Archives for January 2013

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2013 Tax Brackets and Other Tax Changes

The following is a brief discussion of some of the more noticeable tax changes between 2012 and 2013. To be clear, it is not meant to be a comprehensive list.

Tax Bracket Changes

As a result of the American Taxpayer Relief Act of 2012, the tax brackets for 2013 are the same as the 2012 brackets (after adjusting each threshold amount for 2.57% annual inflation), with one exception: There is a new 39.6% tax bracket for people with taxable incomes in excess of $400,000 ($450,000 if married filing jointly, $425,000 if filing as head of household).

Single 2013 Tax Brackets

Taxable Income
Marginal Tax Rate:
$0-$8,925 10%
$8,926-$36,250 15%
$36,251-$87,850 25%
$87,851-$183,250 28%
$183,251-$398,350 33%
$398,351-$400,000 35%
$400,001+ 39.6%

 

Married Filing Jointly 2013 Tax Brackets

Taxable Income
Marginal Tax Rate:
$0-$17,850 10%
$17,851-$72,500 15%
$72,501-$146,400 25%
$146,401-$223,050 28%
$223,051-$398,350 33%
$398,351-$450,000 35%
$450,001+ 39.6%

 

Head of Household 2013 Tax Brackets

Taxable Income
Marginal Tax Rate:
$0-$12,750 10%
$12,751-$48,600 15%
$48,601-$125,450 25%
$125,451-$203,150 28%
$203,151-$398,350 33%
$398,351-$425,000 35%
$425,001+ 39.6%

 

Married Filing Separately 2013 Tax Brackets

Taxable Income
Marginal Tax Rate:
$0-$8,925 10%
$8,926-$36,250 15%
$36,251-$73,200 25%
$73,201-$111,525 28%
$111,526-$199,175 33%
$199,176-$225,000 35%
$225,001+ 39.6%

 

Also of note is that this new tax bracket structure is “permanent.” Not permanent in the sense that it cannot be changed — because it surely will be changed at some point. But permanent in the sense that there is no specific point in the future at which changes are scheduled to take place.

Standard Deduction and Personal Exemption Amounts

The standard deduction and personal exemption amounts are the same as from 2012, after adjusting for inflation and doing the necessary rounding:

  • Personal exemption: $3,900
  • Standard deduction (single): $6,100
  • Standard deduction (married filing jointly): $12,200
  • Standard deduction (head of household): $8,950
  • Standard deduction (married filing separately): $6,100

The additional standard deduction for people who have reached age 65 (or who are blind) is indexed to inflation as well, which means it increases to $1,200 for married taxpayers or $1,500 for unmarried taxpayers.

Personal Exemption and Itemized Deduction Phaseouts

One big change from recent years is that personal and dependent exemptions now phase out via the “PEP” rules (Personal Exemption Phaseout). The total personal exemptions to which you’re entitled will be reduced by 2% of the amount by which your adjusted gross income (note: not taxable income) exceeds a certain threshold amount:

  • $250,000 for single taxpayers,
  • $300,000 for married taxpayers filing jointly,
  • $275,000 for taxpayers filing as head of household, and
  • $150,000 for married taxpayers filing separately.

In addition, the amount of itemized deductions otherwise allowable is reduced by 3% of the amount by which your adjusted gross income exceeds these same threshold amounts. (Exception: Your itemized deductions cannot be reduced by more than 80% by this rule.)

The takeaway here is that there’s now an income range (starting at the applicable threshold amount) in which your marginal tax rate will be somewhat greater than the actual tax bracket you’re in.

  • The phaseout of personal exemptions increases your marginal tax rate by 0.66% for each personal/dependent exemption claimed on your tax return, and
  • The itemized deduction limitation effectively increases your marginal tax rate by 1%.

Estate Tax

The new law makes the 2012 estate tax exemption ($5,120,000) permanent and indexes it to inflation (making it $5,250,000 for 2013). In addition, the exemption is now permanently “portable” meaning that the estate of a deceased person can make an election to allow that person’s surviving spouse to use any portion of the exemption that was not used by the deceased spouse.

