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Law Changes

Way back in February, when President Obama released his 2013 budget request, a handful of long-predicted tax proposals targeting the wealthy were included:

  1. For those married filing joint filing taxpayers whose AGI exceed $250,000, the return of the 3% phase-out of itemized deductions (state taxes, mortgage interest, charity) , but not to exceed 80%.
  2. For those married filing joint filing taxpayers whose AGI exceed $250,000, return of the phase-out of personal exemptions.
  3. For those married filing joint filing taxpayers whose AGI exceed $250,000, reinstate the 36% percent and 39.6% marginal income tax brackets.
  4. Expiration of preferential tax rate of 15% for dividend income.
  5. Increasing the long-term capital gain rate from 15% to 20%.

The above proposals have been in previous administration legislative proposals and are proposed to be effective for tax years after December 31, 2012.

In an effort to ensure that those taxpayers earning more than $250,000 pay their “fair share” of taxes, the proposal also included a provision that wasn’t anticipated, and quite frankly, hasn’t received much attention since the budget was announced:

The proposal would limit the tax value of specified deductions or exclusions from AGI and all itemized deductions. This limitation would reduce the value to 28 percent of the specified exclusions and deductions that would otherwise reduce taxable income in the 36-percent or 39.6- percent tax brackets. A similar limitation also would apply under the alternative minimum tax. The income exclusions and deductions limited by this provision would include any tax-exempt state and local bond interest, employer-sponsored health insurance paid for by employers or with before-tax employee dollars, health insurance costs of self-employed individuals, employee contributions to defined contribution retirement plans and individual retirement arrangements, the deduction for income attributable to domestic production activities, certain trade and business deductions of employees, moving expenses, contributions to health savings accounts and Archer MSAs, interest on education loans, and certain higher education expenses.

In summary, this means that starting in 2013, taxpayers could be taking a haircut not only on some of their deductions, but also on the tax-exempt nature of some of their income.

The approach appears to apply a tax rate to these items equal to the difference between your top statutory tax rate and 28%.  For example, a taxpayer subject to a top statutory rate of 36% would pay a 8% tax on tax-exempt income.

So what does all this mean? First, these are just proposals and not law.   Given the current gridlock in Congress it would not appear that any of these proposals would be brought to a vote before the November election.   My expertise is tax law and not politics, however, but for this to become law in its current form, the President would have to win re-election, the House of Representatives would have to swing back to Democratic control and the Democrats would need to have 60 votes in the Senate.   I will let you have your own opinion on the likelihood of that becoming reality.

In addition, if the proposal does become law then this would significantly increase the costs to state and local governments to fund their budgets. With the reduction in the tax preference the interest rates in municipal bonds would increase.   This would apply significant pressure by state and local governments on the federal government not to include in the taxation of municipal income in the future.  

With that said, this does give an indication of the direction of future tax law. For current investments, I would suggest not moving too far on the yield curve (longer maturities) in tax-exempt bonds because if the proposals become law and municipal bonds rates increase the value of those bonds would decrease. In addition, you again may want to consider private placement insurance and annuities which would allow for your investment income to grow tax-deferred and not subject to this increased taxation (both for fixed income and equity investments).