2013 taxes and rates

When taxpayer's see their 2013 Form 1040, they will notice a few changes to the taxes and rates from previous years.  Following is a summary of the major tax rates and taxes that will be applicable for 2013. For the purposes of this article, MFJ = married filing jointly, S = single, O = any other filing status.

Regular tax rates

Here are the tax brackets for 2013:

Tax rate	Single filers	Married filing jointly or qualifying widow/widower	Married filing separately	Head of household
10%	Up to $8,925	Up to $17,850	Up to $8,925	Up to $12,750
15%	$8,926 - $36,250	$17,851 - $72,500	$8,926- $36,250	$12,751 - $48,600
25%	$36,251 - $87,850	$72,501 - $146,400	$36,251 - $73,200	$48,601 - $125,450
28%	$87,851 - $183,250	$146,401 - $223,050	$73,201 - $111,525	$125,451 - $203,150
33%	$183,251 - $398,350	$223,051 - $398,350	$111,526 - $199,175	$203,151 - $398,350
35%	$398,351 - $400,000	$398,351 - $450,000	$199,176 - $225,000	$398,351 - $425,000
39.60%	$400,001 or more	$450,001 or more	$225,001 or more	$425,001 or more

When calculating tax using this table, taxpayers must work "up the ladder".  This means if a MFJ taxpayer has taxable income of $100,000, they will pay tax at 10% on the first $17,850, then tax at 15% on the amount between $17,851 and $72,500, and then tax at 25% on the remaining amount.  As far as water cooler conversation goes, this taxpayer is "in the 25% bracket", but that doesn't mean they pay a flat 25% on $100,000.

3.8% Medicare surtax

Taxpayers with modified adjusted gross income in excess of $250,000 MFJ / $200,000 S might find themselves completing Form 8960 with their 2013 income tax return.  Taxpayers with this level of income potentially will be subject to the 3.8% Medicare surtax on their net investment income.  Net investment income is loosely defined as all taxable interest, dividends, capital gains, rental/royalty income, and other business activities that are considered passive.  The 3.8% tax is calculated on Form 8960 and added to the taxpayer's regular tax.  For example, MFJ couple has $300,000 modified adjusted gross income that includes $1,000 of taxable dividends.  The couple will pay an additional 3.8% tax on the dividends.  The IRS has recently issued final regs on what is subject to the Medicare surtax.

Higher capital gains rates

Taxpayers with modified adjusted gross income of $400,000 S / $450,000 MFJ will see their long-term capital gains taxed at 20% instead of the 15% rate from the past several years.  This applies to both long-term capital gains and qualified dividends, but short-term capital gains will still be taxed at regular rates.

Personal exemption (PEP) and itemized deduction (Pease) phaseout

Once taxpayers reach a certain level of income, they can potentially be subject to a phaseout of allowable personal exemptions and itemized deductions, which has been discussed in a previous post.

As can be seen, there are several changes to individual tax rates, deductions, and exemptions for 2013.  With proper planning, some of these issues can be either minimized or avoided altogether.

Give yourself a raise

With Halloween having come and gone and stores now ramping up to sell Thanksgiving turkeys and other holiday treats, 2013 is quickly drawing to a close.  This brings colder weather and the inevitable task of raking leaves, but it also presents an opportunity to take a moment and analyze employment benefits, spending for the year, and a budget for 2014. I am joining a group of financial writers to encourage people to increase their savings in 2014 by 1%.  One of the easiest ways to increase savings is through a retirement account, the most common of which I have discussed previously.  The related benefits to increased savings can be demonstrated using the grade school theory of the "5 W's".

WHO needs to increase their savings by 1%?

Anyone that wants to retire or anyone that pays taxes.  Everyone has an idea of what they want to do in retirement.  Whether they want to travel the country in an RV, play golf everyday, or move to Italy, all of those activities require money.  Since it is rare for people to work and earn an income in retirement, those dreams require a nest egg to become a reality.  Employees that participate in a 401(k) plan or similar arrangement can enjoy tax benefits by increasing their retirement contributions.  Contributions are not included in taxable income, so for a taxpayer in the 25% tax bracket, every dollar contributed saves approximately 25 cents in taxes.

WHAT money should be used to increase savings by 1%?

