In the first moments of 2013, Congress eased the fiscal cliff tax increases for taxpayers earning less than $450,000 by enacting the American Taxpayer Relief Act (Act), permanently extending the Bush-era income tax cuts for this group (President Obama signed the Act into law on Jan. 2).
While the legislation extends the current income tax rates for taxpayers earning less than $450,000 ($400,000 for single filers) per year, it allowed the Bush-era tax cuts to expire for all higher-income taxpayers. Similarly, taxes on capital gains, dividends and estates were increased for the wealthiest taxpayers. Though widespread tax hikes were avoided, all taxpayers should expect to see at least slightly higher taxes in 2013 because both parties agreed to allow the 2% payroll tax cut to expire effective Jan. 1.
The Cliff Compromise Part 1: Income Taxes
The Act essentially prevented tax increases for most taxpayers by extending the Bush-era tax rates for taxpayers earning under $450,000 annually for joint filers, $425,000 for heads of households, $400,000 for singles and $225,000 for marrieds filing separately. Tax rates will rise for individual taxpayers earning those new amounts from 35% to 39.6%. At the most basic level, this will increase the income tax burden for a single taxpayer earning $400,000 annually by about $18,400 per year.
Although the marginal income tax rates were increased only for the wealthiest taxpayers, the expiration of the payroll tax cuts increased the tax burden for all taxpayers effective Jan. 1. The payroll tax cuts, which were put into place in 2011 and later extended through 2012, reduced the 6.2% Social Security payroll tax on wages by 2%. This tax cut was allowed to expire at the end of 2012, resulting in an increase in taxes for all wage earners. The tax applies to the first $113,700 of an employee’s wage income for 2013.
Now that the payroll tax cuts have expired, the average American worker earning $50,000 per year will pay approximately $80 per month more in taxes—and high-income employees will see an increase of up to $2,200 per month, on top of the increases in their marginal income tax burden.
The Cliff Compromise Pt. 2: Tax Deductions and Exemptions
Under 2012 law, taxpayers who itemized deductions were allowed a variety of tax deductions—including deductions for mortgage interest, charitable contributions, and state and local taxes—that effectively reduced their income tax burden. In 2012, there was no phaseout of itemized deductions based on AGI, which allowed all taxpayers to deduct larger amounts, thereby reducing taxable income.
Prior to 2010, most itemized deductions were reduced dollar-for-dollar by the lesser of
- 3% of the amount of the taxpayer’s AGI that exceeded $166,800, as adjusted annually for inflation ($83,400 for married taxpayers filing separately) or
- 80% of the amount of such itemized deductions otherwise allowable for the tax year.
In 2005, changes to the tax code implemented a provision that gradually reduced the limitation on itemized deductions until it was eventually repealed for 2010-2012. Despite this, this reduction was temporary and was scheduled to expire at the end of 2012—when the limitations on itemized deductions would resume beginning Jan. 1, 2013.
Because the phaseout was allowed to resume in 2013, upper-middle-class and high-net-worth clients who have earned income above the annual threshold levels are limited in the itemized deductions that they are allowed to recognize. The phaseout will begin at $250,000 for single individual taxpayers and $300,000 for married couples filing jointly and surviving spouses. The phaseout results in a substantially higher tax burden for these taxpayers—in addition to the increase in the marginal tax rates agreed upon for this group.
Also, for 2013, the personal exemption phaseout, which had also been suspended, is reinstated, with a threshold for those making $300,000 for joint filers and a surviving spouse; $275,000 for heads of household; $250,000 for single filers; and $150,000 for married taxpayers filing separately. The total amount of exemptions that can be claimed subject to the limitation is reduced by 2% for each $2,500 (or portion thereof) by which the taxpayer’s adjusted gross income exceeds the applicable threshold.
