Estate Planning Update - September 2012: New Taxes Make Year-End Income Tax Planning More Important

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It is not too early to start planning income tax steps to take before year-end. The Patient Protection and Affordable Care Act introduced two new taxes that will go into effect January 1, 2013. These are a 3.8 percent Medicare Contribution Tax, and a 0.9 percent Hospital Insurance Tax. In addition, significant Bush-era tax cuts are scheduled to expire at the end of 2012.

The Medicare Contribution Tax will be levied on net investment income and higher-income bracket trusts, estates, and individuals. A taxpayer will be required to pay 3.8 percent of the lesser of the taxpayer’s net investment income, or the amount by which his or her modified adjusted gross income exceeds $250,000 (for a couple filing a joint return), $125,000 (for married individuals filing separate returns), and $200,000 (for all other individual taxpayers). Net investment income includes interest, dividends, annuities, royalties, rents, capital gains, and passive activity income. Therefore, for certain taxpayers, passive and investment income will become less attractive, and depending on the circumstances, it may be advisable for taxpayers holding assets with significant unrecognized gain to explore whether to recognize that gain prior to 2013.

In the case of an estate or trust, the 3.8 percent tax is applied to the lesser of the undistributed net investment income or the amount by which the estate or trust’s adjusted gross income exceeds the dollar amount at which the highest tax bracket begins. For 2012, this dollar amount is $11,650. Therefore, in the case of trusts and estates, permissible distributions of undistributed net investment income in 2012 may be advisable, and tax planning for 2013 and beyond should be a high priority.

Also beginning in 2013 is the 0.9 percent Hospital Insurance Payroll Tax on wages in excess of $250,000 for a couple filing a joint return, $125,000 for married individuals filing separate returns, and $200,000 for all other taxpayers. The tax is added to the existing 1.45 percent Medicare tax on earnings below these thresholds. Thus, the payroll tax imposed on employees will increase from 1.45 percent to 2.35 percent for wage earners over the threshold.

In addition to these two new taxes, the tax cuts implemented by President George W. Bush are scheduled to expire at the end of this year. If these tax cuts expire, the highest marginal income tax rates will rise to 36 percent and 39.6 percent from 33 percent and 35 percent, and the highest rate on long-term capital gains will rise from 15 percent to 20 percent. In addition, qualified dividends will be taxed as ordinary income rather than at a 15 percent rate. Finally, itemized deductions will be phased out by the lesser of 3 percent of adjusted gross income, or 8 percent of the value of the itemized deductions.

The cumulative effect of the Medicare Contribution Tax, the Hospital Insurance Payroll Tax and the expiration of the Bush tax cuts will result in substantially increased taxes for taxpayers whose income is derived from passive income. Those taxpayers who will fall subject to the 2013 tax increases are advised to look for opportunities to take action in 2012 to minimize the effect of the increased tax burden.