Will the American Taxpayer Relief Act of 2012, signed by the president on January 2, raise your taxes? That’s the $600 billion question, and the answer depends on your specific financial circumstances. The nation’s top earners will owe significantly more than they did under the previous tax law. And most people, regardless of income, will find themselves paying a bit more in 2013.
But considering the massive tax hikes that would have gone into effect if Congress hadn’t acted, the law is worth noting for what it doesn’t do: It doesn’t touch broad elements of the Bush-era tax cuts of 2001 and 2003. And unlike the temporary extension of those cuts two years ago, this time the rules are permanent. There are no more “automatic” tax hikes looming. However you may view its specific provisions, the new law adds a sense of stability to the tax structure.
That said, few experts see this law as the ultimate fix for the nation’s deficit problem. It leaves unanswered many questions about the combination of further tax increases and spending cuts that may be necessary if the nation is to reduce its long-term debt.
Here’s a look at the major provisions of the new law, some of the key questions Merrill Lynch clients have been asking their advisors, and a summary of the fiscal challenges ahead. The best way to understand the new tax picture may be to consider three main areas of change: income, investments and wealth transfer.
TAXES ON INCOME
The biggest change in the new tax law is a new, higher income tax rate for individuals whose taxable income is more than $400,000, or for couples filing jointly whose taxable income exceeds $450,000. Those taxpayers will now pay a top rate of 39.6%, up from 35%. Because 2013 also ushers in a new 3.8% Medicare surtax on investment income, along with a 0.9% wage surtax for high earners (both part of the 2010 health care law), many people in the new top income bracket will now see an effective tax rate of nearly 45%.
Some proposals had called for higher rates on taxable incomes above $200,000 for individuals or $250,000 for couples. Taxpayers who fall below the $400,000/$450,000 threshold will see no increase in their income tax rates (but note, taxpayers could still be subject to the Medicare surtax, as described above).
Payroll taxes. This is where most Americans will feel the impact of the new tax law. After a two-year “holiday,” during which Social Security and other FICA taxes were reduced to 4.2%, the FICA payroll tax now will rise to its previous level of 6.2% on the first $113,700 of wages—meaning a smaller paycheck for most workers.
Alternative minimum tax (AMT). The individual AMT—an alternative way to calculate taxes that, in some cases, can steeply increase the amount owed—was put in place decades ago to target a handful of extremely wealthy people. But because it was not indexed for inflation, the AMT expanded to include millions of Americans. The new law puts a permanent “patch” on the AMT, preventing an estimated 27 million taxpayers in 2013 alone from qualifying for it.
TAXES ON INVESTMENT INCOME
The tax rate on long-term capital gains and qualified dividends rises under the new law from 15% to 20% for taxpayers in the new top bracket—that is, individuals with taxable income above $400,000 and couples with taxable income of more than $450,000. For those making less, rates will generally stay at 15%. However, couples whose modified adjusted gross income (MAGI) exceeds $250,000, along with individuals whose MAGI is more than $200,000, may also be subject to the new 3.8% Medicare surtax. In practical terms, this means individuals with MAGI above $200,000 (or $250,000 for couples), but taxable income below $400,000 ($450,000 couples) could be subject to taxes on qualified dividend/long-term capital gains of 18.8%. Individuals over $400,000 ($450,000 couples) could pay 23.8%.
TAXES ON WEALTH TRANSFER
Starting this year, the top estate tax rate climbs from 35% to 40%. But many estates won’t be affected, because the amount that can be exempted from estate or gift taxes remains at $5 million (adjusted annually for inflation) instead of plunging to $1 million—which would have been the qualifying amount if Congress hadn’t acted. For 2013 the exemption will stand at $5.25 million, which means a married couple’s combined exemption amount will equal $10.5 million. Even those paying the higher rate have some relief, as the top rate had been scheduled to rise to 55%.
As with estate taxes, the top tax rate on gift taxes and generation skipping taxes (GST) will go from 35% to 40%. But the combined exemption stays at $5 million, adjusted for inflation, resulting in a $5.25 million exemption amount for 2013. This preserved exemption means you can continue to pass along up to that amount (indexed for inflation) either during your lifetime or at your death without owing federal tax on the amount you transfer. For GST, the law likewise maintains the $5 million exemption and extends several tax-related allocation provisions that had been scheduled to disappear at the end of 2012.
