Few people would disagree with the notion that the federal income tax regime has become so complex that few taxpayers can actually understand their federal income tax returns, not to mention state, city and local taxes. From a federal income tax perspective, taxpayers essentially have four tax regimes to deal with. The first is the ordinary income tax, which, under the American Taxpayer Relief Act of 2012 (ATRA), exposes high income earners to a 39.6% marginal income tax rate. High income earners are classified as single people with taxable income above $400,000 and married couples filing jointly with taxable income above $450,000 (these amounts are annually adjusted for inflation). The second regime is capital gains; these same high-income earners are exposed to a 20% long-term capital gain tax rate. For those who do not fall into the high-income-earner category, the long-term capital gain tax rate is 15%, with certain low-income earners paying no tax on long-term capital gains. The third regime is the alternative minimum tax (AMT). The fourth, for some lucky taxpayers, is a 3.8% net investment income tax to deal with.
With all of these various taxes to deal with, accountants, attorneys and financial planners should understand how all of them operate and overlap. Before 2011, when the estate and gift tax exemptions were increased to $5 million (indexed annually for inflation), estate tax planning was a hot topic and concerned many clients. But now in 2015, with the $5.43 million unified estate and gift tax exemption, estate tax planning is dead in the eyes of many clients because most Americans don’t have over $5 million in net worth. Furthermore, with the ability to use a deceased spouse’s unused exemption (“portability,”) married couples can transfer up to $10.86 million in 2015 to their children free of estate and gift taxes. There is also a $5.43 million exemption for generation-skipping transfer (“GST”) taxes, although there is no portability for the GST tax exemption. So now, with the high transfer tax exemptions and the higher income tax rates, the income tax has become the new estate tax to many clients.
While all clients should be doing some form of estate planning, most Americans don’t need estate tax planning. However, almost all Americans need and want advice about how to reduce their income taxes, and it is important for advisors to have at least a basic understanding of the four federal income tax regimes, because while one strategy helps avoid one type of income tax, it may result in other income taxes. Clients may be appreciative of tax planning strategies advisors help them implement, but at the end of the day clients only truly care about how much tax they saved. So if a strategy results in lower ordinary income taxes but correspondingly causes AMT and the 3.8% surtax to increase by a greater amount, the client is not better off and is probably not going to be happy.
Let’s briefly go over the four federal income taxes.
Ordinary Income Tax
At a high level, ordinary income tax is levied on “ordinary” taxable income. For example, ordinary items of income would include wages, qualified retirement plan distributions, short-term capital gains and ordinary trade or business taxable income, among many other items of income. Certain deductions are allowed to reduce one’s gross income and compute ordinary taxable income that is subject to the ordinary tax rates. For 2015, the federal ordinary income tax rates are as follows:
Married Couples Filing Jointly:
Long-Term Capital Gains Tax
Capital gains are income from the sale of capital assets, which, to put it as simply as possible, are nonbusiness assets. The sale of a capital asset is generally subject to ordinary income tax rates. It is only when a taxpayer owns a capital asset for more than 12 months that the preferential and lower long-term capital gain tax rates apply. A donee can add the donor’s holding period to the donee’s holding period in determining if the donee has met the 12-month holding period. Someone who inherits property from a decedent automatically is treated as having met the 12-month holding period requirement and, thus, will receive long-term capital gains treatment upon a sale of the inherited asset (not including income in respect of a decedent). Also, qualified dividends are subject to these favorable long-term capital gain tax rates. The long-term capital gain and qualified dividend tax rates under ATRA are:
The long-term capital gain tax rates, however, are intertwined and dependent on ordinary taxable income and ordinary income tax rates. Based on the complexity of the tax code, a capital gain tax calculation may result in some of the gain being taxed at 0%, some at 15% and some at 20%. For example, if a married couple files a joint income tax return for 2015 and has $50,000 of ordinary taxable income and a $4,000,000 long-term capital gain, the result would be: