It’s no secret that high-income households have historically paid more than their fair share of income tax relative to their numbers.
For the 2013 filing season for 2012 individual income tax returns, as of July 25, 2013, IRS processed 137 million returns with adjusted gross income, or AGI (gross income minus deductions for AGI), totaling $7.6 trillion and income tax after credits totaling $894 billion. Of these returns, filers with AGI of $250,000 or more were responsible for:
- 2.5 million, or 1.8%, of total returns
- $1.4 trillion, or 18.4%, of total AGI
- $330 billion, or 36.9%, of total income tax after credits
2014 tax-season postmortem
Although the IRS hasn’t released statistics yet for the 2014 filing season, I recently completed a tax-season postmortem review of my tax-preparation clients’ 2013 income-tax returns. This is an annual ritual that I perform to assist clients with current-year income tax planning. It involves a detailed analysis of the various components of my clients’ income-tax returns to determine what steps can be taken to reduce their income-tax liability in the current year.
To analyze the impact of the various 2013 tax law changes, I supplemented my traditional review with preparation of pro forma, or “what if,” 2012 income-tax returns using 2013 income and deductions for clients in the top three tax brackets of 33%, 35%, and 39.6%. In other words, I applied the tax law in effect in 2012 to my clients’ 2013 tax returns.
In 2013, you were subject to the 33% rate when your taxable income (AGI minus the greater of itemized deductions or the standard deduction minus personal exemptions) exceeded approximately $183,000 if you used single filing status or $223,000 with joint filing status. You entered the 35% bracket at $398,000 with single or joint filing status. Finally, taxable income of $400,000 (single) or $450,000 (joint) subjected your taxable income to a 39.6% rate.
Even though I studied, wrote about it on my website and did extensive income tax planning to reduce the fallout from the 2013 tax law changes, the review that I completed for the 2014 tax filing season was eye-opening. As expected, the impact on clients in the 33% and 35% tax brackets was minimal, with average income tax increases of 1.2% and 2.9%, respectively, for the same income and deductions in 2013 versus 2012.
It was a much different story, however, for clients in the 39.6% bracket. The average AGI for these clients exceeded $1.4 million in 2013. Their average income tax after credits was $436,000, or $51,000 greater than their pro forma 2012 average income-tax return liability of $385,000 with identical income and deductions.
Despite the fact that the top federal tax bracket increased by only 4.5%, going from 35% in 2012 to 39.6% in 2013, the average increase in federal income-tax liability for my top bracket clients was 13.3%, or approximately triple the amount of their tax bracket increase. Several clients approached, or exceeded, an increase of 15% in their 2013 versus 2012 pro forma income-tax liability, once again using identical income and deductions.
2013 income tax law changes
How is it possible that an increase of 4.5% in the top tax bracket can result in a 13% to 15% increase in income tax liability in 2013 compared to 2012 with identical income and deductions? The answer lies in the fact that the increase in the top tax bracket was just one of several changes, the cumulative effect of which wreaked havoc on high income households.
In addition to the increase in the Social Security tax rate from 4.2% to 6.2% (which wasn’t included in my 2014 tax-season postmortem analysis since it wasn’t an income-tax law change), there were six changes in the tax law that were responsible for a decline in spendable income for high income filers in 2013.
The common theme of the six changes is that they’re all income-driven. Their impact is felt as you exceed defined income thresholds. The thresholds begin at modified adjusted gross income of $200,000 and $250,000, for single and joint filing status, respectively, for the Medicare earned income tax of 0.9% of earned income and the Medicare investment income tax of 3.8% of net investment income.
Adjusted gross income, AGI, of $250,000 (single) and $300,000 (joint) drives the itemized deductions limitation and personal exemption phaseout. The limitation on total itemized deductions resulted in an average loss for my clients of 14% of otherwise allowable deductions, i.e., after limitations on individual deductions were applied. Finally, when taxable income exceeds $400,000 (single) or $450,000 (joint), in addition to the top tax bracket increasing from 35% to 39.6%, long-term capital gains and qualified dividends are taxed at a 20% versus 15% tax rate.
In summary, if you were in the 39.6% tax bracket in 2013, the 4.5% increase in your tax bracket, combined with additional income-tax liability resulting from additional tax on Medicare wages, a loss of itemized and personal exemption deductions, a 5% surcharge on long-term capital gains and qualified dividends, and the 3.8% tax on net investment income, reduced your spendable income considerably. The damage was greater for those subject to state income tax to the extent that unfavorable state tax law changes took effect in 2013.
Begin your 2014 income-tax planning now
If you haven’t done so already, I would recommend that you begin your 2014 income-tax planning now by preparing a detailed analysis of your 2013 income-tax returns, including the effect of the 2013 tax law changes on your returns if you were in a high income-tax bracket. Keeping in mind that the six changes are all income-driven, with most of them based on adjusted gross income, AGI, the primary goal of high-income households should be to reduce AGI using proactive income-tax planning strategies.
Assuming that the experience of my clients is in line with other high-income filers with similar AGI’s, the amount of income tax paid by high income households in 2013 was especially onerous due to the 2013 income-tax law changes.
This should be confirmed when the 2014 tax filing season statistics are released by IRS.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.