Let's turn our attention from the details of the new tax rules and consider three big-picture financial planning implications of the recent changes.
Tell the 20-somethings: Net paychecks will be smaller starting this month
This week I asked several young adults who are still fairly new in the workforce: Do you know that with the new tax rules payroll taxes are going up and that your net paycheck will be about 2% lower—starting this month? For example, if you make $60,000/year, your monthly net paycheck will be lower by about $100.
A typical response after a shocked silence was: "I did not know that. I thought I made so little money that my taxes wouldn't really go up."
For many young adults, once they pay for food, rent, student loans, and commuting costs, there isn't a lot left in the budget. For some, the end of the payroll tax holiday will be a budget buster.
Let's make the end of the payroll tax holiday a new inspiration to keep improving financial literacy—as well as government policy. Are the 20-somethings in your personal circle well informed?
Get acquainted with your AGI
The new tax rules introduce significant tax planning complexity by keying important internal threshold amounts to your Adjusted Gross Income (AGI). There is some ability to manage AGI, primarily by shifting income from one time period to another or from one form to another. The motivation is to manage the tax liability and other expenses that are now keyed to AGI. To name a few of these expenses:
• The income levels where you start to phase out of the very significant tax benefits of itemized deductions and personal exemptions is keyed to your current AGI.
• The two new taxes from the Affordable Care Act—the 3.8% extra tax on net investment income and the new 0.9% tax on high earned income which can increase your overall marginal tax rate by several percentage points—also go up in sync with your AGI.
• Medicare premiums can go up by an additional $286.20/month depending on the level of your AGI two years earlier. NOTE: This potential additional monthly amount includes $219.80 for Medicare Part B and $66.40 for Medicare Part D, or a total of $3434/year.
• Social Security income is taxable either not at all or by up to 85% depending on your current year's AGI.
Do you know your AGI and how it is composed, and therefore how you might minimize it for tax purposes? Check out line 37 on your 2011 tax return—that was your Adjusted Gross Income (AGI) in 2011. It's the last line on the first page of your tax return. By scanning the line items on this first page you can see how all your various taxable income streams (Lines 7 to 21) are assembled into Total Income (Line 22, sometimes referred to as "Gross Income") and then "adjusted" in order to calculate Adjusted Gross Income.
With just this very general mental image of AGI, you will have a better understanding of various tax planning techniques. For example, the very popular charitable giving strategy for taxpayers who are over the age of 70 1/2 (i.e. of funding charitable gifts with IRA distributions sent directly to charity) is an AGI management technique. It keeps such IRA distributions off the front page of the 1040 and so out of AGI. Everything else being equal, contributions to health savings accounts and other such "above the line" deductions, i.e. above the Line 37 Adjusted Gross Income line, keep AGI muffled. Contributions to pre-tax employer retirement accounts and deferred compensation plans can also help to fine-tune AGI by moving income to future years.
Tax planning is no longer intuitive; act accordingly
The new tax rules are now so complex, there is no reliable way to make an intuitive judgment about the value to you in any particular year of any particular tax planning strategy. You have to run the numbers to see how the bottom line of total tax liability actually changes. There is also no time during the early spring tax season to do these tax planning calculations with your tax preparer. Tax preparers are overwhelmed with time pressure during tax season, especially as the tax rules become ever more complex, and the necessary data comes in later each year.
The planning implication is to be sure to be working with a tax preparer that you like and respect, and to consider making a billable appointment to check on tax planning. For complicated returns, make this a summer or fall appointment each year. For less complicated returns, an appointment every other year or so will likely suffice. Ask your financial advisor to contribute to and/or to attend that meeting so that all factors can be considered efficiently and effectively.
Bottom line: The new tax rules require careful attention for your personal financial planning, and are also an invitation to improve financial literacy, for the next generation, for ourselves—and for government policy makers.