Easy Finance4u

One Tax System? How about Four!

tax system

Most taxpayers do not realize it, but there are four — that’s right, four — income tax systems to contend with. Many think about only traditional federal taxes, but actually there are state and two more federal systems to be considered in determining the total tax bite each year: the alternative minimum tax and the net investment tax.

Let us first examine the alternative minimum tax (AMT). Its current form came about in 1982 as a means of having high-income individuals pay a minimum amount of income tax and not use preferential tax deductions to eliminate taxes all together. The AMT is figured by starting with “regular” taxable income, adding “tax preference” items and then subtracting an AMT exemption to arrive at alternative minimum taxable income.

According to the Tax Policy Center, over thirty one million tax returns were subject to the AMT in 2012. Depending on the level of AMT taxable income, either the 26% or 28% tax rate applies on the income. Some of the more common “add-backs” in determining income subject to the AMT include state income and local property tax deductions, certain mortgage interest and miscellaneous itemized deductions.

If a person pays high state income taxes, such as in California, the AMT stands a good chance of applying. That large deduction for state income taxes has to be added to regular taxable income in arriving at “alternative minimum taxable income.” Also, if a person does not use home equity line of credit proceeds to buy, build, or substantially improve the main home, then such interest is also added back to determine income subject to the AMT. The alternative minimum taxable income has to exceed the exemption amount ($51,900 single and $80,800 married filing jointly) before the tax applies.

In order to help fund the benefits under the 2010 Affordable Care Act, a new 3.8% surtax is imposed on net investment income beginning in 2013. When the surtax applies, the new, top income tax rate goes from 39.6% to 43.4%. If the newly minted 0.9% Medicare tax on wages is added into the mix, the top rate climbs even higher to 44.3%.

The new 3.8% surtax is levied on the lesser of: 1.) net investment income; or 2.) modified adjusted gross income minus $200,000 for single or $250,000 for married taxpayers. Net investment income includes interest, dividends, rents, royalties and capital gains reduced by expenses allocable to such income, such as investment adviser fees, investment interest and expenses related to rent and royalty income.

The new tax does not apply to IRA or other qualified plan income or investment income related to a trade or business. For example, capital gain resulting from the sale of a business generally escapes the surtax. Strategies to reduce the tax include managing income levels to stay under the thresholds mentioned above and increasing participation in an investment to have it classified as a trade or business. For example, although IRA income is not subject to the tax, delaying a large IRA distribution income could prevent a person from going over the thresholds that trigger the tax.

The old rules no longer apply. Everyone must be aware of the four tax systems out there. Be on guard!

Also Read: 10 Financial Planning Moves to Start the New Year!

Related posts

Leave a Comment

This website uses cookies to improve your experience. We'll assume you're ok with this, but you can opt-out if you wish. Accept Read More