The recent passage of the “Taxpayer Relief Act of 2012” coupled with the HealthCare Acts of 2010 poses some significant changes in 2013 and additional taxes for some taxpayers. Here is a quick summary of some of the biggest tax changes that may affect you and some tips on reducing your tax bill and providing your own relief.
The first major change, which comes from the Taxpayer Relief Act, was an increase to the employee’s portion of the FICA tax from 4.2% to 6.2%. The FICA tax for employees was reduced temporarily to 4.2% during 2011 & 2012. This tax has returned to the pre-2011 levels of 6.2% as it was never meant to be permanently lowered.
A new tax for some starting in 2013, which stems from the healthcare reform, is the 3.8% Medicare surtax. This tax is imposed on the lesser of total net investment income or the excess amount of modified adjusted gross income (MAGI) over $250,000 filing jointly or $200,000 filing individually. Net investment income includes, but is not limited to, taxable interest, dividends, net capital gains, nonqualified annuities, royalties and rents. The 3.8% surtax applies to the lesser of net investment income or MAGI over the threshold limits. For example, in a given year if you have wages $25,000 above the wage threshold and in the same year have $15,000 in net investment income (dividends, interest, and capital gains), you would pay the 3.8% surtax on the $15,000 since it is the lesser of the two.
Also stemming from the healthcare reform is an additional Medicare tax of 0.9% for all wages above the threshold of $200,000 for single filers and $250,000 for joint filers. All wages under and up to the thresholds will be taxed at the standard Medicare tax of 1.45%. All wages in excess of the thresholds will be taxed at 2.35% (1.45% + 0.9%).
Another possible tax change exists if your taxable income is over $400,000 (single) or $450,000 (joint). Income above these limits will now be taxed at 39.6% instead of 35%. This change came as a result of the “Taxpayer Relief Act”. Additionally, your tax rate on capital gains and dividends will increase from 15% to 20% if your income exceeds this threshold. For example, if you had $20,000 dividends and capital gains you would pay an additional $1,000 in taxes, not including the additional 3.9% Medicare surtax that your investment income potentially faces.
One of the final major tax implications impacts all taxpayers with income above $250,000 (single) or $300,000 (joint). As part of the “Taxpayer Relief Act” components of the PEASE limitations of itemized deductions has been re-introduced. Limitations exist on the following itemized deductions: charitable contributions, mortgage interest, property taxes and miscellaneous itemized deductions. Income over the above threshold amount will introduce a reduction to these itemized deductions that is the lesser of 3% of AGI above their threshold or 80% of the amount otherwise allowed that year.
An important change that will take place in 2013, separate from the tax law changes, is the increased retirement plan contribution limits. These changes occur due to set inflation adjustments. For 2013, the 401(k) limit for employee contributions increases to $17,500 (under 50 yrs. old) and $23,000 (if 50 and over); while IRA/Roth IRA contribution limits were raised to $5,500 (under 50 yrs. old) and $6,500 (if 50 and over). The Roth IRA has income limits associated with it, so check with your tax professional to see if you are eligible.
With all of these new taxes, you are probably wondering how you can relieve some of the impact and tax burden. Below, we outline several different solutions – please make sure you consult your tax professional to see if they will aide in your situation.
- Max out your 401(k) contribution using the new limits of $17,500 (under 50) or $23,000 if over 50 for 2013.
- If you are self-employed, consider setting up a single owner 401(k) and contribute the max employee deferral of $17,500 (under 50) or $23,000 if over 50. In addition, you can contribute 25% of compensation as an employer contribution. The total contribution can’t be more than 100% of your pay or $51,000 (under 50) or $56,500 (if over 50).
- If you work for a company that has a 401(k) plan and you do consulting on the side, you can set up a Defined Benefit Plan (DB plan) in addition to contributing the max to your company’s 401(k) plan. The DB plan offers much larger contributions than the 401(k) and is a way to jump start your retirement savings.
- If you are self-employed the best option might be a single 401(k) combined with a Defined Benefit Plan. DB plan contributions are required and generally you can contribute more than a 401(k). Combining the 401(k) with the DB plan offers greater flexibility because you can contribute $17,500 (under 50) or $23,000 if over 50 + 6% of salary as an employer contribution.
- Consider contributing to a Roth 401(k) instead of the 401(k). Contributions are after tax and the money grows tax free until you reach 70.5. When you retire, you can rollover the Roth 401(k) to a Roth IRA (provided it was already established) and continue the tax free growth. This is a good idea if your tax rate is low and/or you expect tax rates to rise in the future.
- Conversions from a 401(k) to a Roth 401(k) are now available in 401(k) plans. If you have a low income year or you think tax rates are going to rise significantly in the future you might consider this.
- To reduce the potential for the Medicare tax, you should use tax efficient and tax managed mutual funds and muni bonds funds (if appropriate). Finally, your assets should be strategically located in your different accounts (IRA, Roth IRA, 401(k), Roth 401(k) and taxable account) to make your portfolio as tax efficient as possible.
- Finally, don’t neglect keeping your estate plan up to date to minimize taxes in the future. Sometimes this is the hardest because there are so many choices.
Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail firstname.lastname@example.org.
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