In other words, with effective exemptions above $5 million for single taxpayers and $10 million for married taxpayers filing jointly, very few people will need to be concerned with the estate tax going forward.

AMT Exemption Now Inflation-Adjusted

The new law retroactively sets the AMT exemption amount for 2012 at $50,600 for single taxpayers and $78,750 for married taxpayers filing jointly. In addition, the exemption amount is now permanently indexed to inflation so that it will no longer require annual “patch” legislation. For 2013, the exemption amounts are $51,900 for single taxpayers and $80,800 for married taxpayers filing jointly.

Changes in Payroll Tax Rates

One tax cut that the new law did not extend was the 2% reduction in payroll taxes (specifically, the employee portion of Social Security taxes) that had been in place for 2011 and 2012. As a result, employees will see their Social Security tax increase from 4.2% to 6.2%, and self-employed taxpayers will see their self-employment tax increase from 13.3% to 15.3%.

In addition, the new 0.9% Medicare tax on earned income in excess of $200,000 ($250,000 if married filing jointly) that was created by the Affordable Care Act of 2010 goes into effect starting in 2013.

Overall Effect

In short, for most taxpayers (i.e., those with gross income below $200,000), 2013 will look much like 2012 as far as tax planning strategies. For higher income taxpayers, however, there’s a whole list of new tax planning considerations:

  • A 39.6% tax bracket,
  • The 20% tax rate for qualified dividends and long-term capital gains (discussed in Monday’s article),
  • The 3.8% Medicare surtax on net investment income (also discussed in Monday’s article),
  • The 0.9% Medicare tax on earned income, and
  • The personal exemption phaseout and itemized deduction limitation.

For More Information, See My Related Book:

Book3Cover

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

Dividend and Long-Term Capital Gain Tax Rates

As a result of the Affordable Care Act of 2010 and the American Taxpayer Relief Act of 2012, the tax treatment for qualified dividends and long-term capital gains will be somewhat different for 2013 (and future years) than it was for 2012.

0%, 15%, and 20% Tax Rates

Just like before, any qualified dividends and long-term capital gains that fall in the 15% tax bracket or below will not be taxed.

And, just like before, any qualified dividends and long-term capital gains that fall in the 25%-35% tax brackets will be taxed at a 15% rate.

What’s new is that any qualified dividends and long-term capital gains that fall in the new 39.6% tax bracket (which kicks in when your taxable income is above $400,000 if single and $450,000 if married filing jointly) will be taxed at a 20% rate.

New 3.8% Medicare Surtax

The other big change is that the 3.8% Medicare surtax created by the Affordable Care Act goes into effect this year. This 3.8% tax applies to the lesser of:

  • Your “net investment income,” or
  • The amount by which your modified adjusted gross income exceeds $200,000 ($250,000 if married filing jointly).

For these purposes, net investment income includes both qualified dividends and capital gains, as well as other types of income such as interest, royalties, and rents.

An important distinction to make is that the calculation of this 3.8% tax depends on your modified adjusted gross income rather than your taxable income. (In contrast, where you fall in terms of having a 0%, 15%, or 20% income tax rate for qualified dividends and long-term capital gains depends on your taxable income.) For these purposes “modified adjusted gross income” means your adjusted gross income (i.e., the bottom line of the first page of your Form 1040) increased by any foreign earned income that was excluded from your gross income.

Total Tax Rates

The long and short of all of the above is that:

  • If your modified adjusted gross income is below $200,000 ($250,000 if married filing jointly), there’s probably no change in the rate at which your qualified dividends and long-term capital gains will be taxed, and
  • If your modified adjusted gross income is above $200,000 ($250,000 if married filing jointly), your total marginal tax rate for qualified dividends and long-term capital gains is probably 18.8%, or 23.8% rather than just 15%, as it has been for the last several years.

The reason that I say “probably” in each of the above statements is that, as always, different parts of the tax code interact with each other. So it’s possible that your actual tax rate on dividends and capital gains would be greater than what’s indicated above if your dividend and capital gain income is pushing you out of the range in which you would be eligible for some other tax break.

