Tax Deal Preserves Tax Breaks for Most Americans, Targets Upper-Income Taxpayers
After considerable haggling and histrionics throughout New Year's Eve and New Year's Day, Congress gathered itself together and took bi-partisan action to permanently resolve the tax uncertainty that contributed to the fiscal cliff. Although certainty in the tax arena is good news, the respite for the economy may be short-lived. The legislation included only a two-month delay for the mandated budget cuts. These cuts are now scheduled to occur in early March, approximately the time the United States hits the latest debt ceiling limit. It is clear the new Congress will have its work cut out for it.
For most taxpayers, the legislation leaves the income tax status quo unchanged. Businesses, large and small, stand to benefit from the renewal of many expired or expiring tax credits. Wealthier taxpayers will face an increased marginal tax rate, phase-outs of exemptions and deductions, higher capital gains taxes and increased estate tax liability. And, all taxpayers will be hit with a payroll tax increase because the two-percent reduction in the employee-share of Social Security taxes expired at midnight on December 31, 2012.
Higher-Income Taxpayers Face New Rate and Phase-Outs
Most Americans will welcome the news that the Bush-era tax rates (10, 15, 25, 28, 33, and 35 percent) have been retained and made permanent. Also good news for married taxpayers is the fact that the "marriage penalty relief" is made permanent. The standard deduction for a couple filing a separate return will remain two times the standard deduction for an unmarried taxpayer. (This amount had been slated to drop to 167 percent of the unmarried rate.) Similarly, the 15 percent tax bracket for joint-return filers will continue to be 200 percent of the bracket for unmarried filers. (Absent legislation, this bracket would have stopped at 167 percent of the unmarried amount.)
However, higher income taxpayers will face a 39.6 percent bracket based upon income and filing status. The 39.6 percent marginal bracket is triggered when taxable income reaches:
|Filing Status ||Threshold for |
39.6 Percent Bracket
|Single ||$400,000 |
|Married, Filing Jointly ||$450,000 |
|Head of Household ||$425,000 |
|Married, Filing Separately ||$225,000 |
Higher-income taxpayers also face the loss of their personal exemptions and itemized deductions. If there is one constancy in the Internal Revenue Code, it is inconsistency. For purposes of the 39.6 percent marginal tax rate, higher income is $400,000/$450,000. But different—and lower—thresholds trigger the phase-out of personal exemptions and itemized deductions.
|Filing Status ||Phase-outs begin at: |
|Single ||$250,000 |
|Married, Filing Jointly ||$300,000 |
|Head of Household ||>$275,000 |
|Married, Filing Separately ||$150,000 |
|(These amounts will be indexed for inflation beginning with 2014.) |
The amount that can be claimed as personal exemptions will be reduced by two-percent when the taxpayer's adjusted gross income (AGI) exceeds the applicable threshold. At high-enough income levels, the entire value of the exemptions will be lost.
A different formula is used to compute the reduction in a taxpayer's itemized deductions. The amount allowed as itemized deductions is reduced by three percent of the amount by which adjusted gross income exceeds the applicable threshold amount. (Note that medical expenses, investment expenses, casualty losses and wagering losses are not affected.) Unlike the personal exemption phase-out, there is a limit on the amount of itemized deductions that can be lost: The total can not be reduced below 80 percent, regardless of the amount AGI exceeds the threshold.
Capital Gains Increased Only for Higher-Income Taxpayers
As with the tax brackets, the new legislation ensures that most Americans will not see increased capital gains taxes. Taxpayers who are in the 10 percent and the 15 percent tax brackets will continue to enjoy a zero percent capital gains tax rate. The capital gain tax rate remains at 15 percent for those who fall in the 25, 28, 33, and 35 percent tax brackets. Only those taxpayers who are in the new 39.6 percent tax bracket will see an increase: from 15 percent to 20 percent.
In addition, qualified dividends will continue to be taxed at capital gains rates, rather than being taxed at the individual's tax rate. (Broadly speaking, a qualified dividend is one received from a domestic corporation or a qualifed foreign corporation provided that stock has been held for at least 61 days in a specified 121-day period.)
High-income taxpayers with net investment income may also find themselves subject to the 3.8 percent Medicare tax that went into effect on January 1, 2013. For more information on this tax—which is imposed independently of the capital gains tax—see our article Plan Now to Reduce New Tax on Investment Income. This new tax means that for higher income taxpayers, the effective tax rate for capital gains may be 18.8 percent or 23.8 percent, depending on one's taxable income.
