TAX STRATEGIES
Mitigating high tax rate
The newly raised individual income tax rate of 39.6% refers to the marginal tax rate for the portion of taxable income over $400,000 for single taxpayers ($450,000 for married filing jointly). The 39.6% tax rate does not affect the taxable income below this amount. The portion of taxable income below this threshold amount is still taxed at progressive rates of 10%, 15%, 25%, 28%, 33% and 35%. The additional marginal tax rate is actually only 4.6% (39.6% – 35%). However, there is a larger impact on the qualified dividends and long-term capital gains tax rate, which is increased from 15% to 20%. It should be further noted that the 20% tax rate applies to the entire amount of qualified dividends and long-term capital gains. Therefore, this $400,000 (for single taxpayers) threshold amount becomes an important strategic point. It is not in a taxpayer’s best interest to cross this threshold.
For example, if a taxpayer’s taxable income is exactly $400,000, the marginal income tax rate is 35% and the qualified dividends and long-term capital gains tax rate is 15%. If this taxpayer has a chance to earn an additional $1 wage, it would cause the marginal income tax rate to go up from 35% to 39.6%. It would also cause this taxpayer’s qualified dividends and long-term capital gains tax rate to go up from 15% to 20% on the entire amount of qualified dividends and long-term capital gains. The entire amount of qualified dividends and long-term capital gains is taxed at 20% as a result of this increase in $1 income. As a result, it is not worth earning this additional $1 wage when taxable income exceeds the $400,000 threshold for single taxpayers.
It should be noted that at the juncture of the $36,250 ($72,500 for married filing jointly) threshold amount of taxable income there is also a beneficial tax planning strategy. If the amount of qualified dividends or long-term capital gains causes the total taxable income to cross this threshold amount, the portion of the qualified dividends or long-term capital gains below the threshold amount is taxed at zero percent (0%), while the remainder is taxed at 15%. For example, say a single taxpayer has taxable income in the amount of $36,150 before the $300 qualified dividends. How should the $300 qualified dividends be taxed? The first $100 ($36,250 – 36,150) is taxed at 0%, while the remaining $200 ($300 – 100) is taxed at 15%, i.e., $30 ($200 × 15%). Thus, the total qualified dividends tax is $30 ($0 + 30). The additional $200 qualified dividends have crossed the marginal income tax rate boundary from 15% to 25%. As a consequence, it also causes the qualified dividends tax rate to go up from 0% to 15%. This indicates that it is advisable to have only $100 of qualified dividends distribution, not $300. The taxpayer should try to defer the additional $200 qualified dividends distribution to the following year.
A taxpayer should be aware of the threshold points at different qualified dividends and long-term capital gains tax rates so as to minimize the tax liability. In other words, there are always strategies to mitigate the higher tax rate. This strategy has become even more important as the Relief Act has created one more tax rate bracket at 39.6% for ordinary income and 20% for qualified dividends and long-term capital gains.
Phase-out of itemized deductions
In addition to the tax rate spikes, there is a back-door increase in tax burden through the phase-out of total itemized deductions and personal and dependency exemptions. The Relief Act stipulates that, beginning 1/1/13, an individual’s otherwise deductible total itemized deductions are reduced by the lesser of:
(1) 3% of adjusted gross income in excess of the threshold amount of $300,000 for married taxpayers filing a joint return (or $275,000 for a head of household, or $250,000 for a single).
(2) 80% of otherwise deductible total itemized deductions other than medical expenses, investment interest expenses, casualty and theft losses, and wagering losses. In other words, the otherwise allowable itemized deductions include only state income tax, property tax, mortgage interest, charitable deductions, and miscellaneous deductions.
This means that an affluent taxpayer’s total itemized deductions can be greatly reduced when the adjusted gross income goes too far beyond the threshold amount, and the deductions for state income tax, property tax, mortgage interest, charitable deductions and miscellaneous deductions become too large. This implies that a portion of the total itemized deductions may be denied to wealthy taxpayers.
Actually, there are strategies that can mitigate the impact of the phase-out of total itemized deductions. It should be noted that the phase-out is based on adjusted gross income rather than taxable income. There are many adjustments before reaching adjusted gross income, such as capital losses from sales of investment in stock, business losses, rental loss, IRA contributions, contributions to 401(k) retirement plans, health and dental insurance premiums, moving expenses, and alimony payments. These items directly reduce adjusted gross income (for AGI deductions). A taxpayer should attempt to augment these adjustments.
