For high-income taxpayers, like physicians, the fiscal cliff deal increases taxes dramatically. With many physicians now in the 50%-plus marginal tax brackets for the first time in over 30 years, tax planning more important than ever.
On Jan. 2, 2013, President Barack Obama signed the Taxpayer Relief Act of 2012 (the Act). The so-called "Relief" Act permanently extends certain tax cuts, but for high-income taxpayers like physicians, the Act increases taxes dramatically in some cases. While there is much bad news below, the good news is that many of the techniques we normally employ to help physicians reduce taxes are still here and more valuable than ever.
If you recall The Good, the Bad, and the Ugly, we will actually get the ugly out of the way, move on to the bad, and finish with the good. Highlights of the Act include:
The ugly: Income taxes
Many of us now face a 50%-plus marginal income tax regime, when all of the new taxes below are accounted for. Depending on the city/state where you live, tax rates are now no less than 45% to 55%. Income tax planning has not been as important in 30 years.
Reinstatement of 39.6% rate
The Act permanently reinstates the previous highest income tax rate of 39.6% for taxpayers with “taxable income” over $400,000 for single filers and $450,000 for married joint filers (the “39.6% thresholds”). The 39.6% thresholds (as well as the other income thresholds for the lower brackets) are subject to annual inflation adjustments after 2013.
Practical note: Generally, “taxable income” is adjusted gross income (AGI) reduced by allowances for personal exemptions and itemized deductions. These allowances will have substantially less impact for high-income taxpayers; however, due to the reinstatement of the itemized deduction limitations and personal exemption phase-outs, as discussed below.
Reinstatement of itemized deduction limitations
The so-called Pease limitation on itemized deductions is reinstated for taxpayers with AGI in excess of specified thresholds ($250,000 for single filers; $300,000 for married joint filers), which are lower than the 39.6% thresholds. The itemized deduction thresholds are subject to annual inflation adjustments after 2013. The Pease limitation limits itemized deductions by 3% of the amount AGI exceeds the thresholds, up to a maximum limitation of 80% of itemized deductions.
Personal exemption phase-out
The Act phases out personal and dependency exemptions ($3,800 each in 2012, inflation adjusted) at 2% for each $2,500 of AGI in excess of the itemized deduction thresholds.
Practical note: The deduction limitations and exemption phase out can equate to as much as an additional 5% in income tax in some circumstances.
Expiration of payroll FICA tax cut
The employee portion of the FICA payroll tax reverts to 6.2% from 4.2% on wages up to the Social Security Tax threshold ($113,700 for 2013).
Practical note: This will add an additional $2,274 in payroll taxes for taxpayers earning at least $113,700 in wages in 2013.
New Obamacare-related taxes for 2013
Though not technically part of the Act, the Patient Protection and Affordable Care Act of 2010 implements the following additional taxes on net investment income and wages as of 2013:
• A 3.8% Medicare tax applies to the lesser of: 1) net investment income (e.g., dividends, interest, rents, capital gains, passive activity income); or 2) the excess of modified AGI over applicable thresholds ($200,000 for single filers; $250,000 for married joint filers).
• A 0.9% increase (from 1.45% to 2.35%) will apply on the employee’s portion of the Hospital Insurance Tax on total wages in excess of set thresholds ($200,000 single filers; $250,000 married joint filers).
The bad: Capital gains/dividends
For high-income taxpayers, total taxes on long-term capital gains and dividends can now reach 23% to 33% when the new federal tax, Obamacare tax and state and local taxes are assessed.
For taxpayers with taxable income over the 39.6% tax thresholds, the federal tax rate on capital gains and qualified dividend income (QDI) increases from 15% to 20%.
The 3.8% Medicare contribution tax on net investment income will still apply to most capital gains and dividends at reduced threshold levels ($200,000 single filers; $250,000 married joint filers). Thus, for taxpayers in the highest income tax bracket, the effective tax rate on this income will be 23.8%.
Many states also tax dividends and capital gains under their income tax, adding another layer of tax, depending on where you live.
The good: Gift/estate taxes
The $5 million lifetime gift and estate tax exemption has been made permanent. However, the maximum federal gift and estate tax rate will increase from 35% to 40%. Some states will continue to assess their own estate or inheritance taxes. Other “good” provisions include:
• Extension of certain business provisions including the Research and Development (R&D) tax credit through 2013 (retroactive for 2012 as well); and the Work Opportunity Tax Credit for one year
• Provision for Accelerated Deprecation for some businesses — 50% expensing for qualifying property purchased and placed into service prior to Jan. 1, 2014 (or Jan. 1, 2015 for certain long-term assets and transportation).
• A “doc fix” — although only for a year. Many medical groups were hopeful for something more long term, but the deal applied another one-year Band-Aid, as they’ve done every year since 2003. The deal prevents the scheduled 27% payment cuts to Medicare physicians that would have taken effect on Jan. 1, and freezes rates at current levels for one year.
• A permanent Alternative Minimum Tax (AMT) patch. Taxpayers subject to AMT will no longer have to wonder each year whether Congress will act to patch AMT.
More cliffs ahead?
Though far from perfect, the Act does provide some level of certainty in the above-mentioned areas. However, it also delayed a series of automatic cuts in federal spending that go into effect absent Congressional action, in two months. The Act also did nothing to address the U.S. debt ceiling, that has already been exceeded.
Come late February, Congress will face off again in hopes of avoiding another potential cliff.
Tax planning more important than ever
With all of the new taxes, many physicians are now in the 50%-plus marginal tax brackets for the first time in over 30 years. If reducing your taxes in light of these increases is important to you, we encourage you to contact us.
David B. Mandell, JD, MBA, is an attorney and author of five national books for doctors, including For Doctors Only: A Guide to Working Less & Building More, as well a number of state books. He is a principal of the financial consulting firm OJM Group, where Carole C. Foos, CPA works as a tax consultant. David can be reached at (877) 656-4362 or firstname.lastname@example.org. You can also call for a free (plus $10 S&H) hardcopy For Doctors Only: A Guide to Working Less & Building More. If you would like a shorter free E-book download of our “highlights” version, you can download it here.
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This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized legal or tax advice. There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circumstances. Tax law changes frequently, accordingly information presented herein is subject to change without notice. You should seek professional tax and legal advice before implementing any strategy discussed herein.