Alternative Minimum Tax Patch Made Permanent
The Alternative Minimum Tax (AMT) was originally enacted in 1969 to prevent higher-income taxpayers from avoiding taxes by tax planning strategies that were likely to be unavailable to those of lesser means. However, the exemption amounts for the tax were not indexed for inflation. As years went by, inflation turned what had once been considered a vast sum into an amount that many individuals could earn. And, for years, Congress responded by enacting a temporary fix, adjusting the exemption amount to a more reasonable sum. The last such fix expired in 2011, leaving an estimated 29 million middle-class Americans exposed to AMT liability, as opposed to the 4 million that faced AMT liability before the patch expired.
The American Taxpayer Relief Act of 2012 purports to fix the AMT taxing regime once and for all. First, it sets the exemption amount at higher levels, to reflect the erosion in the value of the dollar over the past four decades. And, it indexes that amounts so that they will keep place with inflation.
|Filing Status ||AMT Exemption Amount |
|Single ||$50,600 |
|Married, Filing Jointly ||$78,750 |
|Married, Filing Separately ||$39,375 |
The legislation also provides that all non-refundable personal credits, such as child credit, dependent care credit and the lifetime education credit, are allowed to offset AMT liability.
Numerous Tax Breaks Extended, Many Made Permanent
Dozens of expiring individual tax provisions were made permanent or extended for five years by the American Taxpayer Relief Act.
- Child and dependent care credit. The current 35 percent credit rate is made permanent, along with the $3,000 limit on expenses for one qualifying child or dependent ($6,000 for more than one qualifying individual). The employer-provided child-care credit is also made permanent.
- Coverdell educational savings accounts. The increased contribution limit ($2,000 maximum) and the treatment of elementary and secondary school expenses as qualifying expenses were both made permanent.
- Employer-provided education assistance. The exclusion from income of up to $5,250 in employer-provided education assistance is now permanent.
- Student loan interest deduction. Student loan interest, up to $2,500, can be subtracted from gross income. The 60-month limitation on deductibility is permanently eliminated, as is the ban on deducting voluntarily paid interest. Also, the income range for the phase-out of this deduction is expanded.
- Adoption credit/exclusion. The adoption credit, as well as the income exclusion for employer-paid adoption expenses up to $10,000, are made permanent for both special needs and non-special needs adoptions.
- American opportunity tax credit. Extended for five years, the AOTC provides a tax credit of up to $2,500 per eligible student and can be claimed for up to 4 years of post-secondary education.
- Enhanced provisions of the child tax credit. For the next five years, the credit amount will remain at $1000 per child.
- Enhanced provisions of the earned income tax credit. The current definition of earned income and the current relationship test remain in effect through 2018
Many Expired Credits Were Retroactively Resurrected
Not only did Congress intervene to prevent numerous tax breaks from expiring, it retroactively reinstated a number of provisions that expired at the end of 2011. The following provisions are now in effect for 2012 and 2013:
- The option to deduct state and local sales taxes rather than state and local income tax
- The above-the-line deduction for up to $4,000 in qualified tuition and related expenses
- Primary or secondary educator's above the line deduction for up to $250 of out-of-pocket expenses paid during the year
- Exclusion from gross income of discharge of qualified principal residence indebtedness of up to $2 million.
- Mortgage insurance premiums are deductible as part of qualified residence interest
Retroactive reinstatement means that you can take advantage of these provision on this year's tax return. Now it the time to determine if you qualify and to assemble the necessary documentation for claiming the credit.
Top Estate Tax Rate Increased, Exclusion Amount and Portability Retained
The maximum estate tax rate for individuals who die after 2012 is 40 percent. There is no change in the tax rates that apply to estates of $500,000 or less. For estates over that amount, the new marginal tax rates are
|Estate Value ||Marginal Tax Rate |
|Over $500,000 but not over $750,000 ||37 percent |
|Over $750,000 but not over $1,000,000 ||39 percent |
|Over $1,000,000 ||40 percent |
Each estate is allowed a unified estate/gift tax exclusion of $5 million. The exclusion amount will be annually adjusted for inflation. The portability provision, that permits the surviving spouse to elect to apply the decedent's spouse's unused estate/gift tax exemption, was made permanent.
Other provisions, such as those related to qualified family-owned businesses, installment payment of estate tax for closely held businesses and the repeal of the five-percent surtax on estates over $10 million, were also extended and should provide welcome relief for family-owned businesses.