March 1, 2014
Net Investment Income
High income taxpayers can expect a new tax on capital gains and net investment income. There are, however, slight differences in the respective definitions of “capital gain” and “net investment income.” Net investment income (or “NII”) is defined as “gross income from interest, dividends, annuities, royalties, and rent…other gross income derived from a trade or business [that is considered a passive activity]…and the net gain attributable to the disposition of property,” or what would commonly be called a capital gain. The important thing to note about the definition is that the tax applies to passive activities, or those activities to which the taxpayer does not “materially participate.”
The NII tax rate is 3.8% and applies to the lesser of all NII or modified adjusted gross income over $200,000 for individuals, or $250,000 for married couples filing jointly (or $125,00 per individual, if filing separately). Therefore, where a taxpayer has income exceeding $200,000, (or $250,000 for a couple), but has no NII, then no tax would be imposed. For example, take the simplified scenario where an individual taxpayer has modified AGI consisting of $275,000, which consists of NII of $50,000. That taxpayer would face the 3.8% tax only on the $50,000 of NII, not the amount that their modified AGI exceeds $200,000, and which would result in an additional tax of $1,900.
It is important to note that the NII tax is in addition to any other taxes. So, the taxpayer subject to the NII tax will necessarily be subject to at least a 15% tax on capital gains, plus the 3.8% tax (and state income taxes).
End of the Employee Social Security Tax Holiday
In 2013, the social security tax holiday given to employees expired. Employees in 2013 were subject to an additional 2% tax on wages, which had been suspended in prior years. In 2013 employees paid 6.2% for social security taxes, compared to 4.2% the previous year.
Another of the new taxes is the Medicare surcharge tax. The Medicare surcharge applies to individuals with wages over $200,000 or couples over $250,000. The tax is .9% on the amount that the taxpayer’s wages exceed the threshold amounts, and is in addition to the standard Medicare tax of 2.9%. For example, an individual taxpayer with wages of $250,000 would pay 2.9% on the first $200,000 of wages, and 3.8% on the remaining $50,000 of wages. It is important to note that with regard to the Medicare surcharge, an individual that has other self-employment income, or that is employed at more than one business, may not be subject to automatic withholding and will have to pay this tax at the end of the year.
Increase in Capital Gains
Capital gains rates for top earners increased in 2013. For top bracket earners, i.e. individuals with over $400,000 or couples with $450,000 in adjusted gross income, the capital gains rate increased from 15% to 20%. Note that this tax is in addition to the net investment income tax. Therefore, a top bracket earner that in 2012 would have paid a 15% tax on capital gains will pay 23.8% in 2013.
Income Tax Increase to Top Bracket Earners
Lastly, the top marginal tax rate increased from 35% to 39.6%, creating a new bracket. Individuals with adjusted gross income over $400,000 or couples with over $450,000 fit into this bracket. The increase virtually wiped out the 35% tax bracket for individuals, which now applies only to income between $398,351 and $400,000 for individuals.