2013 Tax Return Sticker Shock: Changes for High-Income 1040 Filers

By Stephanie Joyce February 20, 2014

If you already have completed your 2013 tax returns, you are ahead of the game. For most filers, not much will have changed relative to 2012 returns. However, filers of 1040s reporting high income may see some significantly increased taxes, and this article will explain why.

Regular tax rates have increased

For those in the highest bracket, the top rate has increased from 35% to 39.6%, matching the highest rates seen in a quarter of a century. These higher rates kick in at an adjusted gross income (AGI) of $400,000 for single individuals and $450,000 for married couples filing joint returns. For lower incomes, the rates remain relatively flat, adjusted only for inflation.

Long-term capital gain rates have increased

Although favorable tax rates for long-term capital gains and qualified dividends were made permanent by the American Taxpayer Relief Act of 2012 (ATRA), the top rate was increased from 15% to 20%. Therefore, a rate of 0%, 15%, or 20% will apply, depending on your tax bracket.

Some new taxes were imposed by the Affordable Care Act

High-income earners may also see the effects of two new taxes – the net investment income tax (NIIT) and Medicare surtax.

The NIIT represents an additional 3.8% tax on the lesser of a taxpayer’s net investment income or the taxpayer’s modified AGI above the applicable threshold ($200,000 for single filers and $250,000 for married couples filing jointly). Generally, investment income includes, but is not limited to, interest, dividends, capital gains, rents, royalties and passive business income. The tax does not apply to income that is otherwise excluded from gross income for regular income tax purposes.

Estates and most types of non-grantor trusts are also subject to the NIIT. For trusts and estates, the tax kicks in at $11,950, a significantly lower threshold than for individuals. Jean McDevitt, BNN’s private client service group lead, recently authored an article for our Family Wealth Matters newsletter providing some planning tips for certain trusts subject to the 3.8% tax.

You may be subject to a new 0.9% Medicare surtax if you are single and your AGI exceeds $200,000 or $250,000 if you are married and filing jointly. Although taxpayers could be subject to both the NIIT and Medicare surtax, these taxes do not apply to the same types of income. While the NIIT applies to investment income, the Medicare surtax applies only to “earned income,” which includes wages and self-employment.

Note that both of these new taxes are imposed in addition to the federal income tax.

Itemized deductions are phased out

Additionally, 2013 reintroduces what is known as the Pease limitation, named after former congressman Donald Pease. Introduced in 1991 but in mothballs since 2009, this limitation reduces most itemized deductions by 3% of the amount by which a taxpayer’s AGI exceeds $250,000 for single taxpayers or $300,000 for married couples filing jointly. The maximum reduction is capped at 80% of total itemized deductions. The limitation does not apply to medical and dental expenses, but applies to most other deductions including real estate taxes, state and local taxes, mortgage interest, charitable contributions and miscellaneous itemized deductions.

Not to be outdone by federal tax rules, Maine cooked up some changes of its own. Itemized deductions on Maine income tax returns used to (with a few exceptions) equal federal itemized deductions. However, Maine now caps itemized deductions at $27,500 for 2013 and later years, regardless of the filer’s level of income.

Personal exemptions are phased out

High-income taxpayers may also see their personal exemptions decrease or entirely disappear in 2013. Much like the Pease limits discussed above, the Personal Exemption Phase-out (PEP) has been on hiatus since 2009 only to return for 2013. It reduces the $3,900 personal exemption for both taxpayers and their dependents by 2% for each $2,500 (or part thereof) that AGI exceeds $250,000 for single filers and $300,000 for married couples filing jointly. The exemption amount is reduced to zero for AGIs above $372,500 for single filers and $422,500 for married couples filing jointly.

Why the sticker shock?

For those who were aware of it, the increased income tax rates are relatively easy to quantify: Top rates have increased by approximately 5%. However, it is the combination of that increase with the other taxes and loss of numerous deductions that may cause some sticker shock. It is likely that some taxpayers whose 2013 income and expenses closely resemble those of 2012 will see very dramatic increases in tax. Under not-too-uncommon scenarios, it is quite possible many taxpayers will be paying tax at well over 50% (federal income tax, state income tax and NIIT combined may easily reach that), and the effective rate will be higher, due to the disallowance of formerly allowable deductions.

In summary, taxpayers in higher income tax brackets should prepare to see significant increases in their tax liabilities this year, with the biggest changes impacting those single filers making $200,000 or more and joint filers making more than $250,000. If you would like to discuss further, please contact Stephanie Joyce or your BNN advisor at 800.244.7444.