It could have been worse, but 2013 ushered in the most significant changes in the tax code for more than a decade.
For most American taxpayers, the resolution of the fiscal-cliff drama early last year was good news. The Bush-era tax cuts were made permanent for people in all but the top income-tax bracket; ditto for the low 15 percent tax rates on qualified dividends and capital gains. The deal even included a fix—of sorts—for the dreaded alternative minimum tax (AMT) that has annually threatened millions of taxpayers for years.
For wealthier taxpayers, however, the American Taxpayer Relief Act (ATRA) didn't live up to its name. They now face higher marginal tax rates, new investment income taxes to finance the president's health-care plan, and limitations on the itemized deductions they can claim. The combination of those policy changes will account for the bulk of the $600 billion in new tax revenue the government is expected to take in over the next 10 years as a result of ATRA.
"There were not a lot of big changes last year for middle-income taxpayers," said Dustin Stamper, director of the Washington National Tax Office at Grant Thornton LLC. "The hit was primarily to high-income taxpayers."
There are enough changes that taxpayers of all income levels are likely to find filing their returns more complicated this year. Here areeight of the biggest affecting 2013 returns.
1. Higher marginal rate
President Obama got his wish: Rich folks are going to pay a little more this year. In fact, they're going to pay quite a bit more. The top marginal tax bracket for people making more than $400,000 annually ($450,000 for married couples) was upped to 39.6 percent. That's still quite low from an historical perspective, but it's the highest marginal rate since 2000. Add in the new 0.9 percent Medicare surtax on earned income over $200,000 and the top rate is over 40 percent. The income-tax rates on all earned income below the $400,000 threshold remain unchanged from 2012.
2. New Obamacare taxes
President Obama's Affordable Care Act is being financed largely by two new taxes on wealthier Americans. The first is a new 0.9 percent Medicare surtax that applies to all earned income over $200,000 ($250,000 for married couples). On top of the 1.45 percent tax on income below that threshold, the combined Medicare tax on income above it will be 2.35 percent.
Taxpayers with more than $200,000 in annual gross income (AGI) are also subject to a 3.8 percent tax on investment income—which includes interest, dividends, capital gains, royalties and passive business income. The tax is not entirely straightforward. It's levied on the lesser of an individual's investment income or the amount that their AGI exceeds the $200,000 threshold—again, $250,000 for married couples.
If a single filer reports $210,000 in income—$50,000 of which is investment income—the 3.8 percent tax applies to the $10,000 above the threshold. If they make $300,000, it will apply to the $50,000 in investment income. "It's a big topic of discussion with my clients," said Rebecca Iacobellis, a CPA based in Staten Island, N.Y., whose client base includes a number of small-business owners. "The threshold amounts aren't indexed for inflation, so it will start affecting more small-business owners going forward."
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3. Capital gains bite
The third big hit to wealthy taxpayers is an increase in the tax rate on qualified dividends and capital gains, from 15 percent to 20 percent for single taxpayers with AGI over $400,000. The rate remains 15 percent for taxpayers in lower tax brackets and 0 percent for taxpayers in the 10 percent and 15 percent income-tax brackets.
4. Limited deductions
After a three-year hiatus for wealthy taxpayers, the so-called Pease limitations—named after the Democratic congressman who introduced them in 1990—are back in force for the 2013 tax year. The rule limits the amount of itemized deductions that taxpayers with more than $250,000 in adjusted gross income ($300,000 for married couples) can claim on their tax returns. The limitation applies to things like mortgage interest, charitable contributions and state and local taxes but does not apply to items such as medical expenses, investment interest and casualty and theft losses.
Itemized deductions are reduced by 3 percent of the amount a taxpayer's AGI exceeds the thresholds, up to a maximum of 80 percent of total deductions. For example, a married couple with $400,000 in combined AGI will have their itemized deductions reduced by $3,000 (3 percent of $100,000). "The Pease limitations were not in effect between 2010 and 2012, but they made a comeback last year," said Stamper.
5. Lower medical-expense deductions
Another aspect of the Affordable Care Act will hit a wider range of taxpayers. Per ACA, the threshold for deducting medical expenses was raised from 7.5 percent of adjusted gross income to 10 percent. Taxpayers can now deduct only the cost of copays, insurance plan deductibles (both of which are generally rising), dental costs and other health-care expenses above 10 percent of their AGI. If you're over the age of 65, the 7.5 percent rate applies until 2017.
"The idea is to limit the deductions taken by higher-income taxpayers, but this could apply to almost anyone," said Iacobellis.
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6. The AMT fix
Higher-middle-income taxpayers no longer have to worry about an increasingly dysfunctional Congress agreeing on an annual "patch" for the alternative minimum tax. The tax was never indexed to inflation, and Congress has often waited perilously long to adjust the exemption amount to avoid millions more Americans having to pay it. As part of the ATRA, the exemption amount—$51,900 for 2013—is now indexed to inflation.
7. Home-office deduction
Another favorable change in 2013 is a standardized deduction for home-office expenses. Form 8829 is complicated enough that taxpayers were often getting into trouble claiming too much in deductions for home offices, said New York City–based CPA Vincent Cervone. They can now take a standard $5-per-square-foot deduction, up to 300 square feet, for a maximum deduction of $1,500 per month.
"This affects a lot of people," said Cervone. "More Americans are filing Schedule C's now, and 95 percent of those claim the home-office deduction."
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8. Same-sex marriage
For better or for worse, same-sex partners can now file their federal tax returns jointly if they wish. With the Supreme Court ruling that the Defense of Marriage Act was unconstitutional last year, married gay couples have the choice of filing jointly or separately and can take advantage of the same marriage benefits. With state laws varying, however, many may have to continue filing their state tax returns separately.
In most cases, it makes sense for same-sex couples to file jointly, said Cervone. But people could be surprised with a tax bill this year if they lowered the amount of tax withheld at work because they're filing jointly for the first time.
"I tell my same-sex clients filing jointly not to change their withholding at work. The tax rate may be lower, but they could end up in a higher tax bracket," said Cervone.
—By Andrew Osterland, Special to CNBC.com