Prior to passage of the new law, some lawmakers had also proposed tightening and restricting some popular wealth transfer strategies, such as dynasty trusts or grantor-retained annuity trusts. These strategies are not affected.
There are several other key provisions in the new tax code. They include:
• Limits on itemized deductions and personal exemptions. The so-called Pease limitations have been reinstated in 2013. Individual taxpayers with taxable incomes above $250,000 ($300,000 for couples) will see their itemized deductions reduced by up to 3% of their total taxable income in excess of those thresholds. The law also phases out personal exemptions for these taxpayers.
• Tax “extenders.” The bill extends through 2013 the rule providing that individuals will not be taxed on forgiven mortgage debt. The deal also reinstates for 2012 and extends through 2013 a number of tax provisions that expired at the end of 2011. These include the ”active financing exception” rule that defers U.S. tax on certain income earned by foreign financial subsidiaries; the CFC “look-through” rule; the New Markets Tax Credit; the provision increasing the amount of employer-provided mass transit benefits that may be provided tax-free; and the IRA charitable contribution rule allowing individuals to make charitable contributions directly from IRAs without paying tax. The tax credit for production of wind energy also is extended for one year, available for projects where construction has commenced by December 31, 2013. The deal also extends 50% bonus depreciation through 2013.
• Tax-free distributions to charities from IRAs. The law extends through the end of 2013 a provision allowing individuals who are age 70½ or older to make tax-free distributions from their IRAs directly to public charities, up to a maximum of $100,000 annually. Among special transition rules contained in the law, taxpayers may count distributions made in January 2013 as made on December 31, 2012. Additionally, taxpayers may count distributions they received from their IRA in December 2012 as charitable distributions, so long as the money is transferred to charity before February 1 of this year.
• Charitable contributions of real estate conservation easements. The law extends through the end of 2013
the special rule for contributions of capital gain real property for conservation. This rule allows the contribution to be taken against 50% of the taxpayer’s adjusted gross income. In addition, the new law extends the special rule for contributions by certain corporate farmers and ranchers.
• Student loan interest deduction. The law permanently suspends the 60-month limitation on the $2,500 above-the-line student loan interest deduction, which would have been reinstated if Congress failed to act. It also permanently expands the modified adjusted gross income range for phaseout of the deduction. The law also repeals a restriction against deducting voluntary interest payments.
WHAT LIES AHEAD
The American Taxpayer Relief Act of 2012 averted a potential fiscal crisis, but there’s more to be done in order to assure long-term stability to the U.S. economy. Here are some of the major challenges ahead:
YOUR QUESTIONS ABOUT TAXES
In addition to the provisions we’ve detailed above, here are some of the biggest concerns about the new tax laws that clients have been asking their advisors.
Will surviving spouses still be able to use the “portability provision” to give more to their heirs?
Yes. The portability provision, which lets a surviving spouse take advantage of any leftover portion of a deceased spouse’s estate tax exemption, has been permanently extended under the new law.
What impact does the law have on Social Security and other payroll taxes?
Over the past two years Congress implemented a “payroll tax holiday,” lowering the employee’s share of FICA taxes from 6.2% to 4.2%. Under the new law, the rate goes back up to 6.2%, so most employees will see somewhat smaller paychecks.
Medicare surtax apply to all taxpayers?
The 3.8% Medicare surtax on investment income (interest, dividends, capital gains, etc.) passed as part of the 2010 health care law and takes effect this year. It applies only to individuals whose MAGI is more than $200,000 a year and couples whose MAGI is more than $250,000. When added to the new 39.6% income tax rate for individuals with taxable income of more than $400,000 and couples earning more than $450,000, the surtax means that those highest earners will have an effective marginal tax rate of 43.4% on certain investment income.
Will I still be able to convert from a traditional 401(k) to a Roth 401(k)?
Actually, the new law makes direct conversions easier for employees whose companies allow such transfers by lifting age restrictions and certain other former requirements. Keep in mind that a Roth conversion triggers income taxes on some or all of the amount transferred to the new account. One reason Congress lifted the restrictions was in order to raise revenue.
Will special tax credits for individuals and businesses still be available?
The new law extends more than 50 provisions retroactively for 2012 and ahead through the end of 2013. These include a host of personal credits, such as the child tax credit, the earned income credit and qualified tuition deductions. Business extenders include bonus depreciation, work opportunity tax credits, research credits and others.