The past week’s fiscal cliff deadline has been averted, at least for now. The last-minute compromise — the American Taxpayer Relief Act (ATRA) — extends the majority of tax cuts scheduled to expire at the end of 2012, in addition to retroactively reinstating some rules that had expired in 2011. However, the legislation also introduces a number of changes as well — including a new top tax bracket and an increase in the top long-term capital gains and qualified dividend rates. Some old rules that had lapsed have returned, such as the phaseout of itemized deductions and personal exemptions, and a new rule will allow 401(k) participants to complete intra-plan Roth conversions.
The biggest news about the legislation is simply the fact that it’s permanent – which means once again, it’s possible to engage in more proactive tax planning without a looming tax law sunset! However, it’s not possible to plan for the new rules until you understand them… so here’s a rundown of last week’s fiscal cliff deal and how its new rules might affect you and your finances.
Changed in the Tax Brackets
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. (Note: The tax brackets are based upon taxable income after all deductions.) These thresholds are indexed for inflation, in a manner similar to all other tax bracket thresholds. Notably, this change is effectively the same as just allowing the top tax bracket to lapse back to the old rates, as the top tax bracket was already at $388,350 in 2012, and would have been just shy of $400,000 with the 2013 inflation adjustment. While the 35% tax bracket technically still remains, it is now very small, nestled between the much wider 33% and new 39.6% brackets.
These tax bracket changes are permanent – there is no sunset provision that would cause them to lapse. It would take a new standalone law to change the tax brackets going forward.
Phasing Out Itemized Deductions and Personal Exemptions
The 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 reduces 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 (indexed for inflation).
The personal exemptions phaseout 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 that described above for itemized deductions.
The net impact of both phaseouts is that each rule increases an individual’s marginal tax rate by about 1%; thus, for instance, those in the 35% tax bracket will actually face a marginal tax rate closer to 37%-38%. The impact will be greater on larger families who phase out more exemptions at once.
Current estate tax laws are now 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); the Federal gift and estate tax exemptions remain unified. This outcome is not entirely surprising as the estate tax exemption has not been allowed to decline since the Great Depression. However, the top estate tax (and gift, and Generation-Skipping Transfer) rate is increased from the prior 35% to a new maximum rate of 40%.
Notably, the portability rules, which allow a surviving spouse to inherit the estate tax exemption from a deceased spouse, are also made permanent. This may significantly reduce the use of bypass trusts for all but the wealthiest of families, making estate planning simpler and easier for most.
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 top tax bracket (the new 39.6% bracket with the $400,000 / $450,000 thresholds noted earlier).
Qualified dividend treatment (where eligible dividends are taxed at favorable long-term capital gains rates) is also made permanent; however, because qualified dividends are tied to the long-term capital gains rate, the top tax rate for qualified dividends has now risen to 20%.
Notably, those 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 these income levels.
Other Extended Provisions
The American Opportunity Tax Credit (a $2,500 tax credit for college expenses) that had been scheduled to lapse at the end of 2012 has been extended to 2017. The Child Tax Credit and the Earned Income Tax Credit were also extended over the same 5-year time period.
A series of “extender” rules have been retroactively patched for 2012 and extended one year through 2013, including:
- Deduction for up to $250 in expenses for elementary and secondary school teachers;
- Exclusion from income of discharged mortgage debt (important for those engaging in a short sale of their primary residence);
- Deduction of mortgage insurance premiums as qualified residence interest;
- Deduction for state and local sales taxes paid (in lieu of state and local income taxes paid, which is useful in states that have little or no income taxes);
- Above-the-line deduction for up to $4,000 of higher-education-related expenses;
- Exclusion from income for Qualified Charitable Distributions from an IRA to a charity (still with the age 70 1/2 requirement and the $100,000-per-taxpayer-per-year limitation);
- Business provisions, including the Work Opportunity Tax Credit, the increased Section 179 expense deductions for small businesses, and 50% bonus depreciation for larger businesses.
Notably, the 2% payroll tax cut that has been in place for the past 2 years was not extended, so payroll withholding will be adjusted for employees in 2013, resulting in a slightly smaller take-home paycheck for this year. In addition, high income individuals will also need to start adjusting withholding later in 2013 for the new 0.9% Medicare tax on earned income.
Separately, the favorable treatment of Coverdell Education Savings Accounts (so-called “education IRAs”), including both the higher contribution limits of $2,000 a year and the ability to use qualified distributions for eligible K-12 expenses, has been extended and made permanent under the new law.
Alternative Minimum Tax Relief
The ongoing series of Alternative Minimum Tax (AMT) exemption patches over the past decade have been made permanent, and fixed retroactively (since the last patch expired in 2011). The new AMT exemption amount will be $78,750 for married couples and $50,600 for singles in 2012 — these are essentially the 2011 amounts adjusted for inflation. The AMT exemption amounts will be 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) are also retroactively patched for 2012 and made permanent.
The good news in these provisions is that with inflation indexing, the number of people subject to the AMT should not significant increase from here. The bad news is that it is still anticipated to affect approximately 5-6 million households going forward, including a large swath of those who earn $100,000 to $400,000 of income.
New Roth Conversion Flexibility
In one entirely new rule under the legislation, individuals will now be able to convert their existing 401(k) plan to a Roth 401(k) plan — if the employer offers designated Roth accounts — regardless of whether the individual is allowed to take a distribution out of the plan. The transaction will be taxed in a manner similar to any other Roth conversion.
This new provision is important because under current law, you can only convert a 401(k) plan if you are eligible to take a distribution from the plan, which generally means you have to be 59 1/2, dead, disabled, or separated from service. Basically, you can now do intra-plan 401(k), 403(b), or 457 plan conversions from traditional to Roth in the same manner that you can do for IRAs. But you still can’t go from a 401(k) (or other employer retirement plan) to the IRA unless you’re otherwise eligible for a distribution from the retirement plan.
In theory, the increased flexibility for Roth conversions means more current workers will convert their existing 401(k) and other employer retirement plans, which provides a short-term revenue increase for the Federal government (the new rule was actually scored as a “revenue raiser” in measuring the fiscal impact of the provision).
The New and the Old
For Americans concerned about their own financial plans, the good news to come out of the recent fiscal deal is that not only was the cliff largely averted, but that the changes made under ATRA are permanent. However, some of those changes will require them to revisit their income and estate tax planning going forward. Pinnacle clients should consult with their Wealth Managers before making any decisions in this regard.