The recently passed American Taxpayer Relief Act of 2012 and the health care reform law which was passed back in March 2010 have various tax increases on upper income earners. These tax increases are all effective in the 2013 tax year. The five major tax increases are an increase in the Medicare tax by 0.9%, applying a 3.8% Medicare levy to net investment income, reinstatement of phase outs for itemized deductions and personal exemptions, an increase of the dividend and capital gains rate to 20%, and an increase to the top income tax bracket to 39.6%.
To add confusion, many of these additional new tax schemes become effective at different income levels. The following graph.pdf and discussion lays out the tax and the income level which it kicks in.
0.9% Medicare surtax on wages This is a product of the healthcare reform law. It increases the Medicare tax imposed on wages by 0.9%. It applies to wages in excess of $250,000 for married couples. It applies to wages in excess of $200,000 for single filers. One should note that this applies to wages and not other forms of income. (Unfortunately, most other forms of income are addressed in the next bullet.)
3.8% Medicare tax applied to net income Medicare taxes have historically only been assessed against wages. Effective January 1, 2013, Medicare taxes will now apply to ones net investment income at a rate of 3.8%. Investment income includes: interest, dividends, capital gains, rental income, royalty income, and passive activity businesses. The tax is assessed on joint filers with a modified adjusted gross income (MAGI) over $250,000. For single filers it is assessed with a MAGI over $200,000.
Phase out of itemized deductions and personal exemptions The phase out rules have been reinstated. For a married couple, these rules reduce the amount of otherwise allowable itemized deductions by 3% of adjusted gross income (AGI) in excess of $300,000. As an example, if a married couple has AGI of $400,000 they will lose $3,000 of their otherwise allowable itemized deductions. For single taxpayers the phase out rules become effective on AGI in excess of $250,000.
Personally exemptions are also subject to phase out rules beginning in the tax year 2013. Under these rules, the exemption that can be taken by a married couple is reduced by 2 percent for each $2,500 in which AGI exceeds $300,000. As an example, if a married couple earns $325,000, their exemption would be reduced by 20 percent. At $425,000, their personal exemptions is fully phased out and the couple receives no benefit. For a single person, the phase out of exemptions kick in at $250,000.
Increase in qualifying dividend and capital gains tax rate Qualifying dividends and capital gains will be taxed at a rate of 20% on income in excess of $450,000 for joint filers, $400,000 for single filers. This is an increase from the previous 15% tax rate previously applied to this income. Combine this increase with the 3.8% Medicare tax on net investment income noted above, and certain upper income earners might see a 59% increase on taxes relating to this type of income; from 15% to 23.8%.
Increase in the federal income tax rate As often discussed, an increased top federal income tax bracket of 39.6% has been added. This will apply to taxable income earned in excess of $450,000 for married couples and $400,000 for single filers.
Governor Patrick is also looking to increase the Massachusetts income tax to 6.25%, and reduce a series of tax deductions. This is still to be determined, but you can be sure that state tax increases are on the horizon.
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