The President's Proposed Future Tax Changes and Some Questions About Past Ones
The United States government has once again hit its borrowing limit. The government is permitted to borrow through May 18, after which it can continue to operate without additional borrowing for about three months. By fall, Congress will have to raise the debt limit to prevent the United States defaulting on outstanding debt.
The Republicans are demanding changes to entitlement programs – Social Security and Medicare – as a quid pro quo for their approval to raise the borrowing limit. President Obama has provisionally accepted these changes, if the Republicans agree to new taxes. In that regard, the President has proposed a number of tax changes he wants to see enacted, including taxing municipal bond interest, limiting the amount individuals may accumulate in tax-preferred retirement accounts, and reversing recent expansions of the estate and gift tax exemptions.
A new white paper available for members discusses the proposed entitlement changes, provides a detailed analysis of the proposed tax changes, and predicts the likelihood of the eventual Congressional passage of each. Members may access the paper by clicking here.
In addition, I’ve received a number of questions regarding the application of the tax provisions of the fiscal cliff settlement. I’ve tried to answer some of the most common questions below.
To what types of investment income does the new 3.8% tax apply? Does it apply back to the first dollar or only to amounts over $250,000? Is non-investment income included in the $250,000 threshold?
Under the health care reform law, beginning in 2013 investment income received by families with adjusted gross income over $250,000 ($200,000 for an individual) is subject to a surtax of 3.8%.
The 3.8% surtax applies only to taxable investment income, such as corporate bond and savings account interest, dividends, capital gains, and rental and royalty income The tax does not apply to investment income that is not otherwise subject to tax, such as tax-exempt municipal bond interest and life insurance death proceeds.
The surtax also does not apply to amounts received from qualified retirement plans, such as IRAs, Roth IRAs, 401(k)s, and defined benefit plans.
The 3.8% tax applies to taxable investment income only to the extent that income, plus all other adjusted gross income, exceeds $250,000 for a family ($200,000 for an individual). It does not apply back to the first dollar of income once the threshold is breached For instance, suppose a family has $200,000 of wage income and $80,000 of dividend income. Total adjusted gross income of $280,000 exceeds $250,000 by $30,000. Thus the 3.8% tax would apply to $30,000 of the dividend income.
How does the “Pease phase-out” of itemized deductions work and to whom does it apply?
The fiscal cliff settlement reinstated the “Pease” phase-out of itemized deductions to the extent a family’s taxable income exceeds $300,000 ($250,000 for individuals). Under this phase-out, total itemized deductions are reduced by 3% of adjusted gross income above the income thresholds. However, itemized deductions in total cannot be reduced by more than 80%.
The Pease phase-out is really a disguised increase in the tax rate. As income continues to increase over $300,000, tax due increases by more than expected because itemized deductions are lost at the same time. The deduction phase-out adds about one percentage point to the tax rate for family income between $300,000 and $450,000, and 1.2 percentage points for family income above $450,000.
How does the IRA / charitable contribution rule that is available this year work, and what are the advantages of using it?
The fiscal cliff settlement extended for 2013 only the ability of individuals over age 70-1/2 to make tax-free distributions of up to $100,000 from an IRA to a charity. These charitable distributions may be used to satisfy the IRA holder’s minimum distribution requirement for the year. To qualify as a charitable distribution, the funds must go directly from the IRA custodian to the charity.
The ability to make charitable contributions through tax-free IRA distributions is particularly valuable now that the deduction for conventional charitable contributions is subject to phase-out for many taxpayers. In fact, an individual need not even itemize deductions to take advantage of this provision. Thus, individuals over 70-1/2 who intend to make charitable contributions in 2013 should consider using IRA funds first (after consultation with a qualified tax advisor).
Andrew H. Friedman is the Principal of The Washington Update LLC and a former senior partner in a Washington, D.C. law firm. He speaks regularly on legislative and regulatory developments and trends affecting investment, insurance, and retirement products. He may be reached atwww.TheWashingtonUpdate.com.
Neither the author of this paper, nor any law firm with which the author may be associated, is providing legal or tax advice as to the matters discussed herein. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. It is not intended as legal or tax advice and individuals may not rely upon it (including for purposes of avoiding tax penalties imposed by the IRS or state and local tax authorities). Individuals should consult their own legal and tax counsel as to matters discussed herein and before entering into any estate planning, trust, investment, retirement, or insurance arrangement.
Copyright Andrew H. Friedman 2013. Reprinted by permission. All rights reserved.
