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Tax Tip of the Week | No. 255 | What Kind of Tax Are You Talking About? June 18, 2014

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Tax Tip of the Week | June 18, 2014 | No. 255 | What Kind of Tax Are You Talking About?

A quick look at the various layers of taxes…

There is more to the federal income tax system than just a single calculation. Upper-income taxpayers—especially those with investment income—must cope with six layers of taxation:  (1) ordinary income tax; (2) capital gains and losses; (3) the alternative minimum tax; (4) the net investment income tax; (5) the additional Medicare tax; and (6) a reduction of itemized deductions and personal exemptions.

We have looked into the details of these various layers of taxes in prior Tax Tips of the Week.  Today is a quick summary of these multiple layers on one page:

1.    Ordinary Income Tax.  This is the standard layer of tax most taxpayers are familiar with. Income is taxed using seven tax brackets:  10%; 15%; 25%; 28%; 33%; 35%; and 39.6%.  Tax deductions and credits can be used to offset your tax liability based on these ordinary rates, but certain rules may apply (see #6).

2.    Capital Gains and Losses.  The tax law provides a separate tax treatment for capital assets such as securities, mutual funds and real estate. During the year, gains and losses from the sale of such assets can offset each other.  Long-term gains from assets held over one year may qualify for a 0% tax rate; a 15% tax rate; or a 20% tax rate depending on your ordinary income tax bracket.  Qualified dividends also benefit from these preferential tax rates.

3.    Alternative Minimum Tax.  The alternative minimum tax (AMT) runs parallel to the ordinary income tax.  The AMT rules apply a complex calculation which involves certain additions and adjustments before subtracting an exemption amount based on your tax filing status. There are just two brackets—26% and 28%—for taxpayers with AMT liability.  At tax time, you compare your ordinary income tax result to the AMT result and pay the higher of the two liabilities.

4.    Net Investment Income Tax.  The “net investment income tax” (NII) is a new tax that started when you filed your 2013 tax return. Please see TTW # 237 for a detailed explanation of this tax.  In summary, it is a 3.8% Medicare surtax on the investment income of those with adjusted gross incomes over $200,000 for single filers and $250,000 for joint filers.

5.    Additional Medicare Tax.  This new tax also first appeared on your 2013 tax return.  Please see TTW # 238 for a detailed explanation of this tax.  In summary, it is a 0.9% tax on the earnings of those making over $200,000 for single filers and $250,000 for joint filers.

This means that the top tax rate could be as high as 44.3%! (39.6 + 3.8 + 0.9 = 44.3)

6.    Reduction of Itemized Deductions and Personal Exemptions.  These two tax law provisions were reinstated in 2013 after a long hiatus. Under these “Pease Rules” (named for the congressman who originated it), certain itemized deductions, including those for charitable donations, state income tax, and mortgage interest are reduced if your AGI exceeds the annual threshold.  For 2014, the threshold is $254,200 for single filers and $305,050 for joint filers.  Your itemized deductions will be reduced by 3% of the amount above the threshold, but not more than 80% overall.

A similar rule phases out the tax benefit of personal exemptions.  For 2014, the $3,950 personal exemption will be reduced by 2% for each $2,500 of your AGI that exceeds the threshold level.

Keep these rules in mind as you make financial and tax planning decisions throughout the year.

You can contact us in Dayton at 937-436-3133 and in Xenia at 937-372-3504.  Or visit our website.

Rick Prewitt – the guy behind TTW

…until next week.

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