2013 Will Hit Higher-Income Taxpayers Hard—Be Prepared

Now that Congress has passed the American Taxpayer Relief Act of 2012 (ATRA) and avoided the so-called “fiscal cliff,” higher-income taxpayers need to brace for higher taxes. There are numerous provisions in the ATRA that do not provide the higher-income taxpayer any relief. When these are combined with the provisions of the 2010 Affordable Health Care Act, higher-income taxpayers will feel a significant increase in taxes for which they need to prepare.

Virtually all of the increases are based on a taxpayer’s filing status and income. Even individuals who do not perceive themselves as higher-income taxpayers may be surprised to find out that they may be affected.

Here are two things to watch for in 2013 (we will include more in future emails):

Personal Exemption Phase-out

For tax years beginning after 2012, ATRA reinstated the Personal Exemption Phase-out (PEP), which had been suspended in 2010 through 2012. It is interesting to note that the reinstated phase-out thresholds are higher than in previous years. Thus, the thresholds require significantly higher income before the phase-out begins to take effect. The otherwise allowable exemption amounts are reduced by 2% for each $2,500, or part of $2,500 ($1,250 for married filing separately), that the taxpayer’s Adjusted Gross Income (AGI) exceeds the amount shown in the table below for the taxpayer’s filing status. 

Historical Exemption & Itemized Deduction Phase-out – AGI Thresholds

* Inflation adjusted after 2013.

Example: Ralph and Louise have an AGI of $412,500 for 2013 and two children for a total of four exemptions totaling $15,600 (4 x $3,900). The threshold for a married couple is $300,000; thus, their income exceeds the threshold by $112,500. Dividing $112,500 by $2,500 equals 45. So 90% (45 x 2%) of their $15,600 exemption allowance is phased out, leaving them with a reduced exemption deduction of $1,560. Assuming Ralph and Louise are in the 33% federal tax bracket, the phase-out costs them an additional $4,633 ($15,600 x 90% x 33%).

Planning Tips: Taxpayers subject to the phase-out should consider relinquishing the exemption of a dependent child to the other parent, in cases where the parents are divorced or separated. Where a taxpayer is party to a multiple support agreement, the taxpayer may want to allow another contributing member of the agreement who is not hit by the phase-out to claim the dependent’s exemption.

Itemized Deduction Phase-out

The itemized deduction phase-out referred to as the “Pease” limitation, which also had been suspended for 2010 through 2012, is reinstated for 2013 and later years. The AGI threshold amounts are the same as the exemption thresholds shown in the table above. Like the exemption phase-out thresholds, the reinstated itemized deduction phase-out thresholds are higher than they were in earlier years, thus requiring significantly higher income before the phase-out begins to take effect. For taxpayers subject to the Pease limitation, the total amount of their itemized deductions is reduced by 3% of the amount by which the taxpayer’s AGI exceeds the threshold amount, with the reduction not to exceed 80% of the otherwise allowable itemized deductions.

Not all itemized deductions are subject to phase-out. The following deductions are not subject to the phase-out:

• Medical and dental expenses
• Investment interest expense
• Casualty and theft losses from personal use property
• Casualty and theft losses from income-producing property
• Gambling losses

Thus, a taxpayer who is subject to the full phase-out still gets to deduct 20% of the deductions subject to the phase-out and 100% of the deductions listed above.

Example: Ralph and Louise from the previous example, who had an AGI of $412,500 for 2013, exceed the threshold for a married couple by $112,500. Thus, they must reduce their itemized deductions subject to the phase-out by $3,375 (3% of $112,500) but not exceeding 80% of the deductions subject to the phase-out. For 2013, Ralph and Louise had the following itemized deductions:

The phase-out is the lesser of $3,375, or 80% of $24,000. Ralph and Louise’s itemized deductions for 2013 should be $32,625 ($24,000 – $3,375 + $12,000). Assuming Ralph and Louise are in the 33% federal tax bracket, the phase-out will cost them an additional $1,114 ($3,375 x 33%).

Planning Tip: Conventional thinking is to maximize deductions. However, where taxpayers are not normally subject to phase-out and have a high-income year because of unusual income, it may be appropriate, where possible, to defer paying deductible expenses to the year following the high-income year. Another option is to pay and deduct the expenses in the preceding year.

If you are subject to these increased taxes on higher-income taxpayers, it may be appropriate to review your situation. You may need to adjust your withholding and estimated taxes to prevent underpayment penalties or avoid any unpleasant tax surprises at the end of 2013. If you have any questions, contact the Tax Experts at Henssler Financial: 770-429-9166 or experts@henssler.com

Disclosures:

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