Thanks to the fiscal cliff, President Obama, Congress and the highest court in the land, there are many tax law changes to keep in mind as you prepare 2013 income tax returns and start thinking about 2014 tax planning.
For starters, the American Taxpayer Relief Act of 2012, which was the fiscal cliff agreement, established new tax rates and rules for many taxpayers. In addition, an important Supreme Court decision has greatly altered the tax law landscape for same-sex spouses. Here are some of the significant changes, as well as some general tips related to filing tax returns this year.
Same-sex marriage. In June 2013, the Supreme Court decided that part of the Defense of Marriage Act was unconstitutional and that federal law must recognize same-sex marriages sanctioned by state law. As a result, starting with the 2013 tax year, same-sex spouses are required to file a federal income tax return reflecting their marital status, either as married filing jointly or married but filing separately.
Many same-sex couples may find that this comes with the dubious privilege of having a greater income-tax liability. The so-called marriage penalty tax can force two-earner couples into a higher tax bracket and require them to pay more than they would if they had filed as nonmarried individuals.
Combining incomes may also make it harder for a same-sex couple to qualify for many other federal tax and nontax benefits, such as deducting contributions to an IRA or qualifying for tax credits for college costs. Finally, their state income tax filing status varies, depending on the rules of a given state.
Higher taxes on income, dividends and cap gains. Because of the American Taxpayer Relief Act, rates increased for most taxpayers starting in 2013. The temporary reduction in the Social Security tax from 6.2% to 4.2% was allowed to expire at the end of 2012, which meant an increase of $2,000 in taxes for $100,000 of wages. Also, for high-income taxpayers, the tax rate on ordinary income (wages, interest, rental income, etc.) increased, as did the tax rate on capital gains and dividends. These increases are just the basics. Several other new taxes that became effective in 2013 will further increase marginal tax rates.
Surtax on earned income. The Affordable Care Act introduced many new taxes to pay for the expansion of health care, and those have gradually become effective over the last few years. Starting in 2013, there was a new 0.9% surtax on salary and self-employment income above $200,000 for an unmarried individual and $250,000 for a married couple. Even if taxpayers are not affected now, over time they may be, even with salary increases that do not exceed the rate of inflation.
Surtax on investment income. The ACA also introduced a new 3.8% tax on investment income for individuals making more than $200,000 and married couples making more than $250,000. Like the surtax on earned income, the income thresholds for the surtax on investment income are not indexed for inflation. So, over time, more taxpayers, particularly those in two-income families, will become subject to the tax.
Personal exemptions and itemized deductions limited. ATRA allowed the return of limitations on personal exemptions and itemized deductions that were eliminated in 2010. They promise to make the tax system more complicated and less transparent. In general, taxpayers lose more of the benefit of personal exemptions and itemized deductions as income increases. These changes are estimated to increase the tax burden of a married couple with no children by around 4%.
Theres also a new, higher threshold for deducting medical expenses. Such medical expenses can now be claimed only if they exceed 10%. For taxpayers who are 65 or older, the 7.5% rule continues to apply until 2017.
Beware the IRA charitable contributions trap. For 2013, Congress extended the provision allowing individuals age 70½ or older to make up to $100,000 of charitable contributions using IRA required minimum distributions. The benefit of this approach is a complete income exclusion, as compared to the usual income inclusion with a charitable deduction that may or may not offset the income. However, theres a trap for the unwary: If a taxpayer uses this provision, the IRA provider will still send a Form 1099-R showing it as a taxable distribution. Be sure to include the 1099 information on the return and properly note it as a qualified charitable contribution.
IRS tax-filing season delay. Because of the government shutdown, the IRS tax-filing season started on Jan. 31, 10 days later than usual. That might mean a longer than usual time to process income tax returns. Consider filing electronically as soon as possible to speed up any refund. If money is owed, by filing early and electronically the taxpayer can choose a payment date on or before April 15. Payment may be made by check, debit card or credit card, or via an electronic funds transfer. Credit card payments will be subject to an additional fee.
An IRS audit will be a reality for many. Audits are down as the IRS struggles with reduced funding and increasing demands because of identity theft and the rollout of the ACA. Although there is less than a 1% chance of audit, its still a reality for many Americans, especially higher-income taxpayers. For those who make more than $1 million, chances of an audit skyrocket to more than 12%. For incomes from $200,000 to $1 million, the chances of audit are almost 3%.
Regardless of income level, if deductions are higher than the norm for that income level, the IRS may want to know more about the return. Other audit-friendly circumstances include owning a cash business or reporting business income on Schedule C, because deductions for meals and business expenses are viewed by the IRS as ripe for overstatement.
But dont forgo legitimate tax-minimizing positions simply to avoid audit. The best protection is to report all income, make sure all deductions are appropriate and keep good records.
Robert A. Fishbein is a vice president and corporate counsel with Prudential Financial, where he provides tax law guidance with respect to the development, marketing, sale and administration of life insurance, annuity, long-term care insurance, disability insurance and mutual fund products.