The end-of-year drama that played out in Washington as the President and Congress negotiated over Fiscal Cliff legislation is behind us for now. The result is the American Taxpayer Relief Act of 2012.
We enter 2013 with some relief that legislation was passed, some delight in the permanence of the new law, some irritation that the result was not the comprehensive solution needed, and some trepidation that this is just an intermission until the Federal Government is faced with the need to raise the debt ceiling in early 2013.
For now, however, we have a new set of tax rules with which to comply and plan.
Anyone paying attention to the news in December knew that income tax rates were the primary focus of the negotiations. Without intervention, rates across the board would have increased to Clinton-era levels, and while the President was looking for increased rates on couples who earned more than $250,000, Republicans fought for keeping all tax brackets at 2012 levels. The final compromise made permanent the six tax brackets from 10 to 35 percent and added a new tax rate of 39.6 percent which would apply to incomes above $450,000 for couples ($400,000 for singles).
In addition to the new tax rate imposed by the American Taxpayer Relief Act, higher income families ($250,000 for couples, $200,000 for singles) will also be subject to new taxes ensuing from the Affordable Care Act of 2010. These include a 0.9% Medicare tax on wages above the threshold and a 3.8% tax on most types of investment income. The 3.8% tax applies to the lesser of net investment income or adjusted gross income in excess of the threshold amounts. It does not apply to taxpayers with no investment income, nor those whose adjusted gross income is below the threshold. (Confused? Call if you want an explanation!)
Alternative Minimum Tax Relief
The most expensive part of the American Taxpayer Relief Act, with a cost of $1.8T was a permanent fix to the Alternative minimum Tax. “Fix” is a relative term as the permanent solution does not do away with the flawed AMT system, but only raises the exemption amount and indexes it for inflation going forward. “Cost” is also a relative term in Washington and refers to taxes that would have otherwise been collected if they had done nothing. We have been living with a “fixed” system for the past decade, so there will be no net affect to taxpayers other than eliminating the fear that the fix will expire.
Capital Gains and Dividends
The American Taxpayer Relief Act creates a new 20% tax rate on capital gains and dividends for taxpayers whose AGI is above the threshold for the top marginal rate. This, along with the Affordable Care Act, brings dramatic changes in the complexity and structure of capital gains and dividends taxes for 2013 (which is why, for some clients, capital gains were realized in 2012). There are now four potential tax brackets for long-term capital gains and dividends.
• Zero percent for taxpayers in the 10 and 15 percent marginal brackets
• 15 percent for taxpayers in other brackets up until the 3.8% investment income tax kicks in ($250,000 for couples, $200,000 for singles)
• 18.8 percent (15% plus 3.8%) once the 3.8% tax is applicable but before ordinary income passes the upper bracket threshold ($450,000 for couples, $400,000 for singles)
• 23.8 percent (20% plus 3.8%) once a tax payer is above the threshold for the top income tax bracket ($450,000 for couples, $400,000 for singles)
Deduction Phase Outs
The American Taxpayer Relief Act re-introduces the phase out of both personal exemptions and itemized deductions, which effectively increase marginal tax rates for higher-income individuals. The phase outs begin when AGI is $300,000 for couples and $250,000 for singles. While the tax consequence of these phase outs may prove relatively small for most taxpayers, the unnecessary complexity is very discouraging and will require proactive planning to avoid unexpected surprises..
The new law did not extend the 2% temporary payroll tax holiday that has been in place since 2011. As a result, employees earning the maximum amount of FICA taxable wages ($113,700) with see $2,274 less in take home pay over the course of the year..
Estate, Gift and Generation-Skipping Taxes
Remarkably, the American Taxpayer Relief Act makes permanent the once ever-changing U.S. transfer tax system, and does so with favorable terms. The law locks in the $5M per person exemption amount (which adjusted for inflation is approximately $5.25M in 2013) and permanently unifies the gift, estate and generation skipping tax regimes. The tax rate above the exemption amount is 40% going forward.
The law also extended (from one to five years) a variety of tax breaks, credits, and benefits that were scheduled to expire at year end. Included are unemployment benefits, deductions for state and local sales taxes, tuition credits, and various business tax credits.
Qualified Charitable Distributions
At various times in the past (and with frustrating inconsistency) Congress has allowed individuals age 70 ½ or older to make contributions to charitable organizations directly from IRAs, while counting that contribution towards their required minimum distributions (RMD). The law extends this provision through 2013 and retroactively accommodates reclassification of some 2012 RMDs.
At the end of the day, wealthy families will see their tax bills rise, but the permanence of the law also provides much needed clarity and certainty, and should make long-term tax planning more effective.