Normally, one would think that Congress would have to take some action to increase taxes. However, it is quite the opposite for 2011. If Congress fails to take action, there will be a tax increase affecting just about everyone in every tax category. In order to skirt a Senate rule that requires 60 votes to pass a bill that increases the deficit beyond a ten-year window, Congress passed the Bush tax cuts in 2001 and 2003 with most provisions designed to sunset this year.
Despite President Obama's vow of no new taxes for individuals earning less than $200,000 and families earning less than $250,000, stopping these tax increases from taking place will require Congressional action. However, not only are we in an election year - when most of our politicians tend to steer away from tax-related discussions before voting day - Congress is looking for ways to make up some of the budget deficit, and many legislators consider extending the current laws to be too costly. So, we may not see any action on tax increases or extensions until late in November, if then.
To put this all in perspective, the following is a list of some of the automatic tax changes that have already taken place in 2010 or will take place in 2011 and subsequent years as a result of expiring or new tax laws.
Those Affecting 2010:
- Non-Itemizers Real Property Tax Deduction - The $500 ($1,000 for joint filers) property tax deduction for non-itemizers expired after 2009. This most likely will impact lower-income taxpayers, or those whose homes are mortgage-free and have no home interest expense, and who are unable to itemize their deductions. For taxpayers in the 15% tax bracket, this equates to a $75 tax increase (or $150 for joint filers).
- Sales Tax in Lieu of State Income Tax - The option to deduct sales tax in lieu of state income tax as an itemized deduction on a taxpayer's Schedule A expired after 2009. Although this will impact taxpayers with low state income taxes and those that purchased vehicles, boats or airplanes, it will have the greatest impact on taxpayers in states where there is no state income tax and thus no state income tax deduction to take in place of the expiring sales tax deduction.
- Farm Losses – For tax years beginning after 2009, the Farm Act limits the farming loss of a taxpayer, other than a C corporation, for any tax year in which any applicable subsidies are received. The losses are limited to the greater of (a) $300,000 ($150,000 for a married person filing separately), or (b) the taxpayer's total net farm income for the prior five tax years.
- Alternative Minimum Tax – Way back in 2001, Congress increased the AMT exemption to keep middle-class taxpayers from being caught up in this punitive tax and have been inflation adjusting and extending it on an annual basis in recent years. However, they seem reluctant to adjust it for 2010. If they do not, the exemption will return to $45,000 for joint filers (down from $70,950 in 2009) and $33,750 (down from $46,700 in 2009) for unmarried individuals. This will generally snare middle-income taxpayers, and the tax bite can range upwards to several thousand dollars.
- Teacher's Classroom Supplies Deduction – The $250 above-the-line deduction for teacher classroom supplies expired after 2009.
- Above-the-Line Education Deduction – The up-to-$4,000 above-the-line deduction for education expenses (tuition and fees) expired after 2009.
Those Affecting 2011:
- Tax Rates – As part of the Bush era tax cuts, the marginal tax rates (they increase with taxable income) were reduced to 10, 15, 25, 28 and 33 percent. These rates are set to return to their original levels of 15, 28, 31, 36 and 39.6 percent. The 10% and 15% brackets will be replaced with a single 15% bracket. This results in an increase for everyone. Those in the previously lowest bracket (10%) will see a tax increase of approximately 5%, while others will see increases ranging approximately from 2% to 6%. In addition, an expanded 15% bracket for a married couple filing a joint return has applied for several years as relief for the "marriage penalty." This will not apply as of 2011. Instead, the top of the 15% bracket for joint returns will be about 167% of the end point for single returns rather than the 200% it has been.
- Capital Gains Rates – Also, as part of the Bush era cuts, the capital gains rates were substantially reduced, but will return to their old levels of 10% for anyone in the 15% regular tax bracket and 20% for all others. That is up from 0% and 15% in 2010. This will impact investors, business owners and home owners when they sell a capital asset.
- Qualified Dividends – Generally, qualified dividend income is dividend income from stock held for 60 days or longer before the ex-dividend date. These dividends, for a number of years, have been taxed at capital gains rates (0% - 15%). However, the law providing these beneficial rates expires at the end of 2010 and all dividend income will be taxed at ordinary income rates (15% to 39.6%). This will generally impact investors holding income stocks and mutual funds. These individuals will see an overall tax increase greater than just the general 2% to 6% rise noted above.
- Earned Income Credit – This refundable credit currently has four categories of low-income working taxpayers, with the credit increasing as the number of children increase, up to three or more. In 2011, the "three or more children" category will go away, and taxpayers with three or more children will have to use the two or more category. This can reduce the credit for low-income taxpayers with three or more children by up to about $600.
- Child Credit – The tax law provides a tax credit for each of a taxpayer's children under the age of 17. This credit will drop to $500 (was $1,000 in 2010) per child. Since this credit phases out for higher-income taxpayers, it will generally impact lower-income taxpayers.
