Tax shock ahead for wealthy
By: Brian Faler
January 10, 2014 09:43 AM EST
The wealthy may be in for a bit of a jolt this tax season.
That’s because Democrats have pushed through several new taxes on the well-to-do — many coming online this year — making the top tax bite steeper than advertised. By how much is a matter of opinion, but some experts say the true top rate is about 45 percent — 5 percentage points higher than the usual sticker price or higher still depending on what’s included in the mix.
“People are going to be very surprised in April,” said former Congressional Budget Office Director Robert Reischauer.
Democrats are pushing to make income inequality a major election-year issue with high-profile bids to extend jobless benefits and raise the minimum wage. But they’ve already had some victories moving the tax burden up the income ladder, reversing Bush-era policies that had slashed levies on the rich, especially on investment income.
Taxes on capital gains, for example, top out at 25 percent, once various surcharges are included, a sharp increase from 2012.
Some of the taxes won’t begin being paid until this year so many taxpayers may not yet realize their impact.
The newest taxes, designed to help defray the cost of Obama’s 2010 health care law, didn’t begin taking effect until the 2013 tax year. One requires individuals earning more than $200,000 and couples above $250,000 to pay an additional 0.9 percent Medicare tax, in addition to the program’s 2.9 percent payroll tax. That’s projected to raise $87 billion over a decade, according to Congress’s Joint Committee on Taxation.
Though tax-filing season doesn’t begin until Jan. 31, some may already be feeling the bite because employers are required to withhold the tax from individuals earning more than $200,000.
Thanks to quirks in the law, some may be subject to the tax but not paying it while others who are exempt may nevertheless be paying it, said David Kautter, managing director of the Kogod Tax Center at American University.
That’s because the law requires employers to withhold the tax from employees earning $200,000 even if they file jointly and, as a married couple, their combined income is not enough to subject them to the levy. In those cases, the IRS will make it up to them later with a bigger tax refund.
“You can sleep easier knowing you’ve made an interest-free loan to the U.S. Treasury,” he said.
Conversely, employers won’t withhold it from those making less than $200,000 even if, as a married couple, their combined income requires them to pay. In those cases, taxpayers will have to adjust their income tax withholding or pay estimated taxes in order to avoid underpayment penalties, he said.
The health care law also imposes a new 3.8 percent “net investment” tax on capital gains, dividend, interest and other investments, in addition to the regular 20 percent capital gains tax. That’s expected to generate $123 billion over a decade.
Those two provisions alone mean those earning more than $1 million will see their tax bills increase by an average $41,000, cutting their after-tax income by about 2.2 percent, according to the nonpartisan Tax Policy Center.
“It’s not like they’re going to miss meals,” said Bob Williams, a fellow at the nonpartisan group. “But as a share of income, it’s a substantial change. … Those are not small numbers.”
The increases come on top of ones Democrats won last January as part of the fiscal cliff agreement. That upped the top tax rate to 39.6 percent, from 35 percent, the first increase in a generation. It applies to individuals earning $400,000 and couples earning $450,000 or more.
The deal also included other, stealthier increases on high earners. One provision, known in the tax world as “Pease,” reduces the itemized deductions they may take by 3 percent of every dollar for individuals who earn above $250,000. That adds about 1.2 percentage points to the top rate, Kautter said.
Another provision, known as “PEP,” phases out the value of the personal exemption by 2 percent for every $2,500 earned above $250,000.
It’s no accident that some of the increases come in complicated formulas, said Clint Stretch, senior tax counsel at the nonpartisan Tax Analysts. Politicians find it easier to approve hard-to-understand increases than straightforward rate hikes.
“Congress is afraid of raising people’s taxes,” Stretch said. “So if you can play some games with them” or “if you can do it in a way that people cannot possibly understand what the hell you’re doing,” it is easier to swallow, he said.
All of that means the actual top rate is 44.6 percent, Kautter said.
That doesn’t mean the wealthy pay 45 percent of their income in taxes. Marginal rates are applied to the last dollar earned and they increase like stair steps. So someone earning $500,000 pays the same rate on say, the first $75,000 as a person earning just $75,000. As income increases, higher rates apply.
He adds the combined 3.8 percent Medicare tax as well as the 1.2 percentage point Pease increase to the 39.6 percent rate (in 2013, the 12.4 percent Social Security tax only applies to the first $113,700 in income). The Pease provisions also apply to capital gains, which, along with the 3.8 percent investment tax, push their top rate to 25 percent. In 2012, the top rate was 15 percent.
That will cut the after-tax income of the top 1 percent, who earn at least $506,000, by about $50,000 or about 4.5 percent, according to the Tax Policy Center. The bite is much bigger for the very rich. Those who earn at least $2.6 million, enough to put them in the top one-tenth of 1 percent, will lose about $322,000 or about 6.2 percent of their income.
Of course, the wealthy have savvy tax planners who can minimize these new levies.
Kautter predicted the new investment tax would inspire new forms of tax avoidance, as the rich shift money into forms and vehicles not subject to the levy.