Fiscal Cliff: 6 TAX Increases That Will Cost You On January 1st 2013
Money Morning Staff: That slow moving train wreck known as “The Fiscal Cliff” is suddenly upon us.
If Congress doesn’t act soon, numerous tax breaks will expire – automatic spending cut will kick in – and this one, two punch will hit every American squarely in the wallet.
It’s a fiscal tsunami that will strike as early as December. The damage will be so widespread it could derail the entire U.S. economy.
Nobody in Washington, however, is doing anything about it.
If you’re not worried yet, you should be.
“Taxmageddon” Means Higher Taxes for All
The Bush-era tax cuts will end on Jan. 1, 2013, unless Congress intervenes.
Also set to expire that day will be a temporary payroll-tax holiday on social security.
The tax changes won’t just slam a few income brackets; they’ll reach all taxpayers.
Every one of the existing income tax brackets will be ratcheted up, starting with the lowest 10% bracket, which will be hiked to 15%. The 25% bracket will jump to 28%; the 28% bracket will go to 31%; the 33% bracket will be replaced by a 36% bracket and the 35% bracket will soar to 39.6%.
Stock market investors will also be punished.
Right now, the maximum tax rate on long-term capital gains and dividends is only 15%. Starting next year, the maximum rate on long-term gains is scheduled to increase to 20%.
But get this — the maximum rate on dividends will skyrocket to a whopping 39.6%.
That’s not all…
Investors in the two lowest income brackets who currently pay 0% will have to shell out 10% on long-term gains and 15% and 28% on dividends.
The death of the Bush tax cuts also kills temporary federal estate and gift tax breaks and a measure to ease the marriage penalty for low and middle income couples.
On top of that, workers will lose a 2% cut on social security taxes. That means an average $1,000 tax increase come Jan. 1 for virtually all workers.
In other words, if Congress fails to act, “Taxmageddon” assures that we will all be paying higher taxes next year.
Driving off a “Fiscal Cliff”
Not only are taxes scheduled to go up, but the entire economy could be crippled by a slate of automatic spending cuts set to take effect on Jan. 1, 2013.
Roughly $1.2 trillion in government spending cuts will kick in, stemming from the failure of last summer’s “super committee” to produce a deficit-cutting agreement.
A Congressional Budget Office report issued last month said the economy would shrink by 1.3% in the first half of next year if our legislators drive us off this so-called “fiscal cliff.”
Washington is already filled with people warning of disaster if the cuts go into effect. Hospital executives have besieged Washington with complaints about scheduled cuts in Medicare. Officials at colleges and universities from around the country are raising red flags over big cuts in federal research grants.
Executives from Lockheed Martin Corp. (NYSE: LMT) and other aerospace companies even passed out digital countdown clocks ticking off the seconds until “over 1 million American jobs” will be lost to Defense Department budget cuts, The Washington Post reported.
“How do you plan for chaos?” Marion Blakey, president of the Aerospace Industries Association, posed to the Post during a break between meetings with lawmakers last week. “There’s so much at stake. And there’s nothing that inspires confidence that this will get done.”
In fact, the uncertainty is already hurting the economy.
Many businesses began laying off workers before the election or cut back on capital spending before the end of the year if Congress doesn’t act.
President Obama Re-Elected… Stalemate in Washington Continues
Meanwhile, even with President Obama staying in the White House, the Democratic Senate and the Republican House seem ever more determined to draw lines in the political sand rather than finding meaningful solutions.
Senate Majority Leader Harry Reid, D-NV, insists he won’t take action on the expiring tax cuts or the spending cuts unless Republicans agree to put higher taxes on the table.
For their part, Republicans are focused on the national debt, which is set to exceed its legal limit in January — right when the spending cuts and tax hikes will hit.
This special Money Morning report will examine a number of upcoming or proposed changes in tax laws and rates and suggest strategies to minimize their impact on your investments. Or better yet, take advantage of them if possible.
TAX INCREASE # 1:
Capital Gains Rates Are Set to Skyrocket
As it stands, there are more than two dozen tax-law changes scheduled to take effect in 2013. Some of them target nearly every single taxpayer while others are more narrowly focused on individuals, such as small business stockholders and home sellers.
Of most immediate concern to investors is the scheduled increase in tax rates on capital gains. Currently, the federal government recognizes three types of capital gains:
- Short-term gains – Profits from assets held for less than one full year. These gains are taxed as ordinary income at a rate based on your total personal income, with percentages now ranging from 10% to 35%.
- Ordinary long-term gains – Profits from assets held for more than one year, now taxed at a maximum rate of 15%, regardless of income from other sources. (Note: Individual taxpayers in the 10% and 15% brackets now pay no tax on long-term capital gains but merely include them with other taxable income. However, in 2013 these taxpayers will be subject to a 10% tax on long-term gains.)
