Lower Incomes, Higher Taxes

 In Taxes

As explained in the previous article, “Restoring a Higher Tax Bracket,” individuals with taxable income over $400,000 and married couples who exceed $450,000 generally will be the ones paying the restored 39.6% top income tax rate, as well as higher tax on long-term capital gains and qualified dividends. However, such taxpayers aren’t the only ones facing tax increases. Some people with lower incomes also will owe two taxes that reappear in the new law.
Eroding exemptions Prior law included a phaseout of personal exemptions for taxpayers with high incomes. That phaseout had been— yes—phased out in recent years. Now, the original phaseout has returned, as a permanent feature of the tax law. In 2013, this phaseout will affect people with income over
❖ $250,000 for single taxpayers,
❖ $300,000 for married couples filing joint returns and surviving spouses,
❖ $150,000 for married individuals filing separately, and
❖ $275,000 for heads of households.
As you can see, these income thresholds are lower than the thresholds for the 39.6% top tax bracket. They also refer to adjusted gross income (AGI), the number you report on the bottom of the first page of your tax return, before you take itemized deductions. Therefore, people with taxable income far from the 39.6% bracket may owe more tax because their personal exemptions are devalued. Generally, for each $2,500 (or fraction thereof) of AGI taxpayers are over their threshold, they will lose 2% of their personal exemptions. They can lose up to 80% of their exemptions this way.
Example 1: Sarah and Todd Bailey have two young children, so they can claim four exemptions. Personal exemptions are $3,900 per person in 2013, so the Baileys could claim $15,600 in deductions for their four exemptions. If the Baileys’ AGI in 2013 is $330,000, they are $30,000 over the relevant threshold, which is 12 times $2,500. Twelve times 2% equals 24%, so the Baileys personal exemptions would be reduced by 24%, from $15,600 to $11,856.
Declining deductions
The same income thresholds apply to the phaseout of itemized deductions. Under this provision, itemized deductions will be reduced by an amount equal to 3% of a taxpayer’s AGI over the relevant threshold. Thus, if the Baileys have AGI of $330,000, which is $30,000 over their threshold, they will lose $900 of their itemized deductions: 3% of $30,000. (Deductions for medical expenses, investment interest, casualty or theft losses, and wagering losses are excluded from the calculation.) Again, high-income taxpayers can lose as much as 80% of their itemized deductions.
Sustaining the surtax
In the new tax law, Congress took no action regarding the 3.8% Medicare surtax, included in prior health insurance legislation. As explained in the October 2012 CPA Client Bulletin, this tax takes effect in 2013, affecting people who top these income levels:
❖ $250,000 for married couples filing joint returns and surviving spouses
❖ $125,000 for married individuals filing separately, and
❖ $200,000 for all other single taxpayers
For this surtax, the thresholds are based on modified adjusted gross income (MAGI), which is AGI plus any net foreign income. For many taxpayers, MAGI will be the same as AGI.
As you can see, lowering your AGI may be able to help you reduce or eliminate the 3.8% surtax and the two phaseouts described in this article. Tactics that lower AGI, such as taking capital losses and maximizing deductible contributions to retirement plans, may also lower your exposure to these taxes