Getting Ready for Large Tax Increases – Taking Stock of what is in Store

We are now six months away from some of the largest tax increases imposed on US individuals in just over 17 years. More importantly, for the first time in 24 years, tax rates on capital gains will be increasing next year. During the coming weeks, I am going to examine what you can do to make the best of these important tax law changes. We’ll start in this post, by getting a “lay of the land.” 

The Obama Administration has proposed extending the Bush Administration’s ordinary income tax cuts only to taxpayers in the low to middle income tax brackets while allowing the two highest tax brackets, now 33% and 35% to return to 36% and 39.6% in 2011. At that time, the 39.6% rate will apply to income above $375,700 for individual and married taxpayers, and the 36% rate will apply to individual taxpayers with greater than $192,000 in income or $232,950 for married couples. 

Taxes on income earned from net long-term capital gains (LTCGs) and qualified dividends also will be increasing from 15%. Without new legislation, beginning in 2011 capital gains tax rates will increase to 20% for taxpayers subject to marginal income tax rates greater than 15% while dividends will be taxed at ordinary income tax rates. Although the Obama Administration is proposing a 20% tax rate for capital gains and dividends for individual taxpayers with income in excess of $194,050 or $235,450 for married couples, given the need for revenue, it would be much easier for the President and Congress to simply let the Bush tax cuts expire without doing anything. As a result, qualified dividends may be subject to ordinary income rates beginning in 2011.  

After 2010, the overall limitation on itemized deduction (i.e., the so-called “Pease limitation) will be restored. As a result, itemized deduction (other than medical expenses, casualty losses, investment interest, and gambling losses) will be reduced by the lesser of (1) 3% of the amount of the taxpayer’s income exceeding the applicable threshold or (2) 80% of the deductions subject to the limit.  In addition, after 2010 the $3,650 personal exemption will be fully phased-out for individuals and married couples with adjusted gross incomes  in excess of $289,300/$372,700 respectively (based on 2009 limits). Because these limitations do not apply in 2010, these important benefits (itemized deductions and personal exemptions) will be preserved, regardless of the amount of capital gain accelerated to 2010. 

To make matters worse, starting in 2013 individual and married taxpayers with income in excess of $200,000/$250,000 respectively also will pay a 0.9% surcharge on earned income and a 3.8% surtax on investment income (dividends, interest, long-term and short-term capital gains, passive income, rents and royalties).   

The tables below illustrate the tax rates to which taxpayer will be subject: 

**    Health Care Tax will take effect in 2013
*** Gains on assets held more than 5 years taxed at 2% less