- Qualified long-term gains – Profits from assets purchased after the 2000 tax year and held for a minimum of five years. Qualified gains are currently taxed at a maximum 15% rate.
This relatively simple structure will become more complicated in 2013, for several reasons…
For starters, there is no scheduled increase in tax rates for short-term capital gains – they’ll still be taxed at ordinary income rates. However, if Congress allows the Bush-era tax cuts to expire, those ordinary rates will rise substantially.
For example, those in the lowest income-tax bracket – individuals earning less than $8,700 or married couples earning less than $17,400 – will see their tax rate jump from 10% to 15%, with the increase applying to short-term gains as well. (Note: The income levels cited for various tax brackets are for 2012; they’ll be adjusted for inflation in 2013.)
Taxpayers in the next bracket – individuals earning from $8,700 to $35,350 and couples earning from $17,400 to $70,700 – will see no increase in their current 15% marginal tax rate. But there is one catch! Rather than being double that for unmarried taxpayers, the income level at the top of the bracket for married couples will be reduced to 167% of the individual cap – just $59,035 based on 2012 numbers.
This will put substantially more joint tax filers in the new 28% bracket (now 25%), increasing the so-called “marriage penalty” and effectively almost doubling their rate on short-term capital gains as well.
Taxpayers in the current 25%, 28% and 33% brackets will see their marginal tax rates jump by 3% in 2013, while those in the highest bracket – individuals and couples earning more than $388,350 – will see a 4.6% increase from 35% to 39.6%.
Individuals in the highest brackets could also see an additional 3.8% bump in their capital gains rates because of Obamacare.
How to Minimize the Taxman’s Bite
Given those changes, the best strategy if you have short-term gains and want to take them for other-than-tax reasons – e.g., technical resistance or fading fundamentals on a stock – is to take them before the end of the year, when your ordinary income rates will still be lower.
On the other hand, if you’re in a higher bracket, currently have short-term gains and have no other reason to sell, don’t. You’ll be better off to hold into 2013, let the gains go long-term and then sell, paying the 20% maximum that will be imposed then.
The optimum strategy if you already have long-term gains is the exact opposite.
As noted, the current rate on both ordinary and qualified long-term gains is 15%. However, beginning Jan. 1, 2013, that rate will climb to 20% for ordinary long-term gains and 18% for qualified (or five-year) gains. (Note: Individual taxpayers in the 10% and 15% brackets now pay no tax on long-term capital gains but merely include them with other taxable income. However, in 2013 these taxpayers will be subject to a 10% tax on long-term gains.)
Plus, if you’re in one of the upper income brackets, your gains will also be subject to the 3.8% Medicare contribution tax, which would raise your 2013 rates on ordinary and qualified long-term gains to 23.8% and 21.8%, respectively.
TAX INCREASE # 2:
DIVIDENDS GET HIT HARD
Every dividend investor loves the arrival of those quarterly distribution checks. But thanks to “The Fiscal Cliff 2013″ those checks could get a whole lot smaller.
As things currently stand – with higher tax brackets, no extension of the Bush-era tax cuts and the addition of new levies on higher-income payers to fund Obamacare – the tax bite on some dividend payments could rise from as little as 15% to as high as 43.4%.
That’s dramatically higher than the possible hike in capital gains we already discussed. By comparison, scheduled tax-law changes will increase taxes on long-term profits from 15% to 23.8% for some taxpayers.
Under the current tax laws, dividends received in 2012 are taxed in one of three ways:
- Qualified dividend income – The concept of “qualified” dividends was created by the original Bush tax cuts. It allows dividends received from domestic U.S. companies and certain foreign corporations to be taxed at the recipient’s long-term capital gains rate, which is capped at 15% in 2012.
- Qualified dividends from funds – As an extension of the individual preference, qualified dividend income received by mutual funds and exchange-traded funds (ETFs), and passed on to fund shareholders, is also taxed at the individual’s maximum long-term capital gains rate of 15%.
- Ordinary dividend income – Non-qualified dividends are taxed as ordinary income to the recipient, meaning they will be taxed at marginal rates ranging from 10% to 35% in 2012.
In 2013, however, three things will – or at least could – substantially boost tax rates on dividends.
That means all stock, mutual fund and ETF dividends to individuals in each of the new brackets – 15%, 28%, 31%, 36% and 39.6% – will be taxed at higher ordinary income rates. (Note: The actual income ranges for each of the new brackets has not yet been set, pending an adjustment to 2012 brackets to reflect inflation.)
Third, taxpayers in the highest marginal income brackets could be assessed an additional 3.8% “Medicare contribution tax” on their dividends, as well as on other investment income.
