As your financial advisors, we have been following the legislative developments in Washington. At the last moment, on January 1, 2013, Congress managed to avert the so-called Fiscal Cliff by passing the bill known as “The American Taxpayer Relief Act”. Perhaps the most notable aspect of the legislation is that nearly all of the tax-related provisions are permanent. This affords us a more reliable framework for your personal financial planning. We will be addressing the impact of these new provisions on your individual tax situation in our tax preparation and tax planning meetings this year. A brief overview of the new tax act is provided below:
American Taxpayer Relief Act of 2012
The American Taxpayer Relief Act of 2012 (or "ATRA") extends and makes permanent the majority of tax cuts that were scheduled to expire at the end of 2012, in addition to retroactively reinstating some rules that had expired in 2011. Here is a brief summary of the changes:
2% Payroll Tax Cut NOT Extended - The 2% payroll tax cut that has been in place for the past two years has lapsed. Social Security payroll tax had been 4.2% the past two years, but will rise to its prior 6.2% level going forward. The Social Security tax applies to the first $113,700 in wages or self-employment earnings in 2013.
New Tax Bracket - The top tax bracket rises to 39.6%, and applies to income in excess of $400,000 for individuals and $450,000 for married couples. These thresholds are indexed for inflation (in a similar manner to all the other tax bracket thresholds). Bear in mind that tax brackets are based upon taxable income after all deductions, not Adjusted Gross Income.
The remaining tax brackets are extended at their current levels. This means the 35% tax bracket is still in effect, although it's now one of the smallest tax brackets, applying for only $388,350 to $400,000 (for individuals; or $388,350 to $450,000 for married couples).
The changes to the tax brackets are permanent but, of course Congress could still change the rules in the future!
Phaseout of Itemized Deductions and Personal Exemptions - Phaseout of itemized deductions and personal exemptions returns for 2013. This change was already scheduled to happen with a lapse of the Bush tax cuts, but ATRA applies new thresholds to the rules.
The phaseout for itemized deductions (also known as the Pease limitation) reduces total itemized deductions by 3% of excess income over a threshold. The threshold amounts are now an Adjusted Gross Income of $300,000 for married couples and $250,000 for individuals. These amounts are indexed for inflation.
The personal exemptions phaseout (also known as the PEP), reduces personal exemptions by 2% of the total exemptions for each $2,500 of excess income over a threshold. The threshold for this phaseout will be the same as the threshold for the Pease limitation (AGI of $300,000 for married couples, and $250,000 for individuals, indexed for inflation).
Capital Gains and Dividends - ATRA makes permanent the 0% and 15% long-term capital gains tax rates, but increases the tax rate to 20% for any long-term capital gains that fall in the new 39.6% top tax bracket.
Qualified dividend treatment is also made permanent. Notably, because qualified dividends are tied to the long-term capital gains rate, any qualified dividends that fall in the new 39.6% top tax bracket will also now rise to 20%.
Individuals who are subject to the new 20% top long-term capital gains and qualified dividends tax rate will actually find their capital gains and dividends taxes at 23.8%, due to the onset of the new 3.8% Medicare tax on net investment income that would also apply at this income levels.
AMT Relief - The ongoing series of AMT exemption patches over the past decade are made permanent, and fixed retroactively for 2012. The new AMT exemption amount will be $78,750 for married couples and $50,600 for singles in 2012 and indexed for inflation in the future. In a separate but related provision, the rules that allow nonrefundable tax credits to be used for both regular and AMT purposes (subject to some restrictions) is also retroactively patched for 2012 and made permanent going forward.
Estate Taxes - ATRA makes the current estate tax laws permanent, including the $5,120,000 (in 2012) gift and estate tax exemption (which will rise further to approximately $5.25M with an inflation adjustment for 2013). However, the top estate tax (and gift, and GST) rate is increased from the prior 35% to a new maximum rate of 40%.
The estate portability rules for a deceased spouse's unused estate tax exemption amount are made permanent.
Miscellaneous Extension Provisions:
1) Coverdell Education Savings Accounts (so-called "Education IRAs"), including both the higher contribution limits ($2,000/year), and the ability to use qualified distributions for eligible K-12 expenses, has been extended and made permanent under the new law.
5 year extension:
1) The American Opportunity Tax Credit (the $2,500 tax credit for college) is extended 5 years - it was scheduled to lapse at the end of 2012, and will now run until 2017.
2) The Child Tax Credit and the Earned Income Tax Credit were also extended over the same 5-year time period – until 2017.
Retroactively patched for 2012 and extended one year through 2013:
1) Deduction for up to $250 expenses for elementary and secondary school teachers
2) Exclusion from income of discharged mortgage debt (necessary to prevent a short sale from triggering income tax consequences for the amount of debt that was discharged)
3) Deduction of mortgage insurance premiums as qualified residence interest
4) Deduction for state and local sales taxes paid (in lieu of state and local income taxes paid, useful in states that have little or no income taxes)
5) Above-the-line deduction for up to $4,000 of higher-education-related expenses
6) Exclusion from income for Qualified Charitable Distributions from an IRA to a charity. Notably, a special rule allows qualified charitable distributions made by February 1, 2013 to be counted retroactively for the 2012 tax year, for those who want to take advantage of the rule for 2012 and 2013.
New Roth Conversion Flexibility - ATRA will now allow individuals to convert their existing 401(k) plan to a Roth 401(k) plan, if the employer offers designated Roth accounts under the plan, regardless of whether the individual is allowed to take a distribution out of the plan. The transaction will be taxed in a similar manner to any other Roth conversion. Previously you could only convert a 401(k) plan if you are eligible to take a distribution from the plan, which meant you had to be 59 1/2, dead, disabled, or separated from service, unless the plan allows in-service withdrawals.
“We are pleased to present this summary which is attributed to Brian Shea, CFP, E.A. who provided this to members of the Alliance of Cambridge Advisors to share with our clients.”
Bert Whitehead and Pamela Landy