Even though the new year is still five months away, it’s never too soon to start planning ahead for your taxes (see updated post on tax changes from Fiscal Cliff deal). With several tax cuts expiring and new tax rules scheduled to take effect, taxpayers need to be aware of how these changes may impact their personal tax liability. The following is a brief overview of what taxpayers can expect in 2013.
Medicare Contribution Tax
With the passage of the Affordable Care Act comes a new tax rule in the form of the Medicare contribution tax. The tax, which is targeted primarily at high-income earners, is intended to offset some of the costs of mandated healthcare. Beginning in January 2013, single filers earning more than $200,000 per year and joint filers making over $250,000 annually will be subject to a 3.8 percent tax on capital gains and investment income, including interest, dividends, rents and royalties. There will also be a 0.9 percent increase in the Medicare tax for these same individuals.
The Medicare tax changes also have implications for individuals who pay for their own medical expenses or use Flexible Spending accounts to offset some of their healthcare costs. As of 2013, the itemized medical deduction limit will increase from 7.5 percent of adjusted gross income to 10 percent. Contributions to health flexible spending accounts will be limited to $2,500 per year.
Changes to Estate Tax
With the Bush-era tax cuts set to expire at the end of 2012 (still a possibility that this tax cut may be extended), estate taxes are expected to increase significantly. Currently, there’s a $5 million exemption on gift and estate taxes and beginning in 2012, the exemption is scheduled to reset to its earlier limit of $1 million. If you have substantial assets, this could affect the way you approach estate planning since your beneficiaries may be subject to significantly higher tax penalties for any inheritance or gifts they receive.
Increase in Capital Gains Tax
Capital gains tax applies when you sell stocks, bonds or other investment assets for a profit. Short-term capital gains are taxed at your regular income tax rate. Gains realized on long-term investments that are held for at least one year prior to sale are taxed at a lower rate. Currently, the long-term capital gains tax is 15% but this is set to increase to 20% in 2013. This could have a significant impact on investors who may feel pressured to sell-off assets before the end of the year in order to minimize the capital gains tax. Under the new tax rules, dividends, which are currently taxed at the long-term capital gains rate, would be taxed at the ordinary income tax rate.
Increase in Regular Income Tax Rates
Perhaps the most significant tax change scheduled to take effect in 2013 is the increase in regular income tax rates. Unless Congress takes legislative action to prevent these tax changes, taxpayers may find themselves facing substantially higher tax bills. The current tax rates are based on a six-bracket division of income, with the maximum rate topping out at 35%. If the Bush-era cuts are allowed to expire, then the maximum tax rate will increase to 39.6%. Individuals in the lowest tax bracket will see their taxes increase from 10% to 15%. High-income earners may also see a reduction in the amount of itemized deductions they’re allowed to claim, which could also result in a higher tax bill.
Mortgage Forgiveness Debt Relief Act Set to Expire
With the Mortgage Forgiveness Debt Relief Act, homeowners are able to reduce their tax liability for forgiven mortgage debt. Before this act was in place, homeowners would be subject to income tax on all forgiven mortgage debt. After this expires, homeowners will no longer be able to exclude cancelled mortgage debt from their income taxes.
Preparing for Tax Changes
While it’s not certain whether the proposed tax changes will take effect, there are several things you can do to make sure you’re prepared. For example, if you’re self-employed and invoice customers for payment, it may be to your benefit to try and collect on any outstanding bills before 2013 in case the marginal tax rates increase. If you’re thinking of switching a traditional IRA to a Roth IRA, you may want to do so now to lock in the 2012 tax rates on the conversion. It may also be to your advantage to shift dividend assets into a tax-advantaged investment account, such as an IRA. Finally, if you itemize deductions, you need to consider how they may or may not be able to offset your tax liability should your tax rate increase. Preparing yourself ahead of time is the best way to avoid any unpleasant surprises when the 2013 tax season rolls around.