From taxation of municipal bond interest to tax rates on the gain from a home sale, taxpayers are confused about what’s taxed and what’s not under the new American Taxpayer Relief Act and other recent laws.
In this special Retirement Adviser report, three tax experts clarify how the new rules work and how they affect retirement savings.
New tax law affects everyone more or less
Firstly, there is a misconception that the new tax law affects only the highest income taxpayers. While it’s true the law probably has the biggest impact on those with higher incomes, there are changes for all employees and self-employed individuals, according to Michael Jackson, partner with Grant Thornton and a leader of that firm’s private wealth services team.
“Most retirees who are making less than $250,000 if they’re married, or $200,000 if they are single, aren’t really going to see a change in their taxes,” said Jackson, who was speaking as part of a roundtable discussion at a recent MarketWatch Retirement Adviser event in San Francisco, hosted by Robert Powell, editor of MarketWatch’s Retirement Weekly e-newsletter. “The taxes that were in effect for 2012 and prior basically got extended under the new laws. So, their tax liability shouldn’t change.”
Meanwhile, all employees and self-employed individuals have to contribute a larger portion of their paychecks to Social Security in 2013 than they did in 2011 and 2012. For 2013, the employee’s portion of Social Security taxes, officially old age, survivor’s, and disability insurance (OASDI), is 6.2% and for self-employed individuals it’s 12.4%. (Of note, in 2013, the OASDI tax applies only to $113,700 of wages and self-employment income.)
“Those who have income through salary or wages will see a little bit of a spike up with the repeal of the two percentage point reduction in Social Security taxes that was in effect in 2011 and 2012,” said Jackson. “But their income taxes shouldn’t change.”
Sale of principal residence
Another misconception that exists in the real world of taxpayers has to do with the sale of a principal residence. “There is a misconception out there that the old one-time exclusion of $125,000 is still out there and that taxpayers can roll over the gain into a new property,” said Jackson. “Those rules were replaced many, many years ago.”
According to Jackson, when you sell your home, you generally can exclude up to $250,000 ($500,000 for joint filers) of gain if you’ve used it as your principal residence for two of the preceding five years. “If their gain is less than $500,000 or $250,000 they don’t pay any tax on the sale of their home,” Jackson said. “And that money can be put to use for their retirement.”
Mary Kay Foss, a director at Sweeney Kovar and an instructor for the CalCPA Education Foundation, also noted that taxpayers who have gains in excess of the $250,000/$500,000 limit may not have reason to fret. The taxpayer’s gains over the limit are added to their other capital gain/loss transactions to determine if there is a tax. “So, even if they pass the one threshold they still might not have to pay that additional tax,” said Foss. This is especially true if they have capital loss carry-overs.
Taxpayers who sell their principal residence do, however, have to worry about some of the provisions of the Affordable Care Act which went into effect in 2013. For instance, the gain on the sale of a principal residence may or may not be included in what’s called the Net Investment Income tax (NII) calculation, according to Jackson.
The NII tax is imposed by section 1411 of the Internal Revenue Code. The NII tax applies at a rate of 3.8% to certain net investment income of individuals, estates and trusts that have income above the statutory threshold amounts, according to the Internal Revenue Service (IRS). Read Net Investment Income Tax FAQs.
In essence, individuals will owe the tax if they have NII and also have modified adjusted gross income over the following thresholds: married filing jointly, $250,000 and single, $200,000.
So, if a taxpayer filing single and who has a reportable gain on the sale of their principal residence will have to add the amount over the $250,000 threshold to their NII. And that amount may be subject to what’s also called the Medicare surtax.
Itemized deduction limit affects charitable deductions
The ATRA also brought back the itemized deduction limit, also known as the “Pease” limitation, which reduces the total amount of a higher income taxpayer’s allowable itemized deductions. Allowable itemized deductions can include charitable contributions, as well as mortgage interest, state and local income taxes, real estate taxes and medical expenses.
