Phillips Hinch is an assistant director of government relations at FPA. Contact him at Phillips.Hinch@FPAnet.org .
Few things affect earnings more than taxes. And given that the 2001 tax cuts are set to expire at the end of 2010, it's no surprise that many FPA members are reevaluating asset allocations to include anticipated and existing changes to tax law.
FPA's 2010 Trends in Investing survey found that 43 percent of planners are reevaluating their current asset allocation strategy because of anticipated or existing income tax legislation; of those 42 percent are doing so because of investment tax legislation-including capital gains; and 24 percent because of estate tax legislation.
Despite the looming deadline, Congress has done little on this subject. President Obama has made it clear he intends to prevent any tax increases for taxpayers with incomes under $200,000 ($250,000 for joint filers), and Congressional Democrats seem inclined, so far, to hew to the president's line. For your clients above that line, it's time to start planning accordingly.
Key Tax Increases in Healthcare Reform
This article will examine some of the new tax increases passed in the Patient Protection and Affordable Care Act (PPACA). It will also look at some tax increases we could expect in the near future.
Higher Payroll Taxes and a New Tax on Savings and Investments
Payroll or FICA taxes (they're called FICA taxes because they were passed as part of the Federal Insurance Contributions Act) are broken into two parts: the old age, survivors, and disability insurance (OASDI) tax, equal to 6.2 percent of wages up to the taxable wage base ($106,800 in 2010); and the hospital insurance (HI) tax equal to 1.45 percent of all covered wages. OASDI is more commonly referred to as the "Social Security tax," because Social Security is what it funds. HI tax is usually called "Medicare tax," because HI taxes fund Medicare Part A. FICA taxes are matched by the employer. Self-employed individuals pay the employee and employer contributions, as required by the Self Employment Contributions Act (and hence their moniker-SECA tax).
To fund the recent PPACA, Congress made two significant changes to payroll taxes that start in 2013. The first is an additional 0.9 percent HI surtax on wages over $200,000 ($250,000 for joint filers). See Table 1. The net effect will be to increase the HI tax to 2.34 percent on wages above this level. The employer HI contribution is unchanged by the legislation.
Table 1: Changes to HI Surtax
|FICA taxes||Wages below cap ($106,800 in 2010)||Between cap and $200,000 ($250,000 MFJ)||Above $200,000 ($250,000 MFJ)|
|New HI surtax||-||-||0.9%|
The second change is the creation of a 3.8 percent Medicare contribution tax on investment income for high earners. See Table 2. The calculation in this instance is slightly more complicated. The tax is applied against the lesser of the taxpayer's net investment income (e.g., interest, dividends, capital gains, rents, passive income, etc.) or his modified adjusted gross income in excess of $200,000 for singles ($250,000 for joint filers). The threshold amounts are not indexed for inflation. The Medicare surtax will be in addition to the HI surtax.
Table 2: Creation of Medicare Contribution Tax
|Couple A (married filing jointly)Wages: $300,000Investment income: $50,000AGI: $350,000Threshold: $250,000 for MFJ||Individual BWages: $200,000Investment income: $150,000AGI: $350,000Threshold: $200,000 for singles||Individual CWages: $325,000Investment income: $30,000AGI: $350,000Threshold: $200,000 for singles|
|HI surtax: (300-250) x 0.9% = $450||HI surtax: (200-200) x 0.9% = $0||HI surtax: (325-200) x 0.9% = $1,125|
surtax: lesser of
(50 or 100) x 3.8% = $1,900
|Medicare surtax: lesser of (150 or 150) x 3.8% = $5,700||
surtax: lesser of
(30 or 150) x 3.8% = $1,140
|Additional payroll taxes = $2,350||Additional payroll taxes = $5,700||Additional payroll taxes = $2,265|
In addition to tax increases on high-income individuals, the healthcare reform contains a few tax changes that will affect some in the middle-class. These include:
Higher Limits on Deductions for Medical Expenses. The legislation raises the threshold for claiming an itemized deduction for unreimbursed medical expenses from 7.5 to 10 percent of adjusted gross income (AGI). That change takes effect in 2013, except for any taxpayer (or spouse) who is 65 or older, in which case the threshold remains 7.5 percent until 2017.FSAs.The legislation limits the amount that an employee can contribute under a cafeteria plan flexible spending account to $2,500. Over-the-counter medications will no longer qualify for reimbursement from an FSA without a doctor's prescription.
