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Major tax changes for 2013 will continue to hit physician’s wallets in 2014. Here’s what to look out for.
Reed Tinsley, CFA, CFP, CHBCIn 2013, we saw major tax changes, including 55 tax breaks that expired, that will continue to impact physicians into 2014.
Higher-income physicians will be in for a big surprise when they finally tally up their 2013 tax bill before April 15th. The higher amount of taxes that may be owed will be the result of the combination of several factors, the cumulative effect of which will be significant for many.
These factors include a higher income tax rate, a higher capital gains rate, a new net investment income tax, and a new Medicare surcharge on earned income, as well as a significantly reduced benefit from personal exemptions and itemized deductions for those in the higher income tax brackets. Since most of these changes will cause significant changes to physicians in 2014, let’s take another look at them.
1. Higher top income tax rate
The American Taxpayer Relief Act of 2012 made permanent for 2013 and beyond the lower Bush-era income tax rates for all.
The exceptions are for taxpayers with taxable income above $400,000 ($450,000 for married taxpayers filing jointly, $425,000 for heads of households).
Income above these levels has now been taxed at a 39.6% rate rather than at the top 35% rate since January 1, 2013. Those amounts are adjusted for inflation after 2013 (for 2014, those threshold levels are $432,200, $457,600, and $406,750, respectively. Taxpayers with $150,000 of income above the threshold amounts, for example, must pay an additional $6,900 in tax in 2013 because of the additional tax rate of 4.6%).
2. Capital gains and dividends
The American Taxpayer Relief Act also raised the top rate for long-term capital gains and dividends to 20%, up from the Bush-era maximum 15% rate-again, applicable to all net long-term capital gains from transactions made on or after January 1, 2013.
That top rate will apply to the extent that a taxpayer’s income exceeds the thresholds set for the 39.6% rate ($400,000 for single filers; $450,000 for joint filers and $425,000 for heads of households).
Especially applicable to those investors who have been riding the recent stock market rally, a jump in the rate from 15% to 20% represents a 33.33% tax increase.
3. ACA impact on Medicare taxes
Set into motion on January 1, 2013 by the Affordable Care Act (ACA) of 2010, higher-income taxpayers have been required to pay an additional 3.8% on net investment income as well as a 0.9% additional Medicare tax on earned income.
In both cases, the income threshold levels for being subject to these new taxes are considerably lower than the 39.6% bracket and 20% capital gain rates. The threshold amount is $200,000 in the case of a single individual, head of household (with qualifying person) and qualifying widow(er) with dependent child. The threshold amount is $250,000 in the case of a married couple filing jointly and $125,000 in the case of a married couple filing separately.
For the 3.8% net investment income tax, the threshold is adjusted gross income (modified for certain foreign-based income). For the 0.9% additional Medicare tax, the threshold is measured against compensation earned for the year (including self-employment income):
Net investment income tax
This is one of the most important changes affecting physicians. The 3.8% tax not only covers capital gains and dividends, but also passive-type income flowing from real estate, investments in businesses, and the like. The rules are complex, and many taxpayers will struggle with the extent to which income on their 2013 tax returns will be subject to the new net investment income tax.
For income subject to this tax, the effective rate will increase to 23.8% on net capital gain and dividends and 43.4% on short-term capital gain and all other passive-type income.
Additional Medicare tax
For tax years beginning after December 31, 2012, the 0.9% additional Medicare tax applies to employee compensation and self-employment income above the threshold amounts noted above.
An employer’s withholding obligation for the additional Medicare tax applies only to the extent the employee’s wages are in excess of $200,000 in a calendar year.
For some dual-income couples with combined earned income above the $250,000 threshold but with no one earning more than $200,000, they may find themselves under withheld and subject to an estimated tax penalty as a result.
Couples should remember that to prevent a reoccurrence in the future, an employee may request additional income tax withholding, which will be applied against all taxes shown on the individual’s return, including any liability for the additional Medicare tax.
4. Itemized deductions limitation
The American Taxpayer Relief Act officially the “Pease” limitation on itemized deductions.The new thresholds, first applied in 2013, are $300,000 for married couples and surviving spouses; $275,000 for heads of households; $250,000 for unmarried taxpayers; and $150,000 for married taxpayers filing separately.
The Pease limitation reduces the total amount of a higher-income taxpayer’s otherwise allowable itemized deductions by 3% of the amount by which the taxpayer’s adjusted gross income exceeds this applicable threshold.
The amount of itemized deductions may be reduced up to 80% under this formula. Certain items, such as medical expenses, investment interest, and casualty, theft or wagering losses, are excluded.
5. Personal exemption phase-out rules
The American Taxpayer Relief Act also revived the personal exemption phaseout rules, at the same levels of adjusted gross income revived for the Pease limitation.
Under the phaseout, the total amount of exemptions that may be claimed by a taxpayer is reduced by two percent for each $2,500, or portion thereof (two percent for each $1,250 for married couples filing separate returns) by which the taxpayer’s adjusted gross income exceeds the applicable threshold level.
At the full phase out level, therefore, a family with four personal exemptions in 2013 will lose $15,600 in exemptions, creating $6,178 in additional tax at the 39.6% bracket.
6. Federal estate and gift tax strategies
One bright spot for higher-income taxpayers is the change that took place starting in 2013 directly applicable to estate planning strategies.
The American Taxpayer Relief Act permanently provided for a maximum federal estate tax rate of 40% with an annual inflation-adjusted $5 million exclusion for estates of decedents dying after December 31, 2012.
Couples can combine exclusions and effectively exempt $10 million from estate tax (for 2013, the inflation-adjusted level is $10.5 million, rising to $10.68 million in 2014).