39.6% income tax bracket
On the surface it looks like only the last tax bracket gets hit with higher dividend and capital gains taxes since prior to this year everyone above the lowest two income tax brackets paid 15%. This is where Obamacare strikes again. If you make over $250,000 (married) then you’ve got to tag on another 3.8% Medicare investment tax on investment income, which includes capital gains and dividends. Your investments are now tied to health care policy.
Suppose you make $350,000 (married) in income and generate $20,000 in capital gains and dividends this year. Since you fall into the 33% tax bracket, that $20,000 is subject to the 15% tax, but you have to add another 3.8% Medicare investment tax. And don’t forget state income tax (assume 5%). Your total capital gains/dividend tax bill: 23.8% or about $4,800.
Politicians like to use obtuse language like “expiration of tax cuts” when they are really talking about tax increases. Two more examples of this apply to the new tax law:
There is now a phaseout of itemized deductions, which include deductions such as mortgage interest, charitable contributions, and others. It applies only to income taxpayers making more than $300,000 (married). So the greater your income goes above that amount, the less deductions you can take. This phaseout indirectly pushes you into a higher income tax bracket.
The marriage penalty is back. Again, for higher income taxpayers you start falling into the higher income tax brackets sooner than you would if you remained two separate individuals. While I’m not suggesting you get divorced, it’s another example of a stealth tax.
The new tax law is a more progressive tax system designed to target higher income taxpayers. There are higher income tax rates, dividend tax rates, and capital gains tax rates on higher income individuals including EPs. There is also an interplay between new taxes (payroll taxes and Medicare investment tax) and income taxes, and hidden tactics that push your tax bracket even higher.
Practically speaking, unless your income has gone up significantly this year (doubtful), then you’ll either have to save less and potentially retire later, work more now to make up for it, or cut your current lifestyle. None are very appealing options.
Welcome to the new reality.
Setu Mazumdar, MD, CFP® practices EM and he is the president of Lotus Wealth Solutions in Atlanta, GA www.lotuswealthsolutions.com