This is the biggest challenge for most people trying to increase savings.  "I want to save more, but I also want to keep my subscription to HBO!"  Instead of looking at the savings goal in total, break it down into monthly or weekly amounts.  A goal to increase savings by $1,000 for a year is only $83/month and $19/week.  That equates to not eating lunch out 2 days a week, one less round of golf a month, or no more lattes on the way to work.  Taxpayers that typically receive a refund on their taxes can also consider adjusting their withholdings in order to keep more of that money during the year.  By decreasing tax withholdings and increasing retirement contributions by an equal amount, the taxpayers net take-home pay does not change.  But, the taxpayer will not receive a large refund on their tax return, and that money will have been saved towards retirement.

WHERE should savings be increased by 1%?

As discussed above, a qualified retirement plan offered through an employer is the easiest place to start.  If that's not available, a Traditional or Roth IRA can accomplish similar objectives.  There are also a variety of options available for the self-employed.  IRA accounts can be opened at almost any brokerage such as Vanguard, Fidelity, or TD Ameritrade.

WHEN should savings be increased by 1%?

As soon as the opportunity presents itself.  Several large employers use November and December as "benefits season", giving their employees the opportunity to adjust their benefits, including retirement plan contributions.  Taxpayers contributing to IRA's can make contributions for 2013 by the date their 2013 tax return is filed or 4/15/14, whichever earlier.

WHY should savings be increased by 1%?

Aside from the reasons already listed above, increased retirement contributions align with the time value of money concept.  In short, the time value of money means $1 today will be worth more in the future.  For example, $1,000 today, growing at an average rate of 5% annually for 40 years will be worth $7,040.  These calculations can be made here.

The savings rate in our country has dropped from 5% last year to 4.6% this year.  From an accounting sense, that indicates that current obligations are being met, but future obligations are likely to not be met.  So, I encourage you to put pencil to paper and see where you can adjust your finances to give yourself a raise in 2014 by increasing your savings by 1%.  If anything I have given you a reason to put off raking those leaves for another day.

This post encouraged by the Financial Duckmail blog - see their site and other works here.

Employee vs. contractor

A hot topic with the IRS right now is classifying workers between employees and independent contractors.  There can be both positive and negative results on how a worker is classified, both for the company/employer and the worker.  The IRS considers three factors when determining whether a worker is an employee or an independent contractor. Behavioral control

This characteristic deals with how the company/employer behaves towards the worker and the work they are performing.  If the employer/company has the right to direct or control how the worker does the work, then they are most likely an employee.  The business does not actually have to direct or control the way the work is done, as long as they still have the right.  Also, if the company/employer requires the worker to attend any kind of training, this suggests that the worker is an employee.  If the business does not have the right to direct how the work is done, but merely suggests timing and deadlines, then the worker is most likely an independent contractor.

Financial control

This characteristic deals with how the company/employer directs or controls the financial and business aspects of the work.  If the worker has a significant investment in their work, has unreimbursed expenses related to the work, or has the opportunity to realize a profit or loss on the work, then they are most likely an independent contractor.  Employees typically do not incur expenses that are not reimbursed by their employer, including significant investments such as vehicles or computers.  Employees also do not realize a profit or loss from performing their work since they are paid their same hourly/salary rate.

Relationship of the parties

This characteristic deals with the relationship the parties have and includes written contracts, benefits, the term of the relationship, and whether the services provided are a key part of the company’s/employer’s business.  If the worker is provided any kind of benefit by the company/employer, such as health insurance or participation in a retirement plan, they are most likely an employee.  If the services provided by the worker are at the core of the business’ operations, then they are most likely an employee.

The terms of the worker’s relationship can be easily defined in a written contract, which will also serve as evidence if the worker’s status is called into question.  The worker and employer/company can use the contract to pass or fail all of the tests listed above in order to classify the worker as expected.  A word of caution – if the signed contract says one thing but the actual work performed is different, the classification of the employee or independent contractor can be reversed based on what actually occurred.

In closing, with the IRS calling into question employment status more often, both employers and employees are encouraged to revisit their staffing arrangements and verify that workers are properly classified based on the characteristics above.

Education credits

As discussed in a previous post, paying for higher education can be a stressful task for a parent and/or student.  Unfortunately, expenses for higher education cannot be claimed as deductions on a tax return outright, but there are four available deductions and credits that can help at tax time.

First, it is important to distinguish the difference between a deduction and a credit.  A deduction reduces a taxpayer's taxable income, while a credit reduces a taxpayer's tax.  Therefore a deduction does not reduce a taxpayer's tax dollar-for-dollar like a credit.  Also, some credits are refundable, meaning that if they exceed the amount of tax owed, the taxpayer can receive the difference as a refund.  In all, a credit is better because it reduces tax and could result in a refund.