- American Opportunity Education Credit (AOEC) – This credit took the place of the Hope Education credit in 2009 and 2010. Where the Hope Credit is non-refundable (can only offset one's income tax liability), the AOEC was 40% refundable, and where the Hope Credit is for only the first two years of post-secondary education expenses, the AOEC allowed a credit for the first four years of post-secondary education expenses. In addition, prior to 2009, the Hope credit was limited to a maximum of $1,800 per student but the AOEC maximum was $2,500 per student. If the AOEC is not extended, low-income taxpayers will lose out on the refundable feature of the AOEC and those students in their third and fourth year of post-secondary education. Middle-income taxpayers will also be affected, because the point at which the credit phases out due to income limitations was 60% higher under the AOEC than under the Hope credit rules. Higher-income taxpayers are generally not affected since both credits are phased out for higher-income taxpayers.
- Employer Education Assistance – Employers are allowed to provide up to $5,250 of tax-free educational benefits. This provision expires and is no longer available after 2010. The net effect of this expiring benefit is based on the student's tax bracket. For example, if the student's employer provided the full $5,250 of benefits, and the student is in the 28% tax bracket, the loss of the tax-free benefit would equate to a $1,470 tax increase.
- Business Expense Deduction – Sec 179 of the tax code allows taxpayers to expense rather than depreciate certain tangible business assets and equipment in the year of purchase. For 2011, the amount that can be written off in a tax year will be $25,000, down from $250,000. This will generally impact mid-size businesses that are planning substantial equipment purchases in excess of $25,000 in the near future.
- Standard Deduction – In 2010, the standard deduction of taxpayers filing married joint status is twice the amount of someone filing under the single status. Beginning in 2011, the so-called marriage penalty is back: joint filers' standard deduction will be only 167% (instead of 200%) of the single amount. For a married couple in the 28% bracket, the result is additional tax of about $525.
- Phase-Out of Personal Exemptions – For years before 2006, the personal exemptions were phased out for high-income taxpayers. Then, in 2006 through 2010, that phase-out was gradually reduced to where there is no phase-out in 2010. However, the reduction will no longer apply after 2010, and, in 2011, the phase-out reverts to the rules in effect before 2006. This only impacts high-income taxpayers. Although the phase-out threshold income amounts for 2011 are not currently available, they will be approximately $250,000 for a married couple, $210,000 for head of household and $170,000 for single individuals. The loss of each exemption for a high-income taxpayer in the 36% tax bracket will result in an additional tax of approximately $1,300. Thus, a family of four would see an increase of $5,200.
- Phase-out of Itemized Deductions – At the same time that the exemption phase-out was being reduced (see immediately preceding item), the phase-out of itemized deductions for high-income taxpayers was also being reduced. Thus, for 2011, the high-income taxpayer's itemized deduction phase-out returns. The phase-out impacts all deductions other than medical, investment interest, casualty and gambling losses. The deductions are phased out by an amount equal to 3% of the taxpayer's AGI in excess of the AGI phase-out threshold, but not more than 80% of the deductions can be phased out. The phase-out threshold for most individuals will be approximately $170,000, which is significantly less than the exemption phase-out amount for married joint or head of household filers. The tax impact on an affected taxpayer will be 28% to 39.6% of the lost deductions.
- Coverdell Accounts – The contribution limit to Coverdell education savings accounts will be reduced from $2,000 per year to $500, tax-free distributions will no longer be allowed for elementary and secondary education (only post-secondary education), education credits will not be allowed in the same year as a Coverdell distribution, and contributions cannot be made to a Coverdell account and a Sec 529 plan in the same year.
- Home Energy Improvement Credit – The $1,500 credit for making improvements that increase the energy efficiency of a taxpayer's home expires after 2010.
- Hybrid & Lean Burn Credits – Most manufacturers have reached the 60,000 unit maximum after which the credit is reduced or no longer allowed. As a result, this credit will have very limited application in 2011.
- Health Savings Accounts – The penalty for a nonqualified distribution from an HSA has been increased from 10% to 20% and distribution for over-the-counter medication is no longer a qualified distribution.
- Making Work Pay Credit – Expires after 2010. This refundable credit of $800 for joint filers and $400 for unmarried individuals phases out for higher-income taxpayers so the loss of the credit impacts middle- to low-income taxpayers.
- Higher Education Interest Deduction – This deduction will phase-out for joint filing taxpayers beginning at an AGI of $60,000 (down from $120,000 in 2010). The phase-out for an unmarried taxpayer remains the same. In addition, the deduction is limited to interest paid on the first 60 months (was previously unlimited) in which interest payments are required. This will impact higher-income joint filers and taxpayers who have already exceeded the 60-month limitation.
- Estate Tax – The estate tax, which was eliminated for 2010, returns in 2011 with an exemption of $1 million dollars (down from $3.5 million in 2009), and a maximum tax rate of 55%, up from 45%.
On top of all these changes, there are the Health Care provisions that are taking effect in 2013, including the following: increasing the medical deduction floor to 10% for most individuals (up from 7.5%), adding a 3.8% unearned income surtax to high-income taxpayers, and tacking on an additional .9% to the current 1.45% hospitalization insurance (HI) portions of the FICA withholding (or the SE tax in case of self-employed individuals). The surtax and additional HI withholding apply to incomes in excess of $250,000 for married joint filers, $125,000 for married individuals filing separately and $200,000 for others.
It is anticipated that Congress will extend certain provisions and perhaps limit high-income taxpayers from benefiting from those extended provisions. We will advise you when changes are made.
If you have questions related to any of these issues or would like to set up a planning appointment, please give our office a call.
