A few substantial tax increases took effect on January 1, 2013. The primary tax increases are the 3.8% Medicare net investment tax on investment income, the 0.9% Medicare tax on wages and self-employment income, and the increase in the maximum ordinary income rate to 39.6%.
The following table summarizes the compounded increased marginal tax rates on three common forms of income.
|
2012 Maximum Tax Rate |
Modified AGI Over $250,000 (joint filer) or $200,000 (single filer) |
Taxable Income over $450,000 (joint filer) or $400,000 (single filer) |
|
| Wages and/or Business Income |
35% |
35% plus an additional 0.9% Medicare tax |
39.6% plus an additional 0.9% Medicare tax |
| Short Term Capital Gain |
35% |
38.8% (35% maximum tax rate plus 3.8% Medicare tax) |
43.40% (39.6% maximum tax rate plus 3.8% Medicare tax) |
|
Long Term Capital Gain |
15% |
18.8% (15% long term capital gain rate plus 3.8% Medicare Tax) |
23.8% (20% long term capital gain rate plus 3.8% Medicare tax) |
** These are only federal marginal tax rates. Don’t forget about state taxes. **
The 3.8% Medicare Tax on Investment Income
The 3.8% Medicare net investment tax applies to investment income such as interest, dividends, capital gains, royalties, rental income, and passive business income. This 3.8% tax applies to the lesser of net investment income or the excess of the taxpayer’s modified adjusted gross income over $250,000 (married filing joint) or $200,000 (single filer). Modified adjusted gross income is the bottom number on your Form 1040 increased by any foreign earned income excluded from income (for virtually all taxpayers, modified adjusted income will equal the adjusted gross income amount on the bottom of the first page of Form 1040)
Example: Tina is a married filing joint taxpayer. She has rental income of $20,000 and modified AGI of $260,000. Her investment income is $20,000 of rent, and the excess of her modified AGI over the threshold amount of $250,000 is $10,000. Therefore, the lesser of these two figures–$10,000 is subject to the 3.8% Medicare tax. The tax amounts to $380.
Example 2: Laura is a married filing joint taxpayer. She has rental income of $150,000 and modified AGI of $410,000. Her investment income is $150,000 of rent, and the excess of her modified AGI over the threshold amount of $250,000 is $160,000. Therefore, the lesser of these two figures–$150,000 is subject to the 3.8% Medicare tax. The tax amounts to $5,700.
The 0.9% Medicare Tax on Wages and Self-Employment Income
The 0.9% Medicare tax on earned income applies to Medicare wages and self-employment income in excess of $250,000 for joint files and $200,000 for single filers. Self-employed taxpayers currently pay 15.3% self-employment tax, which increases to 16.2% after addition of the 0.9% Medicare tax once the Medicare wage threshold is exceeded.
The New Maximum Tax Rate of 39.6%
The highest tax rate on ordinary income (including short term capital gains) is increased from 35% to 39.6%. This higher tax rate applies when taxable income exceeds $450,000 on a joint return or $400,000 on a single return. This is a different threshold from the Medicare taxes whose threshold is based on modified adjusted gross income. The threshold for the 39.6% tax rate is based on taxable income which is adjusted gross income reduced by the standard deduction or itemized deductions, and personal exemptions.
Additionally, when taxpayers’ taxable income exceeds the $450,000/$400,000 thresholds, the long term capital gain rate and qualified dividend tax rates are increased from 15% to 20%.
Death by a Thousand Cuts
Things get ugly when the above taxes are stacked on top of each other. For example, in 2012, short term capital gains were taxed at a maximum 35% ordinary income rate. For married taxpayers over $250,000 modified AGI, the maximum short term capital gain rate is 38.8%. If these married taxpayers also have taxable income in excess of $450,000, the short term capital gain rate is 43.40%. This is just the federal tax, then you have to add 4.25% Michigan tax for a maximum tax rate of 47.65%!!!
Example: John is a married filing joint filer and has taxable income of $500,000. He has a short term capital gain of $10,000. This gain is taxed at 43.4% so the tax is $4,340. He also pays Michigan income tax of 4.35% or $435 for a total tax of $4,775. John will be able to deduct the $435 state tax on his federal tax return…unless AMT applies.
The long term capital gain rate and qualified dividend rate in 2012 were 15%. When the Medicare tax applies, this tax rate is increased to 18.8%. When married taxpayers’ taxable income hits $450,000, this tax rate is increased to 23.8%. This 23.8% rate is based on the higher 20% capital gain rate when taxable income hits the $450,000/$400,000 threshold plus the 3.8% Medicare tax when modified AGI exceeds $250,000/$200,000.
Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.