Fiscal Cliff Compromise Pt. 3: Capital Gains and Dividends
Like the income tax rates, the favorable tax rates applicable to capital gains and dividends were part of a compromise agreement set to expire at the end of 2012. Under the Act now signed into law, Congress increased the capital gains and dividend tax rates for individual taxpayers earning over $400,000 annually and married couples earning over $450,000, but prevented large increases on this income for lower-income taxpayers.
Under 2012 law, investments held for more than one year (long-term capital gains) were taxed at a maximum rate of 15% for taxpayers in the 25% tax bracket or higher. Taxpayers in the 10% and 15% tax brackets were taxed at 0% on long-term gains recognized in 2012. Similarly to capital gains taxes, dividends were taxed at 0% for taxpayers in the 10% and 15% tax brackets in 2012; taxpayers in higher brackets paid a 15% tax on dividend income.
Prior to the Bush-era tax cuts, capital gains were taxed at 15% or 20%, respectively. Dividend income, however, was taxed as ordinary income, meaning that taxpayers in the highest tax brackets could be taxed nearly 40% on this income.
Congress prevented these substantial increases in the American Taxpayer Relief Act so that dividend income continues to be taxed in the same manner as income from capital gains. For taxpayers who fall within the new 39.6% tax bracket, the 15% rate was increased to 20% effective Jan. 1. When coupled with the new investment income tax (discussed below), the capital gains and dividend rates will rise to 23.8% for high-income taxpayers. Taxpayers who are taxed below 25% will be taxed at 0% on capital gains and dividends, and the 15% capital gains and dividends rate will continue to apply to taxpayers taxed at higher than 25%, but who earn less than the $450,000 ($400,000 for single filers) income threshold. The additional 3.8% tax on net investment income applies as well to arrive at 18.8%.
Fiscal Cliff Compromise Pt. 4: Estate and Gift Tax Rates
In 2012, the maximum estate and gift tax rate was 35% for taxpayers who were not able to shelter their entire estate through the generous $5.12 million exemption. These rates were reached through a series of phased-in reductions in the tax rate and increases in the exemption amount. However, like most of the other tax cuts implemented during the Bush-era, these rates were set to expire effective Jan. 1, 2013, when tax rates would revert to pre-2001 levels. Had the estate tax provisions been allowed to expire, the top tax rate would have reverted to 55% with an exemption level of only $1 million.
The new Act sets the top estate and gift tax rate at 40%, and the exemption was fixed at $5 million as of Jan. 1. As under 2012 law, the $5 million exemption will continue to be indexed annually for inflation. The estate and gift taxes will remain unified, so that the $5 million exemption also applies for gift tax purposes.
Further, the deal continues the estate tax portability provisions that allow a surviving spouse to automatically take advantage of his or her deceased spouse’s unused exemption amount. This provision allows a surviving spouse to avoid complicated estate planning by recognizing that gifts between spouses are typically tax-free, and allowing the exemption to be portable between both spouses.
Because the exemption level will permanently remain at its generous 2012 level and will remain portable between spouses, estate planning will be simplified for most families. Even those high-income taxpayers who expect to leave estates in excess of $5 million can plan with certainty.
Fiscal Cliff Compromise Pt. 5: AMT and Credits
The new American Taxpayer Relief Act also:
- Provides a permanent Alternative Minimum Tax patch by increasing exemption amounts and allowing individuals to offset AMT liability with nonrefundable personal credits,
- Extends the American Opportunity Tax Credit as well as many other deductions and exclusions,
- Continues many business tax breaks, such as employment-related and energy-related credits.
Beyond the Act: Investment Income Tax
Separate from the American Taxpayer Relief Act, an additional 3.8% tax on the investment income earned by certain higher-income taxpayers was added as part of the Patient Protection and Affordable Care Act (PPACA, aka Obamacare). Under the PPACA, this additional tax becomes effective for gains realized on or after Jan. 1, 2013. Though this tax was not a part of the fiscal cliff negotiations, it will result in a tax increase for many investors.