More Paperwork for Business Owners. Congress created a new requirement that an information report be filed for payments to corporations exceeding $600 annually. Current law only requires information reporting for such payments to individuals. The information return is generally submitted on a Form 1099. This change is not so much a tax increase as an additional burden for business owners who will now need to separately report payments in excess of $600 for such services as shipping, telephone service, wireless connection, cleaning, office equipment purchases, etc.
Congress is considering a similar requirement for the reporting of rental property expenses, such as payments to a plumber, painter, or property manager. It might already be law by the time you read this. Visit FPA's government relations federal page at www.FPAnet.org/GovernmentRelations/FederalIssues for the latest on this issue.
Likely Tax Increase in the Near Future
Each year the administration releases its budget, spelling out the president's priorities on various policy issues, including taxes. The most recent budget mirrored promises from the presidential campaign. The tax increases listed below only apply to high-income taxpayers making more than $200,000 annually ($250,000 for joint filers). The administration has recommended the amounts be indexed for inflation, however because the new payroll tax thresholds are not indexed for inflation, the outcome of this recommendation is uncertain.
Increases to the Top Marginal Income Tax Rates
The administration has proposed to extend the 2001 tax cuts for the middle class but to allow the 33 and 36 percent brackets to revert back to 36 and 39.6 percent, respectively, at the end of 2010. Certain taxpayers could receive a modest tax cut. To prevent an increase to taxpayers making less than $200,000 ($250,000 joint filers), the 28 percent bracket would be expanded up to the threshold amount. The current cutoff is $171,850 ($209,250 joint filers).
Capital Gains and Dividends
Capital gains and dividends for high-income taxpayers would be subject to a 20 percent rate, instead of the current special top rate of 15 percent. The new Medicare contribution tax discussed earlier would bring the combined top rate to 23.8 percent. The top rate for nonqualified dividends, such as those offered by REITs, would rise to 43.4 percent (39.6 + 3.8).
Limitation on Itemized Deductions, Personal Exemption Phaseout
As part of the 2001 tax cuts, itemized deductions were reduced up to a maximum of 80 percent, if the taxpayer's AGI exceeded a threshold amount. The limit on deductions (known as "Pease" after the congressman who helped create it) is not applied to medical or investment expenses or casualty losses. The personal exemptions to which taxpayers are generally entitled for each dependent were similarly phased out. The president recommends reinstating these phaseouts.
Limit Itemization Deductions to 28 percent
Deductions become more valuable and generally more numerous as one climbs the income ladder. A taxpayer in the 10 percent bracket deducting $100 sees a $10 reduction in her tax liability, but if she is in the 35 percent bracket, she receives a $35 reduction. The president's proposal would limit deductions to 28 percent.
This proposal has received considerable pushback both from Democratic and Republican members of Congress who believe that limiting itemized deductions will reduce the incentive to make charitable donations.
Example: Combining the Two Limits on Deductions
A single filer with no dependents has AGI of $310,000 and $25,000 of deductions. Her income exceeds the limit by $110,000 ($310,000 - $200,000). Her deduction would be reduced by $3,300 (3% x $110,000) to $21,700 ($25,000 - $3,300). This would reduce her tax liability by $6,076 ($21,700 x 28%). The tax reduction without either limitation would be $8,250 (25,000 x 33%). [End Screened box]
The Long-Term Outlook
Few independent economists believe that the United States can meet its fiscal obligations without raising taxes. A recent report by the non-partisan Congressional Budget Office paints a gloomy picture. Over the next decade, public debt is projected to swell from $7.5 trillion to $20 trillion. As a percentage of GDP, that is an increase from 53 to 90 percent. And the next 10 years barely begin to reflect the pressures that Social Security and Medicare will place on the federal budget. While it's impossible to know what our future tax burden will be, there's probably only one good answer-more than it is today.
Did you recently (within the past three months) or are
you currently reevaluating the asset allocation strategy you
Why did you/are you reevaluating the asset allocation
strategy you typically recommend/implement?
I continually reevaluate the asset allocation strategy I typically recommend/implement 79%
Anticipated/existing changes in the economy in general 75%
Anticipated/existing changes in specific investments 46%
Anticipated/existing changes in income tax legislation 43%
Anticipated/existing changes in investment tax (capital gains, interest, etc.) legislation 42%
Anticipated/existing changes in estate tax legislation 24%
Anticipated/existing changes in healthcare legislation 17%
Anticipated/existing changes in administrative aspects of investments (cost, lead manager, etc.) 15%
Other anticipated/existing changes in legislation 3%
Source: FPA's 2010 Trends in Investing survey
This article is part of a Trends in Investing Special Report from the June 2010 Journal of Financial Planning. For complete coverage of the Special Report, visit www.FPAjournal.org/CurrentIssue/Supplements.