At this time last year, a lame duck Congress and the President were working on a bipartisan agreement to avoid going over the “Fiscal Cliff.”  The result of their efforts was the American Taxpayer Relief Act of 2012 (“ATRA”) which was signed into law on January 2, 2013.  Even though things appear to be relatively calm in Washington right now compared to last year at this time, there is plenty going on behind the scenes.  Most of what is going on involves talk about comprehensive tax reform in 2014.  The House is ahead of the Senate right now.  Democratic Senators want tax reform to result in a tax increase, while Senate GOP members want a revenue-neutral measure – this has slowed the process in the Senate.  In the House, the chairman of the House Ways and Means committee vows that his committee will approve a bill before year-end.  This seems unlikely given the anticipated fights over deficit reduction, funding the federal government and raising the debt limit that are expected to begin in December and last into 2014.  Given this stalemate, we will explore some of the more salient provisions enacted into law by ATRA and two tax provisions enacted into law by the Patient Protection and Affordable Care Act of 2010 (“Affordable Care Act”) that took affect in 2013.

New Income Tax Rate and Capital Gain Tax Rate.  For 2013 and years thereafter, the marginal income tax rates remain the same as in 2012 with the addition of a new 39.6% marginal income tax bracket.  This new 39.6% bracket kicks in at taxable income of $400,000 for single individuals and $450,000 for married couples.  The long-term capital gain tax rate will increase from 15% to 20% in 2013 and subsequent years for those individuals who fall into the new 39.6% marginal income tax bracket.  For those individuals who find themselves in the 25% to 35% marginal income tax bracket, their capital gains tax rate will remain at 15% and for those individuals whose marginal income tax bracket is between 0% and 15%, their capital gains tax rate will be zero.  To the extent you are in a position to control the timing of your income or the timing of when you pay deductible expenses, it makes sense to manipulate these items between years to your advantage.  For instance, you should consider whether you will be in different tax brackets in one year and not the next, whether you are subject to the AMT in one year and not the next, whether you are subject to the surtax on net investment income – discussed next – in one year and not the next.

Surtax on Net Investment Income.    A new 3.8% surtax on net investment income begins in 2013.  Net investment income is defined to include, among other things, dividends, rents, interest and capital gains.  It does not include retirement income.  This is the tax that was enacted to pay for President Obama’s health care plan implemented under the Affordable Care Act.  This tax applies to married couples with modified adjusted gross incomes in excess of $250,000 and to single individuals with modified adjusted gross incomes in excess of $200,000. So, for a married couple with modified adjusted gross income between $250,000 and $450,000, they will pay a 15% capital gain tax on any capital gains they incur as well as a 3.8% surtax on any net investment income they have, which includes capital gains.  This makes their effective capital gain tax rate 18.8% in 2013 and beyond.  For married couples with modified adjusted gross income in excess of $450,000, they will pay a 20% capital gain tax on any capital gains they incur as well as a 3.8% surtax on any net investment income they have, which includes capital gains.  This makes their effective capital gain tax rate 23.8% in 2013 and subsequent years.  Remember, if you have capital loss carryforwards, you can use those losses to offset realized capital gains in your portfolio.  If your capital loss carryforwards exceed your realized capital gains for the year, you can use $3,000 of those loss carryforwards to offset other income. 

Phase-out of Itemized Deductions.  After a three-year hiatus, 2013 marks the return of the phase-out of certain itemized deductions for higher-income taxpayers.  If you are affected by this rule, your itemized deductions are reduced by 3 percent of the amount by which your adjusted gross income exceeds a threshold amount.  For single individuals, the threshold amount is $250,000 and for married couples the threshold amount is $300,000.  Deductions for medical expenses, investment interest, casualty and theft losses, and gambling losses are not subject to the limitation.  Nor can the amount of your itemized deductions be reduced by more than 80 percent.  As to medical expenses, most of you are aware that you can deduct medical expenses only if the total of all your expenses exceeds 7.5% of your adjusted gross income.  In 2013, that threshold amount increases to 10% unless you are 65 or older in which case the threshold amount stays at 7.5%.

