More On Tax Planningfrom The Advisor's Professional Library
- IRAs: In General Individual Retirement Accounts are highly popular tools for contributing funds that grow on a tax deferred basis. Depending on the type of IRA, the accumulation can be tax free.
- Annuities: Variable Annuities Annuities are hot. The tax rules vary with the circumstances. Advisors must be aware of these intricacies when discussing annuities with clients.
As the deadline for a congressional compromise that would prevent the automatic expiration of the Bush-era tax cuts and other stimulus benefits approaches, your clients are likely asking themselves one seemingly simple question—how will this affect me? The deadline for reaching a compromise that would avoid sending the United States over the “fiscal cliff” is less than 20 days away and, in the eyes of some observers, the prospect of reaching a compromise is becoming less likely by the day.
So we present a case study below, excerpted from Tax Facts Online, of how going over the cliff will affect your clients.
The Clients: Jack and Marilyn
Your clients, Jack and Marilyn, have scheduled an appointment to discuss how the expiring provisions will affect them. Jack and Marilyn are a relatively typically couple—they’re in their mid-50s, live in New Jersey and have three children—two in college and one in high school. Jack works in advertising and Marilyn is a high school teacher and, together, they earn approximately $300,000 annually. They each contributed the maximum $17,000 to their employer-sponsored 401(k) plans in 2012 (though they were unable to manage the additional $5,500 catch-up contributions), to reduce their taxable income to $266,000.
They have invested during the years, and tend to sell stocks, bonds, and mutual funds each year as the college tuition payments become due; to help offset college expenses, they need to bring in approximately $25,000 from these sales each year. Additionally, they will recognize about $5,000 in dividend income in 2012, which is what they have typically seen each year and what they anticipate recognizing in 2013.
They own their primary residence—they purchased it for $200,000 twenty years ago—but took out a second mortgage to expand their small home as their family grew, and are still paying off their mortgages. Further, they own a beach house in Florida where they intend to retire after all of the kids have finished school. The beach house is rented to vacationing families much of the year to help cover expenses, but upon retirement, Jack and Marilyn plan to sell their home in New Jersey and retire to the beach permanently. In today’s market, they hope to sell their primary home for approximately $750,000, though the future is, of course, uncertain.
Jack and Marilyn have done plenty of reading on the potential impact of the expiring tax provisions, but are really concerned with how a plunge over the fiscal cliff would impact them on a more personal level. How do you advise?
Jack and Marilyn are in the same situation as thousands of taxpayers today—they’re relatively comfortable after years of planning and responsible investing, but they’ve become accustomed to the current tax system and have no idea what to expect concerning their financial future if negotiations that would prevent a fiscal cliff crisis fail. Right now, they’re interested in the “worst case scenario” that could play out if all of the current expiring tax provisions are permitted to expire.
Impact No. 1: Higher Income Taxes
If the fiscal cliff negotiations fail, the most noticeable impact for Jack and Marilyn will be a substantial increase in their marginal income tax rates—in other words, they will see an obvious decrease in their take-home pay. The current income tax rate brackets were agreed upon in 2001, with rate reductions accelerated in 2003 that brought today’s rates into play.
Jack and Marilyn’s current income would place them in the 33% tax bracket for 2012. Though they were able to reduce their taxable income through retirement savings contributions, they were not able to defer enough to drop them into the lower 28% bracket. The marginal income tax brackets will increase if we fall off the fiscal cliff—meaning that in 2013, Jack and Marilyn will be taxed at 36% on their ordinary income from wages.
Under the Patient Protection and Affordable Care Act (also known as the PPACA, or Obamacare), an additional 0.9% Medicare tax on Jack and Marilyn’s income that exceeds $250,000 ($200,000 for single taxpayers) is scheduled to take effect regardless of the outcome of fiscal cliff negotiations. Further, the 2% Social Security payroll tax cuts that have been in place for the past few years will expire at the end of 2012. Assuming this happens, we can assume Jack and Marilyn’s income tax rate on their first $250,000 will effectively rise by 5%, and by 5.9% on their income that exceeds the $250,000 mark. State, local and property taxes, while not directly affected, only steepen the slope of the fiscal cliff.
Impact No. 2: Higher Capital Gains and Dividends Taxes
While the income tax ramifications will affect Jack and Marilyn greatly if Congress fails to reach a compromise, this is far from the end of their story. This is because they have begun to sell investments to fund their children’s education, and this income is taxed under a different system.
Today, Jack and Marilyn’s long-term capital gains are taxed at 15% because they fall within one of the higher income tax brackets (capital gains rates for taxpayers in the lowest tax brackets were reduced to zero through 2012). However, if this reduced rate is allowed to expire, their capital gains rate will increase to 20%—resulting in about $1,250 more in capital gains taxes each year. Effectively, they will be required to sell more investments each year to fund their children’s college expenses.