There are many nontaxable income items, such as interest income from municipal bonds, withdrawals from Roth IRAs, social security, life insurance proceeds, donation of appreciated property to charity, and capital gains of a property at the time of death. These income items do not increase adjusted gross income. A taxpayer should take advantage of these tax-free income items.
There are deductions that reduce taxable income, but not adjusted gross income (from AGI deductions), such as itemized deductions and personal and dependency exemptions. If a taxpayer can move these “from AGI” deductions to “for AGI” deductions, it would be more advantageous. For example, a business travel expense as an employer is a reduction of business profit, and thus it is a “for AGI” reduction of adjusted gross income. However, a travel expense as an employee is an itemized deduction, which makes it a “from AGI” reduction of taxable income. That is why it is always better for the employer to pay for the business expenses even if the employee’s wages are reduced.
Should a taxpayer convert his or her home to a business office? The property tax on the home is an itemized deduction, while property tax on the business office is a business expense. The former reduces taxable income only, but not adjusted gross income; whereas, the latter reduces both. Obviously, the latter is more beneficial.
Finally, assume that a taxpayer is eligible to claim tuition either as “tuition and fees” as an adjustment or as “education expense” as a miscellaneous itemized deduction. What is the better strategy? The former is a “for AGI” deduction that reduces the adjusted gross income; whereas, the latter is a “from AGI” deduction that reduces taxable income, but not adjusted gross income. Obviously, the former is more advantageous than the latter, which makes it more beneficial to claim a tuition and fees deduction rather than an education expense.
Phase-out of personal exemptions
Along with the phase-out of itemized deductions there is another back-door reduction in personal and dependency exemptions. The Relief Act further stipulates that, beginning 1/1/13, an individual’s otherwise allowable deduction for personal and dependency exemptions is reduced by 2% for each $2,500 or fraction thereof by which the adjusted gross income exceeds the threshold amount of $300,000 for married taxpayers filing a joint return (or $275,000 for a head of household, or $250,000 for a single taxpayer).
It means that by the level of $375,000 adjusted gross income for a single taxpayer, the amount of personal exemptions is completely phased-out to zero [($375,000 – 250,000) / 2,500 = 50, and 2% × 50 = 100%). For upper middle class and wealthy taxpayers it is possible that both the total itemized deductions and the personal and dependency exemptions may be entirely denied.
Conclusion
There are five major changes, among others, under the Relief Act. It increases the maximum individual income tax rate from 35% to 39.6%, and the dividends and long-term capital gains tax rate from 15% to 20%. Effective 1/1/13, in conjunction with the Relief Act, there is a new NIIT at a rate of 3.8% of net investment income. In addition, the Relief Act reinstates the phase-out provision on total itemized deductions and personal and dependency exemptions.All these changes have a detrimental impact on taxpayers, particularly the middle class and the affluent.
These changes take effect only above certain threshold amounts. The 39.6% income tax rate and the 20% dividends and long-term capital gains tax rate apply only when the taxable income goes above $400,000 for a single taxpayer ($450,000 for married taxpayers filing a joint return). The 3.8% new NIIT is imposed only on the net investment income, but only when the taxpayer has adjusted gross income in excess of $200,000 for a single taxpayer ($250,000 for married taxpayers filing a joint return). Both the total itemized deductions and the personal and dependency exemptions start to phase-out only after the adjusted gross income reaches $250,000 for a single taxpayer ($300,000 for married taxpayers filing a joint return).
Taxpayers should be aware of these triggers. They serve as a pivotal point in tax planning strategies. The income tax rate and the dividends and long-term capital gains tax rate depend on taxable income, while the new NIIT rate and the phase-out of total itemized deductions and personal and dependency exemptions depend on adjusted gross income. Therefore, tax planning strategies should aim at taxable income when a taxpayer is concerned with income tax rate and the dividends and long-term capital gains tax rate. However, if the taxpayer is more concerned with the new NIIT and the phase-out of the total itemized deductions and the personal and dependency exemptions, the strategies should be designed to reduce adjusted gross income.
There are many effective strategies. For example, taxpayers may change a business form from a sole proprietorship, or incorporate as a partner in partnership. Further, it might be preferable to switch from personal itemized deductions to business expenses, because the latter reduces adjusted gross income, but not the former. In addition, when a taxpayer is about to sell a personal-use property for a gain, less income tax may result if the property is converted to business-use. Furthermore, it may be advisable for a taxpayer to donate an appreciated property to a charity because the capital gain on the property is tax-exempt. These strategies represent some of the effective ways that taxpayers can avoid paying higher taxes after the passage of the Relief Act.
There are enough changes here when combined with trying to strategize the alternative income tax also at the same time to make even an accountant want a flat tax.