Under the Pease limitation, the experts noted, the deduction is reduced by 3% of the amount by which the taxpayer’s adjusted gross income (AGI) exceeds the income threshold. The income threshold at which Pease kicks in for 2013 is $250,000 for individuals and $300,000 for married couples filing jointly (adjusted for inflation in subsequent years).
However, the amount of itemized deductions under Pease cannot be reduced by more than 80%. Also, certain items, such as medical expenses, investment interest and casualty or theft are excluded from the Pease limitation.
Jackson said there is “big misconception out there that if people are spending more on charitable contributions that they’re not going to get the full benefit of them.”
But that is not the case, he said. “The Pease limitation is not a limitation on the deduction itself,” said Jackson. “It’s calculated based on your income.”
According to Jackson, this represents yet another area where taxpayers can plan for their income levels to help determine how much they’re going to be able to save on their taxes. For instance, if taxpayer is losing 3% of their adjusted gross income in excess of the $300,000 threshold that is going to come right off the top, he said. Your limitation on deductions is tied directly to your income in excess of the applicable threshold, so “If you add another $1 of deduction on top of all of your other deductions, you are going to get the full value of that dollar’s worth of deduction,” said Jackson. “So, that next dollar that is going to charity is going to give them a tax benefit.”
The experts also advised taxpayers against giving less to charity because of 3% haircut. “If you have a taxpayer who’s paying state income taxes you can look at in such a way that their state income taxes are basically what they’re losing,” Jackson said. “And every dollar they’re giving to charity they’re actually going to get a benefit for. The only taxpayers who are going to lose their charitable deductions are when they really don’t have any other deductions to absorb that 3% haircut.”
Jackson did, however, note that taxpayers ought to plan their charitable donations so that they don’t pay more than their fair share of taxes to the government. “The timing of events is very, very important,” said Jackson. “So, while you may be charitably inclined, it is still important to take a look at how it impacts your overall tax situation so you can get the best benefit for those charitable contributions. And if it’s going to be limited in a particular year, you may want to spread them out over multiple years.”
Foss said taxpayers should also be reminded that the Pease limitation is merely an old law that’s come back on the books. “People don’t realize that this is the same old, same old that we had a few years ago,” she said.
Meanwhile, Frank Paré, an instructor in the personal financial planning program at the University of California Berkeley and the founder of PF Wealth Management, reminded taxpayers against making charitable decisions solely on whether they get a deduction on their tax return.
“Your motivation for giving to charity should not be solely related to tax planning, but maybe what you hope to accomplish by donating to that charity. I don’t mean to judge a person for whatever their charitable inclinations might be, but at the end of the day when we make a decision to give to a charitable cause it’s because we believe in the cause, not necessarily because of the tax benefits we might get as a result.”
Another misconception about the new ATRA law has to do with municipal bonds.
Some taxpayers, for instance, think the interest from such bonds is taxable. It’s not. The interest is federal and state income tax free. “Municipal bond interest is still completely tax free,” said Jackson, who also noted that retirees who find themselves in higher tax bracket might examine the tax equivalent yield on municipal bonds.
But even though the municipal bond interest itself is not taxable, it’s possible that taxpayers who don’t hold their bonds to maturity might have a taxable gain when should they sell their bonds. And that could all sorts of tax headaches.
“In the instance where they’re looking to diversify out of their municipal bonds and they go ahead and they sell a bond that hasn’t been held to maturity there could be some taxable gain on that bond which again will create more gross income and potentially subject their income to the additional Medicare tax or a higher limitation on their itemized deductions,” said Jackson.
Foss also noted that taxpayers who purchased a municipal bond at a premium and then sell that bond before maturity below the premium cannot deduct a loss. “People think I bought this (bond) in excess of the par value, so when it comes due I can deduct that loss and you cannot do that with a municipal bond,” she said.
Robert Powell is editor of Retirement Weekly, published by MarketWatch. Learn more about Retirement Weekly here.Follow his tweets at RJPIII.
Robert Powell is a MarketWatch Retirement columnist. He has been a journalist covering personal finance issues for more than 20 years. Follow him on Twitter @RJPIII.
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