Bush-era tax rates are set to expire at the end of 2012, which would cause rates to become sharply higher. Even if they remain in effect, rates for upper-income individuals will move up in 2013.
The culprit is a comprehensive health care reform package that Congress enacted in 2010 (known officially as the Patient Protection and Affordable Care Act of 2010 and the Health Care and Education Reconciliation Act of 2010). The health-care legislation introduces Medicare surtaxes that increase taxes for higher-income individuals. Two distinctly different increases take effect at the start of 2013.
The first surtax is on earned income. For 2013 and later years, the additional Medicare tax of 0.9 percent applies only to joint filers with wages above $250,000 ($125,000 for married couples filing separate returns) and single filers over $200,000. Their employers pay nothing extra. The levy also applies to individuals with self-employment income above the thresholds.
The second surtax drastically changes the rules. Before 2013, the Medicare payroll tax applied just to wages, not investment income. The legislation expands it to apply to certain kinds of investment income. For 2013 and later years, the new tax of 3.8 percent kicks in only when MAGI exceeds specified amounts. MAGI is an acronym for modified adjusted gross income. It's the same as AGI for almost all individuals except for expatriates. The law requires them to add back certain amounts that are excludable from U.S. income taxes.
The 3.8 percent tax applies only to joint filers with MAGI above $250,000 ($125,000 for married couples filing separate returns) and single filers with MAGI over $200,000. Even then, it's imposed on the smaller of a person's net investment income or the amount by which MAGI exceeds the threshold amounts of $250,000 ($125,000) or $200,000.
The legislation precisely defines investment income. It includes interest, dividends, capital gains on the sales of investments like stocks, bonds, second homes and rental properties, the taxable portion of annuity payments, royalties, and passive income from real estate and investments in which a person doesn't actively participate, such as partnerships.
There are exceptions, and they're important. Investment income doesn't include tax-exempt interest from municipal bonds or muni bond funds, withdrawals from retirement plans, such as IRAs, Roths and 401(k)s, and payouts from traditional defined-benefit pension plans or annuities that are part of retirement plans. Other exceptions include life-insurance proceeds, veterans' benefits, Social Security benefits, and income from businesses in which a person does actively participate, such as Subchapter S corporations or partnerships.
Be mindful of the rules for withdrawals from retirement plans. While such withdrawals are one of the exceptions, they're reportable income and increase MAGI. The rules are more favorable for withdrawals from Roth accounts, another one of the exceptions. Roth removals don't increase MAGI.
The 3.8 percent tax doesn't affect someone without investment income. Similarly, it doesn't affect someone whose entire income is from investments, as long as total investment income is under the MAGI thresholds.
Assume 2012's top rate of 15 percent for long-term capital gains and dividends remains in effect for 2013. The additional Medicare tax increases the top rate from 15 percent to 18.8 percent.
When the surtax does apply, here's how the numbers work in 2013. Suppose a couple filing jointly has investment income of $100,000 and MAGI of $300,000. Besides their regular income taxes, they have to pay a surtax of $1,900 -- 3.8 percent on the $50,000 excess over $250,000. This is because their MAGI of $300,000 reduced by their $250,000 threshold amount is less than their investment income of $100,000.
For a single person with investment income of $100,000 and MAGI of $400,000, the surtax is $3,800 -- 3.8 percent on the income of $100,000. This is because her investment income of $100,000 is less than her MAGI of $400,000 reduced by her $200,000 threshold amount.
There's more bad news. Investors must separately calculate the extra 0.9 percent wage-based tax and the new 3.8 percent tax on investment income. Assume a single person has wages of $180,000, investment income of $60,000 and MAGI of $220,000. She escapes the 0.9 percent tax and is billed $760 for the 3.8 percent tax on $20,000 (MAGI of $220,000 minus threshold of $200,000).
What happens when she has earnings of $300,000, investment income of $60,000 and MAGI of $400,000? Her wages of $300,000 put her $100,000 above the threshold of $200,000, boosting her tax tab by $900 ($100,000 times 0.9). She also is nicked for $2,280 (3.8 percent on the entire $60,000 -- the lesser of her investment income of $60,000 or the amount by which MAGI of $400,000 exceeds her threshold of $200,000). Her total increase is $3,180.
With Washington's cantankerous mood, it's uncertain whether the Bush-era tax rates will be extended beyond 2012 or taxes will revert to higher rates in 2013. What could happen is that Congress and whoever is in the White House cut deals for more changes like the Medicare surtaxes: a few percent here, a few percent there, rather than straightforward rate increases or decreases. What's certain is that our lawmakers will enact even more complications to an already confusing tax code.
Julian Block is an attorney and author based in Larchmont, N.Y. He has been cited as: "a leading tax professional" (New York Times); "an accomplished writer on taxes" (Wall Street Journal); and "an authority on tax planning" (Financial Planning Magazine). This article is excerpted from "Julian Block's Year Round Tax Savings," available at julianblocktaxexpert.com.