Phase-out of Personal Exemption.  A personal exemption is available to every taxpayer, that taxpayer’s spouse and that taxpayer’s dependents.  The personal exemption amount for 2013 is $3,900 per person.  Beginning this year, the personal exemption amount is phased out for higher-income taxpayers.  For single individuals, the phase-out begins at adjusted gross income of $250,000 with the exemption being completely phased out at adjusted gross income of $372,500.  For married couples, the phase-out begins at adjusted gross income of $300,000 with the exemption being completely phased out at adjusted gross income of $422,500.

IRA Distributions to Charity.  Some popular, but temporary, tax incentives known as “extenders” are scheduled to expire after 2013.  Whether these extenders get extended again is questionable at best given how divided our politicians are in Washington.  One of the most popular extenders is the ability of individuals age 70 and 1/2 and older to make tax-free distributions of up to $100,000 from their individual retirement accounts directly to their charity of choice. It you are in a position to take advantage of this extender, it makes sense to act on it now rather than waiting to see if it gets extended.

IRA and Retirement Plans.

• Taxpayers can make IRA contributions for 2013 up to April 15^th of 2014.  Contribution limits are 100% of compensation up to $5500 per taxpayer for individuals who were less than 50 years old in 2013.  Catch-up contributions for those individuals 50 and older in 2013 are $1000, bringing the total contribution limit for the 50 and older crowd to $6500.
• Taxpayers who did not participate in a retirement plan in 2013 can fully deduct their IRA contribution, regardless of the level of their income.  However, taxpayers who were “active participants” in either a defined contribution or defined benefit retirement plan can be phased out of a deductible IRA contribution, depending on the amount of their adjusted gross income (AGI).  Those limits are $69,000 for single taxpayers and $115,000 for married taxpayers who file jointly.  For married couples filing jointly, where one spouse is an active participant and one spouse is not, the deduction for the spouse who is not an active participant is phased out if the couples’ joint income exceeds $188,000. If you do exceed the aforementioned income limits, you can still make a non-deductible IRA contribution which will grow on a tax-deferred basis.  You are required to keep track of your non-deductible IRA contributions on your Federal income tax return.
• 2013 contributions to a Roth IRA are phased out for single taxpayers at an AGI of $127,000 and $188,000 for married taxpayers filing jointly.  Roth IRA contributions are not deductible but grow tax-free, distributions are withdrawn tax-free and mandatory distributions are not required at age 70 ½.

Contribution limits for qualified plans for 2013 are as follows:

401(k) contributions                                $17,500

401(k) catch-up contributions                  $ 5,500

Payroll Tax

The Social Security wage base will increase in 2014 to $117,000, a $3,300 increase over 2013’s figure.  In both 2013 and 2014, the tax rate paid by employers and employees was and is 6.2%.  New for individuals in 2013 is the .9% Medicare payroll tax that kicks in for single individuals with modified adjusted gross income in excess of $200,000 and for couples with modified adjusted gross income in excess of $250,000.  This payroll tax applies to earnings of self-employed individuals and wages of employees, but does not affect employers.

Estate and Gift Tax

The Federal estate tax exemption amount is currently $5,250,000 and the Federal estate tax rate is 40%.  This exemption amount is projected to increase another $90,000 per person in 2014 to $5,340,000.    This allows a married couple to pass $10,680,000 of assets Federal estate tax-free to their beneficiaries.  The estate tax rate will remain the same.  For gift tax purposes, the annual gift tax exclusion amount for 2013 is $14,000 per donee and is expected to remain the same in 2014.

Year-end Gifting and Retirement Account Contributions

Please keep in mind that if you plan on making gifts to your favorite charity, to a family member or make a contribution to a qualified retirement plan before the end of the year, Schwab needs time to process those requests to make sure they occur in calendar year 2013.  In order to meet Schwab’s deadlines, we generally need to be provided with any gift or contribution requests by the end of the day on December 13, 2013.  Thanks for your understanding with this.