December 1, 2015
There are several provisions in the U.S. income tax laws that make high income individuals also high income tax individuals as well. As income increases, so does the percentage of income that is paid in income and other taxes.
Among the most common culprits that raise the rate of taxes paid by high income individual are graduated rates, the alternative minimum tax (AMT), the additional Medicare tax, the Net Investment Income Tax (NIIT) and phaseouts.
Graduated tax rates means simply that as taxable income increases, the rate applied to that income increases. However, the higher rates only apply to the higher income. Lesser income is still taxed at the lower rate. For example, if a married couple has taxable income of $500,000, only the income above $464,851 would be taxed at the maximum rate of 39.6 percent. The other income would be subject to rates from 10 to 35 percent.
The AMT is basically a tax parallel to the regular income tax rates. If a person is subject to the AMT, the taxpayer would pay that higher amount rather than the regular income tax amount. The AMT does not allow certain deductions that are available under the regular income tax system. If AMT taxable income is greater than $83,400 for a married couple filing jointly, they may be subject to the AMT. For single people, the exemption amount is $53,600 for 2015.
Among those excluded are state income, real estate, personal property, and foreign income taxes. Some mortgage interest is disallowed for AMT purposes, as are all miscellaneous itemized deductions. There are other AMT adjustments. The additional Medicare tax is 0.9 percent on earned income in excess of $250,000 for a married couple filing jointly. If one spouse has income in excess of $250,000, the tax will be withheld by the employer. Otherwise, the couple reports the tax on Form 8959.
The net investment income tax (NIIT) is levied on certain unearned income at a rate of 3.8 percent if the taxpayer exceeds the threshold amount, which is $250,000 for a married couple filing jointly. Included in the calculation are interest, dividends, rental and royalty income, and nonqualified annuities, among other items. It is levied on the lesser of net investment income or the amount by which adjusted gross income exceeds the threshold.
Another provision that hits individuals in high income brackets is the phase out of itemized deductions. For 2015, married couples filing jointly will have their itemized deductions reduced when their AGI exceeds $309,900. Other items are also subject to the phase out provisions, including IRA deductions, education credits, student loan interest deductions, personal exemptions and the child tax credit.
Several strategies may be available to avoid some of these tax increases. One involves deferring taxes on earnings. Nonqualified deferred compensation plans and stock option plans are good vehicles for postponing the tax until such time that the taxpayer is in a lower tax bracket.
A related strategy is deferring taxes on investments. Purchase of U. S. savings bonds is one such strategy, because the tax on the interest earned can be deferred until the bonds are redeemed.
Nonqualified annuities are subject to the NIIT, but the tax can be deferred until distributions begin. Purchase of assets that produce capital gains can reap savings through the lower capital gain rate. Capital losses also can be taken against capital gains to avoid the NIIT.
Investment in tax-exempt state and municipal bonds can avoid income tax on the interest of these bonds. However, the interest may be subject to state taxes if your residence is not the state in which the bonds were issued.
To compare these investments with others that are subject to tax, the taxable equivalent yield should be determined. This takes the tax-exempt yield and divides it by one minus the tax rate. If the tax equivalent yield is higher, it is a good investment, tax-wise.
Shifting income may be a possibility by transferring ownership of certain income-producing assets to adult children. The children likely would be in a lower bracket and not subject to some of the taxes their parents are subject to.
Although taxpayers generally cannot get around the phaseout items, they can monitor their income and, if not subject to the phaseouts in a particular year, can take steps to increase the items otherwise subject to phaseout. For example, if income is below the phaseout level for a particular year, a year-end contribution may be made to a charitable organization, rather than making it the following January when the phaseout might apply.
Reducing taxes for high income individuals is a complex topic, and only the highlights have been discussed here. You should consult your CPA for details on these and other strategies.
This article was originally posted on December 1, 2015 and the information may no longer be current. For questions, please contact GRF CPAs & Advisors at firstname.lastname@example.org.