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Did Tax Reform Really Hurt the Rich?

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At the beginning of the year, lawmakers passed new tax laws that imposed some substantial tax increases. With the exception of the lapse of the payroll tax break, most of those higher taxes focused squarely on the rich. But just how big a hit will rich taxpayers take under the new laws? Let's take a closer look at the provisions of the new tax laws and how much they add to the burden that the rich carry.

Getting the full story on new taxes
As the first source for useful information about the current tax season and recent tax changes that took effect this year, I turned to the Motley Fool ONE Tax Center and Fool financial planning and retirement expert Robert Brokamp's in-depth tax report. There, you'll see a nice summary of all the changes that the resolution of the fiscal cliff made -- both positive and negative.

The clearest tax hike on the rich came in the form of restoring an old tax bracket that had previously disappeared. In a blast from the past, the old 39.6% tax bracket from the 1990s is back, applying to single filers with taxable income of $400,000 or more and joint filers with at least $450,000 in taxable income. With the old rate being 35%, the new bracket means an extra $46 in taxes for every $1,000 in income above those threshold amounts.

A slightly higher tax increase will apply to the same taxpayers on any long-term capital gains or qualified dividend income that they receive. The new maximum rate on that income has now risen from 15% to 20%, equating to $50 more in tax liability per $1,000 of extra income.

Those two provisions are the easiest to understand of the tax increases on the rich. But there are several other things to watch out for, and they interact with each other in complex and sometimes unpredictable ways.

Taxing investment income
One complication in the new laws comes from the fact that various taxes apply at different threshold points. For instance, a new Medicare tax applies to rich taxpayers, but it kicks in at a lower amount of income: $200,000 for singles and $250,000 for joint filers. Moreover, these amounts are based on adjusted gross income rather than taxable income, making deductions and exemptions irrelevant in reducing Medicare tax liability.

The Medicare tax applies to both wage income and investment income. For wages above the limit, the law adds 0.9 percentage points to the existing combined 2.9% Medicare tax that employers and employees split. The worker is responsible for the entire amount of the additional tax.

But because investment income generally isn't subject to Medicare taxation, rich taxpayers get the full brunt of the 3.8% tax. Because the tax applies to interest, dividends, capital gains, and other investment income, the Medicare tax adds to the overall tax increase on investment income described above. For instance, on dividend income, high-income taxpayers could see tax rates rise from 15% to 23.8% -- an increase of more than half.

Indirect effects
The other big tax hike on the rich isn't nearly as transparent, but it's big. The return of what's known as the Pease and PEP limitations affect the ability of the rich to take itemized deductions and personal exemptions. By phasing out these reductions to taxable income, they have the net impact of raising tax rates on the rich.

Of the two, the Pease provisions can have a much larger impact because reduce your itemized deductions by a fixed percentage. With reductions of up to 80%, a taxpayer with $4 million in income and $125,000 in itemized deductions could see taxable income rise $100,000, leading to an additional $39,600 in income tax liability.

By contrast, the PEP limitations only affect the relatively small personal exemptions of $3,900. A corresponding tax hike of more than $1,500 per exemption isn't chump change, but it's relatively small for rich taxpayers.

Get protected
Each individual new tax provision by itself adds a fairly small burden to the tax bill that rich taxpayers face, but when you consider them all together, they add up to a pretty significant hit. If you're one of the taxpayers most affected by the new laws, you'll want to take steps to protect yourself from their full impact this year and in the future. 

To save on your tax bill in light of these new provisions, you need solid advice with specific tips you can use. To get them, be sure to check out our Motley Fool ONE Tax Center. You'll find Robert Brokamp's extensive report there as your free gift. With tax season winding down, this limited-time offer won't last long, so click here right now and claim this valuable tax resource today!


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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