Their dividend income requires consideration, as well. Today, dividend income is treated as income from capital gains—so Jack and Marilyn have been paying tax at the reduced 15% rate. Prior to 2003, however, dividend income was taxed as ordinary income—reverting to those rates in 2013 will mean that the taxes Jack and Marilyn pay on their dividends would more than double—from the 15% they’re paying today to the 36% income tax rate that would become effective in 2013.
Impact No. 3: New Obamacare Tax
As outlined above, taxes on investment income will increase (dramatically, in the case of dividends) if fiscal cliff negotiations fail, but because of Jack and Marilyn’s income level, they must also consider the new tax on investment income that will come into play January 1. Under the PPACA, a 3.8% tax on “unearned income” will apply to taxpayers with adjusted gross income (AGI) of more than $200,000 for single filers, or $250,000 for married couples filing jointly.
This 3.8% will be added to the 2013 tax rates regardless of whether Congress extends the current rates, increasing the capital gains rate from 15% to 18.8% in 2013 if the current rates are extended. However, if the Bush-era tax cuts are allowed to expire at the end of 2012, the extra 3.8% tax will push Jack and Marilyn’s capital gains rates to 23.8% in 2013 and will effectively increase the taxes they pay on dividends to nearly 39.8%.
Essentially, the tax will apply to any “net investment income” that Jack and Marilyn recognize. Net investment income means income that is “unearned”—for example, income received from investments such as stocks, bonds and mutual funds. Net investment income obviously includes dividends and interest received through investment in these vehicles, but can also apply to income derived from a trust or, in some cases, the sale of a primary residence. It won’t include their Social Security benefits (when they begin claiming them) or their eventual 401(k) withdrawals, though these amounts can be used to push them above the threshold $250,000 per year mark.
Impact No. 3A—Higher Capital Gains Taxes on an Appreciated Home
The new investment income tax can further complicate Jack and Marilyn’s financial picture because they are beginning to envision the day when they will sell their home, which has appreciated substantially in their 20 years of ownership. The rules are complicated and will depend heavily upon when Jack and Marilyn choose to sell their home. To explain how the tax could affect them, assume they sell the house in 2013 at their hoped-for $750,000 figure.
A married couple is permitted to exclude the first $500,000 of gain from their AGI. So if Jack and Marilyn purchased their home for $200,000 and sell it for $750,000 next year, their capital gain is $550,000. They would then subtract the $500,000 exclusion and add the $50,000 excess to their AGI for 2013. Note that there is no exclusion for a secondary residence. Hopefully, this exclusion will continue after the fiscal cliff compromise.
Impact No. 4: More Limited Tax Deductions and Exemptions
Under current law, Jack and Marilyn are not limited in the value of the tax deductions they can claim each year (for example, their mortgage interest is currently deductible, along with any charitable contributions they make in any given year). The marital standard deduction they are entitled to claim each year is twice the deduction allowed for single filers in 2012, and Jack and Marilyn are each entitled to exempt a certain inflation indexed “personal exemption” amount (in 2012, $3,800).
If the current provisions are allowed to expire, Jack and Marilyn’s annual deductions will be limited—by 3% of AGI over a threshold amount set annually. This would reduce the mortgage interest deduction they are entitled to claim each year. Their personal exemptions would be similarly limited—by 2% for each $2,500 that their AGI exceeds the threshold amounts. Jack and Marilyn would most likely itemize their deductions, but if they claim the standard deduction, it will be reduced from $11,900 to $10,150 (re-implementing the so-called “marriage penalty”). Effectively, reducing or limiting the deductions available to Jack and Marilyn will increase their income tax rates even though it isn’t as obvious as an increase to the rate levels.
Beyond Jack and Marilyn: The Impact on the U.S. Economy
Even though every client wants to know how, exactly, the expiring tax provisions will impact him or her personally, it’s also important to take a look at the bigger picture—because that bigger economic picture will affect clients such as Jack and Marilyn on an individual level as well. The Tax Policy Center estimates that if all tax increases take effect in 2013, the overall tax liability of American taxpayers will increase by approximately $536 billion over 2012 levels.
Removing this massive sum from the economy will reduce the disposable income of millions of families and cause a dramatic decrease in consumer spending. This, in turn, will cause serious economic consequences—or even another recession—as businesses struggle and are forced to eliminate jobs and reduce salaries.
As an added consequence, because dividend and capital gains rates are set to increase dramatically, many investments will become less appealing for upper-class investors who fuel economic growth and development by pouring capital into corporations and related investments. Reducing the availability of investment funds limits the ability of companies to expand and will, in many cases, necessitate contraction—meaning more cuts in jobs and salaries as businesses scramble to reduce expenses.
Expiration of many tax credits that benefit taxpayers with lower AGI levels will further exacerbate the picture, making it more difficult for families to afford higher education and childcare expenses. The picture isn’t pretty, but clients should be prepared and understand that they, just like Jack and Marilyn, will be affected on a personal level if the worst-case scenario comes to pass.
We invite you to visit the AdvisorOne Fiscal Cliff landing page for up-to-date coverage on the fiscal cliff negotiations and the implications of going over the cliff.
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