Theresa Fry, Vice President and Manager, IRA and Retirement Plans
Jeffrey R. Wolfe, Vice President, Estate Planning Associate

The American Taxpayer Relief Act of 2012 has almost completed its first full year of implementation. Have you noticed a difference in your tax bill yet? If you are a higher income earner (more than $200,000 individually, more than $250,000 married) you may have noticed a slight change in your paycheck at some point during the year. That’s because the new rules require that anyone earning wages above these limits must pay an additional 0.9% in tax as part of the Medicare Health Insurance Surtax (aka Obamacare). The extra withholding requirement from your paycheck doesn’t begin until you’ve earned more than $200,000 at one place of employment. And at 0.9%, maybe you haven’t noticed.

What you may notice in the coming months while preparing your tax return is that there’s a lot more taxes aimed at higher income earners, and these taxes may sting a bit more than the .9% you may have overlooked. At the $200,000/$250,000 income level, you also become subject to the Net Investment Income tax (“NII”), which is a 3.8% surtax on all “passive” income like interest, dividends, capital gains, rents, etc. What this means is that your tax bill on these items has gone up 3.8% from last year. Don’t feel bad if you have forgotten about this increase. There is a good chance most people won’t recall this tax increase until they sit down to do their taxes in the next few months.

If your adjusted gross income exceeds $250,000 as an individual or $300,000 if you are married, your personal exemption also begins to phase out at a rate of 2% for each $2,500 above the thresholds. In fact, personal exemptions are completely phased out at incomes exceeding $372,550 ($422,500, if married). Each situation will be unique, but depending on the number of exemptions you may claim, your tax increase can exceed 4% with the loss of these exemptions.1

And the hits keep coming. At the same $250,000/$300,000 thresholds, itemized deductions are also reduced by 3%, with a limitation of no more than an 80% reduction of your total itemized deductions. Generally, what this means for the taxpayer who itemizes is that you will pay about an extra three cents of tax for every itemized dollar that is phased out.2

For those who earn more than $400,000 individually ($450,000 married), on top of all of these taxes there is a new highest tax bracket, 39.6%. At these income levels you also have higher qualified dividends and capital gains rates of 20% (versus 15% for lower brackets).

What does it all mean? For high-income earners, it means your tax bill due April 15th is going to be higher than it has been in the past. For those in the highest tax bracket, your marginal rate for qualified dividends and capital gains is now 23.8%. Moreover, with the various phase-outs and the .9% earned income tax increase, your effective marginal ordinary tax rates are nearing 50%.

So what can you do about it? While fleeing to the Caymans may seem enticing (especially this time of year), any time you “avoid” tax you tend to “earn” incarceration. There are some safer alternatives to consider if you are affected by these new tax rules, but there is no time to waste if you want the impact to be felt for your 2013 taxes. Work with your tax advisor to see if any of these actions may benefit your specific situation:

  • Consider fully funding employer sponsored plans and/or tax deductible IRAs. Maximizing these contributions may lower your tax bracket.
  • Consider Roth retirement planning options. Transferring existing pre-tax assets to a Roth IRA, or funding a Roth IRA or Roth 401(k) plan now may provide more after-tax cash flow during retirement.
  • If you are over the age of 70½, examine whether a qualified charitable distribution from your IRA is right for you.
  • Review whether you should take or defer gains or losses this year. Choosing the appropriate time to take such actions can help you control your potential tax liability.

Taxes remain a complicated and moving target. Work together with your tax advisor and with your Benjamin F. Edwards & Co. financial consultant to make sure your investments are aligned with your tax strategy.

Note: Benjamin F. Edwards & Co. does not provide tax or legal advice.

1Hungerford, Thomas L.; Congressional Research Service, Deficit Reduction: The Economic and Tax Revenue Effects of the Personal Exemption Phaseout (PEP) and the Limitation on Itemized Deductions (Pease); Feb. 1, 2013

2Ibid.