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Higher 1040 Tax Rates Ahead; Upper-Income Levels Targeted

Story Highlights

  • High-income earners (single filers with income of $190,000+ and joint filers $230,000+) could see tax rate increases in 2011.
  • Two increases in Medicare taxes, affecting earned and investment income, were enacted in the health reform legislation. These changes are effective in 2013.
  • It’s important to understand which areas of income are impacted by what rate hikes, and what you might do to minimize the impact.

Higher 1040 Tax Rates Ahead; Upper-Income Levels Targeted“In most cases, it is difficult to predict what a politically divided Congress might enact. But as we look at the locked-in hikes in the income tax rates for 2011, combined with what has already been enacted for 2013 in the health reform legislation, the direction is clear: upper income individuals are in for hefty tax increases,” says Andy Biebl, tax principal with LarsonAllen.

The 2011 increases
Today, the top two federal individual income tax rates are:

Filing Status

Tax Rate

Single filers with income $172,000+

Joint filers with income $209,000+

33%

All incomes over $374,000

35%

The Obama administration has released its 2011 budget proposal calling for these changes:

Filing Status

Tax Rate

Single filers with income $190,000+

Joint filers with income $230,000+

36%

All incomes over $374,000

39.6%

What if Congress doesn’t act?
If a stalemate develops and these changes are not passed, the rates still go up. The Bush tax cuts enacted in 2001 had a 10-year duration. If Congress does nothing, they will expire, bringing us back to the 36 and 39.6 percent rates. But those tax breaks were across the board, affecting all filers, not merely the top end. If they are allowed to expire in 2011, all taxpayers would pay more, including lower-income filers.

“While returning to 2001 rates is unlikely, it is clear that upper-income filers will have a rate increase under either scenario,” Biebl says.

Other proposed changes
The administration’s tax increases go beyond the direct rates; the budget proposal also calls for a restoration of the itemized deduction phaseout and the personal exemption phaseout. These will apply to the same higher-bracket taxpayers, and the effect will be roughly another 2 percent hike. Accordingly, the actual top rate will be closer to 42 percent rather than 39.6 percent.

Another proposal is to increase the top rate on capital gains and dividend income from 15 to 20 percent. It would continue to link the dividend and capital gain rate. But a Senate committee recently passed a resolution indicating its intent to return to the former approach of treating dividends as fully taxable ordinary income. If that goes through, it would increase the tax rate on dividends from today’s 15 percent to about 42 percent for upper-income filers.

The 2013 increases
While we await the specific outcome of the legislation on the 2011 tax rates, several increases are already law and become effective in 2013. These were part of health care reform and are imposed in the form of two separate Medicare tax rates.

Earned income
Currently, the Medicare tax is only imposed on earned income (wages and self-employment). The rate today is 2.9 percent and applies to all earned income without limit. A self-employed individual pays the full rate, but in the case of an employee, the employer picks up half.

The increases in 2013 fall entirely on individuals, not employers. For those in the workforce with salary or self-employment income, there will be roughly an extra 1 percent Medicare tax (officially 0.9 percent) for those with income in excess of $200,000 for single filers and $250,000 for joint filers.

Investment income
There is a heftier increase in the form of a second Medicare tax of 3.8 percent on investment income. This is a major change, as the Medicare tax in the past has only applied to wages and self-employment income. But starting in 2013, it will apply to these broad investment income categories:

  • Interest income
  • Dividends
  • Capital gains
  • Rental income
  • Annuities
  • Royalties
  • Business income held by a passive investor

These categories will not be subject to the tax:

  • Pension income
  • Retirement plan withdrawals
  • Capital gains and other income from a business in which the taxpayer actively participates

Generally, this tax increase falls on the same individuals as the other Medicare hike: single filers with adjusted gross income (AGI) over $200,000 and joint filers over $250,000. AGI is the bottom line income on page one of Form 1040, U.S. Individual Income Tax Return.

High-income tax saving strategies
While the two Medicare tax increases will not apply until 2013, awareness of these rates and how they pertain to income categories can influence the structure of business entities. Owners often extract income in multiple forms: compensation, rent, interest on loans, etc. The categorization becomes more important as we plan under these new rates.

“Those big picture concerns will be a significant part of our planning over the next year or so,” Biebl says. “But today, we believe the more urgent focus should be on the pending 2011 tax increases. They are imminent, and they are larger.”

High net worth individuals (HNWI) with discretionary earnings that can be recognized in 2010 versus 2011 will profit by reporting the income at today’s lower rates. Here are examples of actions that could be beneficial to high-bracket taxpayers:

  • Recognize extra bonus or compensation income in 2010 that otherwise would be drawn in subsequent years.
  • Accelerate capital gain transactions into 2010 rather than selling in 2011.
  • Postpone tax deductible expenditures to 2011 when they can offset higher bracket income.
  • Convert individual retirement account (IRA) and other pre-tax qualified retirement plans to Roth status in 2010, thus taxing these funds at current lower rates to achieve nontaxable future growth.

Summary of current and anticipated tax rates for high-income individuals

 

2010

2011

2013

Wages

36%

(35% income tax rate plus 1.45% employee Medicare)

43%

(39.6% rate plus 2% phaseout increase plus 1.45% Medicare)

44%

(add 0.9% Medicare increase)

Self-employment earnings

38%

(35% income tax rate plus 2.9% Medicare rate)

45%

(39.6% rate plus 2% phaseout increase plus 2.9% Medicare)

46%

(add 0.9% Medicare increase)

Ordinary investment income

35%

42%

(39.6% rate plus 2% phaseout increase)

46%

(add 3.8% Medicare increase to investment income)

Ordinary business income

35%

42%

(39.6% rate plus 2% phaseout increase)

42%

Capital gains

15%

20%

24%

(add 3.8% Medicare increase to non-business capital gains)


View our tax principals.

 

Published: 7/1/2010

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