Specifically, the law says:
“For individuals, the 3.8% tax will be imposed on the lesser of the individual’s net investment income or the amount by which the individual’s modified adjusted gross income (AGI) exceeds certain thresholds ($250,000 for married individuals filing jointly or $200,000 for unmarried individuals). For purposes of this tax, investment income includes interest, dividends, income from trades or businesses that are passive activities or that trade in financial instruments and commodities, and net gains from the disposition of property held in a trade or business that is a passive activity or that trades in financial instruments and commodities. Investment income excludes distributions from qualified retirement plans and excludes any items taken into account for self-employment tax purposes.”
Given that, your accountant will most likely have to determine whether you’re subject to the new tax; we certainly can’t!
However, if you are, this means your dividend income for 2013 will likely be taxed at a 43.4% rate – nearly triple the 15% rate you will owe in 2012 on qualified payouts, or 8.4% more than the maximum of 35% now due on ordinary dividends.
TAX INCREASE # 3:
Small Businesses Suffer
2013 will also see several changes affecting owners of small businesses and certain corporations, the biggest being a sharp reduction in the portion of a depreciable asset’s cost that can be expensed.
Under current law, up to $139,000 in costs for so-called Section 179 assets – which include most manufacturing and processing equipment, machinery, computers, software and other tangible property – can be deducted as an expense in the year acquired rather than capitalized and depreciated over time (though that allowable deduction is reduced dollar-for-dollar by the amount the assets exceed an investment ceiling, currently set at $560,000).
In 2013, computer software will no longer be considered a depreciable asset and the maximum allowable expense will be reduced to just $25,000. The total investment ceiling over which that $25,000 is reduced will also be cut to just $200,000.
This will substantially reduce business tax deductions in 2013 so owners should accelerate purchase of Section 179 assets into 2012 wherever possible in order to get the immediate tax benefit. New computer software should also be purchased before the end of 2012 since it won’t be eligible for immediate expensing in 2013.
Taxpayers who realize gains from the sale of stock in some small businesses – so-called C corporations – are currently given certain tax preferences, depending on their holding periods, with respect to how those gains impact the alternative minimum tax liability. A significantly higher percentage of such gains will be used in the calculations for the AMT in 2013, so if you hold such stock and are considering selling, you should do so before the end of 2012 to take advantage of the current 7% AMT preference level.
Business owners who are currently structuring new ventures should also consult their accountants and other advisors as the new laws may make other types of entities preferable to C corporations for future tax purposes.
One other popular business strategy is to structure new ventures as so-called S corporations, or to convert existing C corporations into S corporations. However, under new laws that went into effect for 2012 corporate fiscal years, sale of assets by companies that converted from C to S corporations are subject to a 35% built-in gains (BIG) tax on the sale price of the assets over and above their aggregate value on the conversion date, if that date was less than 10 years ago.
That holding requirement is up from just five years in fiscal 2011. As such, owners of S corporations converted from C corporations less than 10 years ago should, if possible, defer the sale of assets beyond the new 10-year cutoff, after which the BIG tax will no longer apply.
TAX INCREASE # 4:
Your Take Home Pay Is About To Shrink
Individual taxpayers need to be aware of changes to FICA taxes.
FICA is short for the Federal Insurance Contributions Act, the Depression-era law that imposed payroll taxes to fund America’s Social Security retirement and disability programs. Withholding for the Medicare elder-health program was added in the 1960s.
The FICA tax is imposed on both employees and employers, who are required to withhold a certain percentage of a worker’s wages (up to a specified limit) when paychecks are issued, and match that sum when passing the withheld monies on to the government.
What Taxmageddon 2013 Means for FICA Taxes
FICA taxes started at less than 3% total, but rose steadily over the past 50 years, surpassing 15% in 2010. However, they were reduced for the 2011 tax year by the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, with the reduction subsequently extended for the 2012 tax year.
The withholding tax rate for 2011 and 2012 was 4.2% of gross wages up to limits of $106,800 in 2011 and $110,100 for 2012. The Medicare withholding tax for employees was 1.45% of total wages, with no limitation. Employers had to match all contributions, so the total FICA tax was 11.3% up to the $110,000 limit.
To date, the FICA reductions have not been extended, so the employee withholding percentage will rise to 6.2% in 2013. For workers, that’s $620 for each $10,000 in gross wages, up from $420 per $10,000 in 2012 – or $6,820 total if you make the $110,000 limit.
The Medicare tax will also increase by 0.90% for higher-income earners – from 1.45% to 2.35% for couples making more than $250,000 and individuals making $200,000 or more. The employer Medicare share will remain unchanged, so the total tax for lower-bracket workers and employers will climb to 15.3% (6.2% + 6.2% + 1.45% + 1.45% = 15.3%), and to 16.2% for upper-income earners (6.2% + 6.2% + 2.35% + 1.45% = 16.2%).
