The new American Taxpayer Relief Act is actually going to create higher taxes for many of our clients.
Now that the dust has settled, it's time to take a look at how the American Taxpayer Relief Act of 2012 is really going to work. It doesn't look like much "relief" for most taxpayers. In fact, those with moderate to high income are only going to be relieved of the money in their wallets.
The new act is going to create higher taxes for many of our clients. Even if their taxable income isn't over the $450,000 threshold to join the new highest bracket of 39.6%, they may still pay higher taxes due to phase-outs of personal exemptions and itemized deductions. Anyone with income over $200,000 will also be faced with Medicare taxes on both earned income and investment income as a result of Obamacare. And the marriage penalty is back with a vengeance for couples where both spouses work and make similar incomes.
Sources of New or Higher Taxes That Take Effect in 2013
Ordinary income tax rate changes
Single taxpayers with taxable income above $400,000 and married couples with taxable income above $450,000 will fall into the new 39.6% bracket. For taxpayers under these amounts, their ordinary tax rates might actually go down a bit because the brackets were indexed for COLA.
Capital gains and qualified dividends tax rate
The same taxpayers that are subject to the new higher income tax bracket will also see an increase of 5% on the qualified dividends and long-term capital gains rate--from 15% to 20%.
Itemized deductions phase-out
Itemized deductions (except for medical, investment interest, and gambling losses) are subject to a phase-out of 3% of adjusted gross income (AGI) over $250,000 for singles and $300,000 for married couples. According to Don Farmer, CPA, in his annual income tax update, this adds 1% or more to the effective marginal tax rate, depending on the taxpayer's tax bracket.
Personal exemptions phase-out
Personal exemptions are subject to a phase-out of 2% for each $2,500 of AGI over $250,000 for singles and $300,000 for married couples. This means that at an AGI of $372,500 for singles and $422,500 for married couples, the exemptions are fully phased out. According to Farmer, this adds the equivalent of another 1% or more to the effective marginal tax rate for each exemption.
The Medicare taxes will be felt in two areas. A 0.9% tax on earned income over $200,000 for singles and $250,000 for married individuals will be withheld by employers for salaried employees. Self-employed taxpayers will have to calculate the tax on their return.
In addition, there is a 3.8% tax on the lesser of net investment income or modified AGI on income in excess of $200,000 for singles and $250,000 for married couples. Net investment income includes interest, dividends, capital gains, annuities (other than pension payouts), and net passive income.
The provisions that were affected are too numerous to cover here and include a myriad of individual and business deductions and credits. Some of the key items that may be applicable to your clients are:
--No more waiting for the annual AMT patch: The AMT tax exemption amounts were made permanent and will be indexed in future years (the 2012 amounts are $78,750 for joint returns and $50,600 for singles); the exemption phase-out thresholds of $150,000 for joint returns and $112,500 for singles will also be indexed after 2012
--Tax-free IRA distributions to charities for taxpayers over 70½ were extended through Dec. 31, 2013; also, cash contributions made by taxpayers after the date they took their RMD for 2012 but before Feb. 1, 2013, will be treated as though paid directly from the IRA account. Be sure to alert your client's tax preparer if this applies.
Estates and Trusts
The good news is that the estate and gift tax applicable exclusion amount was extended indefinitely and indexed for future years. The exclusion amount of $5,250,000 for 2013 applies to both estate and gift taxes--great news since many expected the gift tax exclusion to return to $1,000,000 for lifetime gifts. However the top rate was increased to 40%. Additionally, the annual gift exclusion amount for 2013 is $14,000 and will be indexed to inflation in $1,000 increments.
The portability rules were also extended, allowing the executor of a deceased spouse to pass their unused exclusion amount to the surviving spouse. As a planning point, all surviving spouses should file a timely estate tax return to make the election, even though the estate tax return for their deceased spouse would otherwise not be required. This will protect their heirs in the future should a windfall appear. It's important to note that the generation skipping tax (GST) exemption is not portable.
The bad news for estates and trusts is that the income tax rates on fiduciary tax returns will reach the maximum rate of 39.6% on all taxable income over $11,950. For this reason, estates and trusts should distribute income whenever possible to the individual beneficiaries.
Planning Considerations and Opportunities
--Even now, there are some opportunities for your high-income clients to recognize income in 2012 to avoid the higher rates in 2013:
First, clients with Series E bonds can elect to report all accrued interest in 2012, thereby avoiding both the higher income tax rate and the 3.8% Medicare tax. The caveat here is that they then need to report the accrued interest on those bonds each year going forward.
Second, clients who are reporting income from installment sales can elect out of the installment sale treatment in 2012 and report all the remaining gain. This may allow them to avoid the 20% capital gain bracket and possibly also the 3.8% tax, depending on the source of the gain.
--Tax-free IRA distributions to charities for taxpayers over 70½ will be more valuable in the future because they reduce AGI, thereby lowering the personal exemption and itemized deduction phase-outs.
--Tax-exempt income will be more attractive than ever as a triple winner: no income tax, no phase-outs, and no 3.8% Medicare tax.
--Asset location needs to be considered when creating portfolios for your clients, concentrating high income-producing assets in the tax-deferred accounts.
--The new Medicare taxes of 3.8% and 0.9% are subject to estimated taxes, so clients who don't meet the 110% safe harbor rule for the amount of taxes paid in for 2013 may find themselves paying underpayment penalties.
--And the most interesting planning tip of all: Dare we suggest that our unmarried clients live together without the benefit of marriage in order to save taxes? Maybe not, but they do need to be aware of the tax hit facing them in their first year as their two incomes get added together on a joint return!