On March 23, 2010 President Obama signed into law the Patient Protection and Affordable Care Act, also known as “Obamacare”. Without discussing the relative merits, or lack thereof, of the legislation as a whole what is certain is that beginning in 2013 a number of income tax provisions contained in the law become effective.
The single largest revenue raiser, according to the Congressional Budget Office, is the additional 3.8% tax on investment income for “high income” taxpayers.
Investment income includes interest, dividends, capital gains, rents and passive income (which includes income from partnerships and S corporations in which the taxpayer does not actively participate).
The additional tax does not apply to muni-bond interest income, taxable annuity payments, pension plan or IRA distributions, or taxable Social Security benefits. When considered solely on its own this new tax increase of less than 4% doesn’t appear to be particularly onerous. However, when coupled with what may be the expiration of the so-called ”Bush Tax Cuts”, also effective beginning in 2013, and for California taxpayers, if either Proposition 30 or Proposition 38 passes, a significant tax increase results, particularly for dividend income.
The current tax rate on dividend income (with some exceptions) is 15%. With the expiration of the Bush tax cuts this rate will rise to 39.6%, the maximum individual tax rate prior to 2001 (this rate will also apply to all other sources of income, except capital gains, as well). The Obamacare tax rate of 3.8% is then added to this to make the marginal Federal tax rate 43.4%. Thus, for Federal tax alone, the increase in the tax rate on dividend income is 289%. The current maximum individual tax rate for California residents is 9.3% (for incomes under $1 million). If either of the above mentioned propositions passes this rate could be raised to as high as 13.3%. Combining these two the combined tax rate on investment income other than capital gains could be as high as 56.7%. The current Federal rate of 15% for capital gains would rise to 23.8%, and again combined with California could be as high as 37.1%.
An additional tax of .9% is also becoming effective in 2013 for high income wage earners and self employed individuals. The income thresholds are the same as for the tax on investment income discussed above. This new tax raises the HI element (health insurance) of the Medicare tax on wages and self employment tax on income for self employment tax purposes. The current rate of 2.9% will rise to 3.8%, matching the tax rate on investment income.
Another tax provision which could affect all taxpayers regardless of income level is the increase in the threshold level for deductibility of medical expenses. Currently medical expenses that exceed 7.5% of adjusted gross income result in tax benefit. This threshold has been increased to 10% beginning in 2013. It is estimated that this change will raise $18.7 billion in government revenue in the next ten years.
Clearly 2013 will, from a tax perspective, be a challenging new year. There is still time, however short, to implement planning strategies to minimize or avoid some of these increases. It may be advantageous to accelerate income into 2012, change the mix of an investment portfolio, or defer deductions into 2013 to take advantage of higher tax benefit from higher rates. In any event those strategies need to be addressed in 2012, when plans can be fully implemented so they can be fully effective.
Please contact me or any of my partners directly if you need assistance with, or have any questions about what was covered in this article. We are here to help.
-Jim Jordan, CPA (818) 493-6650