Although no announcement has yet been made, the limitation on wages subject to FICA will also likely increase in 2013 – probably to around $112,500 based on the recent rate of annualized inflation.
Sadly, there’s no way around this tax increase, so your only real strategy is to recognize that the government will be taking as much as $3,403.75 ($112,500 x 8.55% – $110,000 x 5.65% = $3,403.75) in extra FICA withholding from your paycheck in 2013, and budget accordingly.
The minimum withholding rate for income taxes will also rise in 2013 based on the increases in the tax brackets (discussed in more detail in Part Two of our series) and higher marginal tax rates. Most workers will face a hike in the basic withholding rate from 28% to 31% (though this rate can be reduced based on exemptions claimed). Withholding rates on supplemental wages up to $1 million will rise from 25% to 28%, with rates climbing from 35% to 39.6% on supplemental wages in excess of $1 million.
TAX INCREASE # 5:
Big Changes In Exemptions and Deductions
Beginning in 2013, higher-income taxpayers will also face a phase-out of personal exemptions.
All taxpayers now get a personal exemption of $3,800, but in 2013 that will start to shrink once income exceeds an inflation-adjusted level – not yet officially announced, but expected to be $261,650 for married joint filers and $174,450 for single taxpayers.
Married couples who don’t itemize their deductions will see a decrease in their standard deduction in 2013.
Now, couples get double the standard deduction allowed single taxpayers, but that will drop to just 167% of the single deduction, which is currently $5,950. That means, based on 2012 numbers, the standard deduction for couples will fall from $11,900 to just $9,900 in 2013.
Fewer medical and dental expenses will be deductible for younger taxpayers as well. Currently, health expenses in excess of 7.5% of adjusted gross income (AGI) are deductible, but that threshold will rise to 10.0% in 2013 – though the 7.5% limit will continue until 2016 for taxpayers or spouses age 65 and older.
Credits to offset expenses for dependent care will fall in 2013 – from $3,000 to $2,400 for a single individual and from $6,000 to $4,800 for two or more individuals. The maximum dependent-care credit will drop from 35% to 30% of allowable expenses – or, if you use the AGI-based formula, from $15,000 to $10,000.
The maximum child-care credit will decrease from $1,000 to $500 per child, and the credit can no longer be used to offset liabilities under the alternative minimum tax (AMT). Earned income tax credits will also be phased out on joint returns, depending on the number of qualifying children claimed.
Taxpayers already struggling with student-loan debt will see a cut-off date applied to their interest deductions. Currently, interest on student loans is deductible from AGI for as long as payments are made, but starting in 2013, above-the-line deductibility of interest will be phased out after 60 months. The phase-out will be based on reduced AGI limits, currently projected to be $75,000 for couples filing jointly and $50,000 for all other returns.
Students enjoying up to $5,250 in income exclusions for employer-paid on-the-job training and continuing education will see an end to those benefits in 2013. In other words, employer assistance with educational expenses will now be taxed as regular income.
TAX INCREASE # 6:
- Heirs, estates and qualified trusts will no longer be able to exclude up to $250,000 in gains from the sale of a decedent’s principal residence, with the full amount becoming subject to estate taxes.
- Debt forgiven in connection with the foreclosure of a principal residence will again be considered taxable income, unless the homeowner losing the property is in bankruptcy or has officially been declared insolvent.
- The special itemized deduction for mortgage insurance premiums paid on loans taken out after 2006 expires in 2013.
What You Can Do About Taxmageddon
As an individual taxpayer, there’s very little you can do to mitigate the impact of this change in 2013.
One is urging your Congressperson to extend the Bush tax rules and the other is trying to manage your deductions and income stream to get into a lower marginal tax bracket.
However, on the other side of the equation, if you own a closely held company that has sufficient earnings and profits, you may want to consider declaring and paying a larger-than-normal dividend to you and fellow shareholders this year while the payout will be subject to the lower rates.
Again, be sure to discuss this strategy with your accountant – and do it only if there are sufficient earnings and profits. That’s because any distribution in excess of earnings and profits will reduce the shareholders’ cost basis in their stock, potentially increasing their capital gain when they eventually sell – which will most likely be taxed at a higher rate at that time.
There is one thing you can do to reduce the future impact of the new Medicare tax on your dividend payouts.
You can maximize your retirement-plan contributions each year, since distributions from qualified retirement plans are not included in investment income for purposes of the tax.
Be aware, however, that while those distributions aren’t subject to the tax, they do increase your modified AGI. If that pushes you above the threshold, the rest of your investment income might also become subject to the 3.8% levy.
Related: Dow Jones ETF (NYSEARCA:DIA), S&P 500 ETF (NYSEARCA:SPY), S&P 500 Index (INDEXSP:.INX), Dow Jones Industrial Average (INDEXDJX:.DJI).
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