The American Opportunity Credit (AOC) is a credit available for each eligible student enrolled at least half of the year for the first four years of postsecondary schooling (college).  The credit is the maximum of qualified education expenses or $2,500, and is available to taxpayer's with adjusted gross income (AGI) of $180,000 MFJ / $90,000 S or less.  On top of that, 40% of the credit can be refundable.

The Lifetime Learning Credit (LLC) is a credit available per return, not per student, up to the maximum of qualified expenses or $2,000.  This credit can be claimed for an unlimited number of years which makes it great for students attending law or medical school.  The credit is available to taxpayer's with AGI up to $127,000 MFJ / 63,000 S.  This credit is completely nonrefundable.

Taxpayer's that pay student loan interest can benefit from the Student Loan Interest Deduction (SLID).  The student loan must be taken out solely to pay qualified education expenses and the student must be the taxpayer, spouse, or a dependent.  The student must be enrolled at least half-time.  A deduction is allowed up to the maximum of $2,500 or the amount of interest paid during the year for taxpayers with AGI less than $155,000 MFJ / $75,000 S.  This deduction is an "adjustment to income" on page 1 of the 1040 and reduces AGI before other deductions.

Finally, the Tuition and Fees Deduction (TFD) is available as an "adjustment to income" up to the maximum of $4,000 or qualified tuition and fees.  Note that this deduction is available only for tuition and fees, not other expenses such as room and board, meal plans, or books.  This deduction is available to taxpayers with AGI less than $160,000 MFJ / $80,000 S.  The catch is that the tuition and fees deduction cannot be claimed if the taxpayer is already claiming the American Opportunity or Lifetime Learning credits.

These are four of the most popular education benefits offered to individual taxpayers, and their benefits are maximized in certain situations.  The AOC maximizes its benefits during the first four years of college because it has a high AGI limit and is a credit to reduce tax.  The LLC is beneficial for students that go past the first four years, but is limited in that it has a lower AGI threshold and can only be claimed per return.  The SLID removes some of the sting from paying interest on student loans, but the maximum $2,500 deduction usually pales in comparison to the total amount of interest that is paid in a year.  The TFD is beneficial for someone that goes back to school and only pays tuition, is no longer eligible for the AOC, and has a higher AGI than the threshold for the LLC.

Information from the IRS on benefits for education can be found here. Education benefits can be confusing, but seeking the advice of a professional on the best use of these credits during the college years can help reduce tax liability during years of high expenses.

Ordinary and Qualified Dividends

When a taxpayer receives a form 1099-DIV at the end of the year, a common question they have is "what is the difference between an ordinary and qualified dividend?".

A taxpayer that owns or is the beneficiary of an investment that pays dividends will typically receive a form like this at the end of the year.  The dividends they received during the year are reported in box 1a "Total ordinary dividends" and any of those dividends that are qualified will be reported in box 1b "Qualified dividends".  If dividends are received through a passthrough entity such as a trust or partnership, they will be reported on the Form K-1.

Dividends are the most common way for a corporation to distribute profits to its shareholders.  All of the dividends paid to a shareholder during the year are reported as ordinary dividends and are taxable to the taxpayer.  Qualified dividends will be included in the amount of ordinary dividends, but are subject to capital gains tax rates.

Qualified dividends are subject to the 15% capital gains tax rate if the taxpayer's regular tax rate is 25% or higher.  But, if the taxpayer's regular tax rate is less than 25%, then the qualified dividends are subject to a 0% tax rate.  For 2013, the 25% bracket kicks in when adjusted gross income hits $72,500 MFJ / $36,250 S.

In order for dividends to be considered qualified, they must meet three criteria.  First, the dividends must have been paid by a US or qualified foreign corporation.  Second, the dividends must not be considered capital gain distributions, payments in lieu of dividends, or payments from a tax-exempt organization or a farmer's cooperative.  Third, the taxpayer must meet the holding period for the investment.

For a dividend to be considered qualified, the taxpayer must have held the investment for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.  So if an investment's ex-dividend date (first day someone can own the investment without receiving the dividend) is September 1, then the taxpayer would have had to own the investment for at least 60 days during the period of July 1 to Nov 1 (121-day period beginning 60 days before ex-dividend date).

Confusing?  It can be, but in theory the investment should be owned for a longer term in order for the dividends to qualify for capital gains tax rates.

In all, taxation of qualified dividends with capital gains tax rates is an attractive reason to own domestic, qualified, dividend paying investments for the long-term, as long as the taxpayer is familiar with how the qualified dividends are calculated and whether or not their investments meet the characteristics for qualified dividends.