Taxpayer Sticker Shock

By Steve Barlotta, CPA

Sticker shock can be defined as disgust, shock, or fright upon learning the price of an item offered for sale. Well, many upper-income taxpayers experienced something very similar to this recently when they filed their 2013 tax returns. While most of these individuals knew their 2013 tax liability would increase somewhat, they were very surprised to the extent of their tax hike.

Many of these taxpayers believed that all would be well if their federal withholding was adjusted according to the updated IRS income tax withholding table. This adjustment only addressed the increase in marginal tax rates for upper-income taxpayers from 35% to 39.6%. Unfortunately, there were many other tax increases that went into effect on January 1, 2013 that were not accounted for; causing an unpleasant experience for a lot people at “tax time”.

Let’s take a brief look at these tax increases that went into effect in 2013:

As I mentioned above, the top tax bracket increased from 35% to 39.6% for individuals with at least $400,000 of taxable income or married couples with at least $450,000 of taxable income.

There were two Obamacare tax increases; the first one is a .9% Medicare surtax on earned income. It applies to joint taxpayers with wages above $250,000, and single filers with wages over $200,000. This tax also applies to self-employed individuals with incomes in excess of the above thresholds. For many upper-income filers, this tax was automatically withheld through a payroll deduction once their incomes exceeded $200,000.

The other, and more problematic, Obamacare tax increase is a 3.8% Medicare payroll tax on unearned income. This includes investment income like interest, dividends, capital gains on the sales of investments like stocks, bonds, second homes and rental properties. Also, affected by this surtax is passive income from real estate and investments; including rental income from residential properties. The 3.8% tax applies to joint tax taxpayers with modified adjusted gross income (MAGI) above $250,000 and single filers with MAGI over $200,000.

Then there are limitations on certain deductions that I like to refer to as “back door” tax increases. One is the phaseout of personal exemptions for couples with $300,000 or more of adjusted gross income (AGI), or single taxpayers with $250,000 or more of AGI. The exemption gets phased out completely for married taxpayers at $422,500 of AGI, and $372,500 for single filers. The personal exemption for 2013 was $3,900. So, a couple with three children whose AGI exceeded the limits discussed above would lose $19,500 in deductions for their exemptions.

The other “back door” tax increase is the itemized deduction limitation. It encompasses all itemized deductions like mortgage interest, property taxes and charitable contributions. Married taxpayers with $300,000 or more of AGI, or singles with AGI of $250,000 or more, can lose as much as 80% of their itemized deductions.

So, it’s easy to see how this confluence of rate increases, new taxes and deduction limitations created a perfect storm of tax increases for many upper-income taxpayers. The question is, how can these filers be better prepared for 2014?

For those taxpayers that receive their income via a W-2 they can apply a fixed percentage rate to their federal tax withholding. To determine a percentage to be withheld from your wages, divide your 2013 tax liability by your 2013 W-2 federal wages. For those taxpayers that have self-employment income, pay estimated taxes in 2014 based on the amount of tax that was due on your 2013 federal tax return.

While both solutions are not full-proof, it can help mitigate any potential underpayment penalties imposed by the IRS and unpleasant surprises at tax time next year.