Impact on Asset Location Strategies

For the last several years, conventional wisdom has been that, if you have to hold something in a taxable account (as opposed to in tax-sheltered retirement accounts), it’s best to keep stocks in the taxable account given that dividends and long-term capital gains are taxed at lower rates than interest income from taxable bonds. The tax changes from 2012 to 2013 don’t have much impact in that regard given that:

  • Most taxpayers will not be experiencing a change in their tax rate for dividends and long-term capital gains, and
  • Taxpayers who will be experiencing an increase in dividend and LTCG tax rates will be experiencing an increase in tax rates on interest income as well.

That said, as fellow blogger The Finance Buff has noted, the currently-low yields on bonds (and the resultant fact that they put out a relatively low amount of taxable income) could by itself be enough to turn the conventional wisdom on its head.

Tax-Gain Harvesting: Still Makes Sense

For investors in the 15% tax bracket or below (for whom long-term capital gains will continue to be taxed at a 0% rate), tax-gain harvesting continues to be a worthwhile endeavor. It still provides a way to bump up your cost basis (and thereby reduce the gain upon which you might have to pay taxes later) without having to pay any additional tax costs now.

For More Information, See My Related Book:

Book3Cover

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

Using Morningstar’s Tax-Cost Ratio

When I’m looking for information about a mutual fund, Morningstar is typically the first place I look. In addition to the most obvious pieces of information such as the fund’s expense ratio and portfolio composition, one thing I often check is the fund’s “tax-cost ratio.” (To find a mutual fund’s tax-cost ratio, look up the fund on Morningstar and click over to the “tax” tab.)

What Is Tax-Cost Ratio?

Morningstar’s tax-cost ratio figure shows what an investor in a given fund would have paid in taxes over a given period, if the investor was in the highest tax bracket throughout the period in question.

The figure is expressed as a percentage of fund assets, making it analogous to a fund’s expense ratio in that a fund’s expense ratio tells you what percentage of your investment is eaten up by fund expenses each year, while the fund’s tax-cost ratio tells you what percentage of your investment would have been eaten up by taxes over a given year (assuming that you were in the highest tax bracket that year).

What Is Tax-Cost Ratio Useful For?

Tax-cost ratio can be very helpful for comparing different funds or categories of funds to see which ones are more tax-efficient.

For example, a comparison between Vanguard Total Stock Market ETF and Vanguard Total Stock Market Index Fund shows that their tax costs are nearly identical. And a comparison between Vanguard Total Bond Market ETF and Vanguard Total Bond Market Index Fund provides a similar result. (Conclusion: If you’re trying to decide which share class of these funds to own, taxes are probably not going to be a major factor in your decision.)

Or, if you were to meet with a financial advisor who recommended, for example, American Funds’ Growth Fund of America as a holding in your taxable account, you could compare that to an index fund in the same fund category (e.g., Vanguard Growth Index Fund), and you would find that Growth Fund of America tends to experience higher tax costs. (This should not be particularly surprising. Actively managed funds tend to be less tax-efficient than index funds, because they have higher portfolio turnover.)

What Tax-Cost Ratio Is Not Useful For

You’ll want to be careful, however, not to use tax-cost ratio for purposes for which it is not intended. For example:

  • Tax-cost ratio is not relevant for holdings within an IRA, 401(k), or other tax-sheltered retirement account, because you do not have to pay taxes each year on the gains that you earn in those types of accounts, and
  • Tax-cost ratio is not particularly helpful from a budgeting, how-much-tax-should-I-expect-to-pay perspective, because the figure is historical and therefore naturally dependent upon the returns the fund earned over the period in question, and
  • Because the tax-cost ratio calculation uses the assumption that the investor is in the highest tax bracket at all times, it’s not a good estimate of how much you would have paid in taxes, unless you really did happen to be in the top tax bracket for each of the years in question.

In other words, tax-cost ratio is useful for comparing two different funds or groups of funds to see which tends to be more or less tax-efficient when held in a taxable account. But the actual specific figure isn’t necessarily going to be very useful from a forward-looking perspective.

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