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Tax Newsletter
October, 2012

In recent years, end of the year tax planning has been complicated by uncertainty over future tax rates and the availability of certain tax incentives. This year is no different; however, the breadth of possible changes in income and estate taxes gives this year the potential to be more tumultuous than prior years. We may have a better feel for where things stand after the elections, but following are some of the key elements of our current uncertainty.

Provisions that will become effective in 2013

3.8% Medicare Surtax. Beginning in 2013, individuals with modified adjusted gross income greater than $200,000 ($250,000 for joint filers), are scheduled to pay an additional 3.8% in Medicare surtax on net investment income. Net investment income includes gross interest, dividends, royalties, rents, net capital gains, and income from passive activities less deductions allocable to such income.

The 3.8% surtax applies to the lesser of net investment income or the amount of modified adjusted gross income in excess of the threshold.

  • Example: A married couple has income from salaries of $270,000. Since this exceeds the $250K threshold, the 3.8% Medicare surtax would generally apply to their net investment income.
  • Example: A married couple has salaries totaling $230,000. They could be subject to the Medicare surtax if their net investment income is greater than $20,000. For example, if the couple has net investment income of $30,000, $10,000 will be subject to the 3.8% surtax.

While 3.8% alone may appear to be only a few percentage points above what would be a “nuisance tax”, its combination with the ordinary income or capital gains rates makes planning worth serious consideration. For example, in 2012 qualified dividends are taxed at 15%. In 2013 those same dividends may be taxed at the taxpayer’s highest ordinary rate (as high as 39.6%; see “Bush Era Tax Cuts, “ below) with the possibility of an additional 3.8% Medicare surtax, resulting in a potential total of 43.4%. Long term capital gains, currently taxed at 15%, could rise to 23.8%.

For those taxpayers who have the discretion to realize capital gains either in 2012 and 2013, it may be more beneficial to realize those gains in 2012 to take advantage of the lower capital gain tax rates and avoid the 2013 rate increase plus the 3.8% Medicare surtax. On the other hand, losses may provide a greater benefit in 2013 in reducing the amount exposed to the surtax.

.9% Medicare Tax. Beginning in 2013, individuals who earn more than $200,000 for the year ($250,000 for married couples) are scheduled to pay an additional .9% (from 1.45% to 2.35%) in Medicare tax. All wages (as well as self-employed income on Schedule C) that are currently subject to Medicare tax are subject to the additional Medicare tax if they exceed the applicable threshold for the taxpayer’s filing status.

Pease limitation. Under current law, the so-called “Pease limitation” and personal exemption phaseout (PEP) are scheduled to be revived after 2012. The Pease limitation reduces most itemized deductions by 3% of the amount by which AGI exceeds a specified threshold, up to a maximum reduction of 80% of itemized deductions.

  • Example: A married couple with two children has an AGI of $275,000. AGI exceeds the phaseout threshold by $97,450 ($275,000 - $177,550). 3% of $97,450 is $2,923.50. Itemized deductions may be reduced by $2,923.50, up to a maximum of 80% of itemized deductions.

”Bush-era tax cuts”

The “Bush-era” tax cuts were initially scheduled to expire in 2010, were extended for 2011 and 2012, and now are scheduled to expire at the end of this year. Congress may decide to extend the cuts further, but if the tax cut provisions expire, the tax landscape will change in the following ways:

  • The maximum tax rate for long term capital gains will increase from 15% to 20%
  • The top tax rate for individuals will increase from 35% to 39.6%
  • Dividends will cease to be taxed at capital gains tax rates and will again be taxed at the ordinary income tax rates (as high as 39.6%)

Other Expiring tax provisions

A number of other provisions are scheduled to expire at the end of 2012, including:

  • 50% bonus depreciation is eliminated in 2013
  • Maximum section 179 expensing will be reduced to $25,000 in 2013 (from $139,000 in 2012)
  • The employee reduced payroll tax rate of 4.2% increases to 6.2% on January 1, 2013
  • Certain education credits will no longer be available in 2013

Estate and Gift Tax

There is currently a maximum estate tax rate of 35% on the portion of the taxable extate that exceeds the current $5 million exemption that is available for either gifts during life or transfers at death. This $5 million exemption is scheduled to revert to $1 million in 2013 and the maximum estate rate is set to increase to 55%. The potentially significant reduction in exemption amounts and increase in tax rates could provide compelling reasons for making gifts during 2012.

Running the numbers. We recommend running tax projections for 2012 and future years before implementing year-end tax strategies. Please let us know if you would like our assistance in preparing a projection.

We often remind our clients that tax considerations should generally not drive financial decisions. However, once financial objectives are defined and understood, it becomes easier to determine the tax planning strategies that are consistent with overall objectives. Unfortunately, frequent changes in the income tax rules, coupled with the changes and uncertainty in the estate tax area, make both short and long-term planning more complex. With the year-end approaching, it may be a good time to review your financial objectives with a view toward assessing whether any of the recent tax incentives can be incorporated into the financial plan.


The information contained in this newsletter is general in nature and does not constitute tax advice or opinion. Applicability to specific situations should be determined through consultation with your tax advisor.

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