The American Taxpayer Relief Act of 2012 was enacted into law early in 2013 and, together with the Patient Protection and Affordable Care Act (PPACA) from 2010, impacts nearly all taxpayers, some in better ways than others. Like the old spaghetti western movie, there is good for most taxpayers, bad for almost all, and ugly for many others. The new law offers some good with more certainty for financial and retirement planning, some bad in the form of increased rates, and some ugly in increased complexity that creates traps for the unwary.
The good: Increased certainty
On the positive side, the Taxpayer Relief Act creates greater certainty in terms of income tax rates, the application of the Alternative Minimum Tax (AMT), as well as the estate tax rules. All of these provisions are now made permanent for 2013 and beyond, which is beneficial from the perspective of trying to do financial and retirement planning.
Since 2001, the tax law has provided for temporary income tax, capital gains, dividends and estate tax rates. Depending on what year we were in, the rates could be scheduled to go up or down, and it is hard to do financial, retirement and estate planning when you are not sure what the rates will be in the future.
The Taxpayer Relief Act eases this planning burden by making these rates permanent, which means that we now know what the rates will be a year from now and 10 years from now. Of course, new legislation, including the much discussed possibility of tax reform, could change these rates. But at least the laws in effect today do not provide for the rates to change over time.
The tax law for the past decade also provided uncertainty in terms of the application of the Alternative Minimum Tax to taxpayers. The AMT was created to catch millionaires using tax planning techniques to zero out income, but since the AMT exemption amount was not indexed for inflation it has come to impact many taxpayers, particularly in states with high income taxes and high property taxes. The so called “AMT fix” has been an almost annual Congressional action to limit the impact of the AMT by providing an increased exemption to shield many from the tax simply because of inflation increases in salary.
The Taxpayer Relief Act fixes the AMT exemption permanently, which means that we will no longer be waiting at yearend to see if Congress acts to provide a temporary fix. By making the AMT fix permanent, individuals need not worry about the AMT exemption reverting to its original amount and increasing the burden of the alternative tax or making one subject to it in the first place. In addition, we will no longer be waiting for Congress to act each year, which has resulted in delays of the tax filing season so the IRS could reprogram its computers.
Since 2001, the estate tax exemption has increased from $1 million to over $5 million, with estate tax rates decreasing from 55 percent to 35 percent. In one year, 2010, the estate tax was entirely repealed. Consequently, during the past decade, it has really mattered in what year a person died, with significant differences in estate tax liability depending on the actual year of death. This uncertainty made estate tax planning very challenging, and was not good policy since death was effectively encouraged in some years more than others. Indeed, 2010 was sometimes referred to, with tongue in cheek, as the “throw Grandma from the train” year. But the Taxpayer Relief Act makes these rates and exemption permanent so that planning can once again occur without factoring in the specific year of death.
The Taxpayer Relief Act also makes permanent the estate exemption portability rule that allows a surviving spouse to utilize the unused portion of a deceased spouse’s estate tax exemption amount. This portability concept was introduced as a temporary provision for 2011 and 201, and making it permanent also aids the estate planning process.
Rounding out the good news from the Taxpayer Relief Act is the extension through 2013 of several provisions, such as the deduction for state and local sales taxes and the exclusion from income of up to $100,000 of required IRA distributions when given to charity. While the extenders included in the bill are temporarily prolonged and do not provide the certainty of the other changes, they do provide tax benefits for many taxpayers.
The bad: Increased taxes
As the Taxpayer Relief Act was being negotiated, the president, senators and representatives proudly pointed out that its passage avoided a tax increase on 98 percent-plus of American taxpayers. This is technically true, if you are looking at that ordinary income tax and capital gains rates scheduled to increase in 2013. But it avoids the point that the Social Security tax was scheduled to increase automatically from 4.2 percent to 6.2 percent. While this had always been viewed as a temporary rate reduction for 2011 and then 2012, the fact that Congress did not extend it means that wage earners will pay 2 percent more in taxes on income up to $113,700. Again, this was not a tax that resulted from the Relief Act, but the reality is that a wage earner making $100,000 will pay $2,000 more in taxes in 2013 than in 2012. This effective tax increase will be borne by all wage earners, which means that even with the lower tax rates being the same the average worker will have a significant tax increase in 2013.
As for the higher wage earner, there are new taxes galore. The Patient Protection and Affordable Care Act, the new health-care law enacted in 2010, created some new taxes with an effective date of January 1. First, for individuals making more than $200,000 and married couples making more than $250,000, the employee portion of the Medicare tax is increased by 0.9 percent from 1.45 percent to 2.35 percent. For self-employed individuals the rate is increased from 2.9 percent to 3.8 percent. In addition, PPACA created a new tax of 3.8 percent on investment income using the same individual and joint-filer thresholds. While the thresholds of $200,000 or $250,000 might seem high to those with more modest income levels, and perhaps not of concern, these thresholds were not indexed for inflation. This means that over a period of years, as salaries increase over time, more and more middle class taxpayers will become subject to these new taxes.
Returning to the Taxpayer Relief Act, there are two stealth taxes that apply to reduce personal exemptions and itemized deductions. The first has been referred to as the PEP, or personal exemption phase-out, rule. The PEP rule reduces the tax benefit of personal exemptions, such as for a child, by 2 percent for every $2,500 of income over $250,000 for individual filers (or $300,000 joint filers). The Pease rule, named after the Congressman who originally proposed the idea, limits itemized deductions by 3 percent of the amount of income earned over $250,000 for individual filers ($300,000 for joint filers). These taxes can effectively increase the levy one pays by around 2 percent, and they present a real tax planning challenge.
The current income tax rates are preserved for individuals who make $400,000 or less, and for joint filers who make $450,000 or less. For those who make more than those amounts there is a new ordinary income tax rate of 39.6 percent and a new capital gains rate of 20 percent. Qualified dividends, which also have enjoyed the lower capital gains rate for many years now, will also be subject to the higher 20 percent tax rate for these higher income taxpayers. Prior to the Taxpayer Relief Act, the highest ordinary income tax rate was 35 percent and the highest rate for capital gains and dividends was 15 percent.
Finally, the Taxpayer Relief Act increases the highest tax rate applicable to estates from 35 percent to 45 percent.
Notwithstanding the political rhetoric, the reality is that starting in 2013 almost all taxpayers will be paying more in federal tax. This increased tax burden is more dramatic for the wealthy, but the middle and lower wage earners are paying more by virtue of the increase in the Social Security tax. Also, the failure to index the new 0.9 percent Medicare tax and the new 3.8 percent tax on investment earnings means that more and more middle class taxpayers will be subject to these increased taxes in the future. For those who are paying more now and those who will be paying more later, this is the bad part of the new tax law.
The ugly: Increased complexity
Simplicity is not one of the hallmarks of either the Taxpayer Relief Act or the Affordable Care Act. When viewed together taxpayers now have to keep an eye on many new tax hurdles. If you are an individual taxpayer you now need to keep in mind the dollar amounts $200,000, $250,000 and $400,000. If you are married filing jointly the dollar amounts to keep in mind are $250,000, $300,000 and $450,000.
The $200,000 or $250,000 mark, depending on whether the taxpayer is an individual or joint filer, is the amount that triggers the new additional tax of 0.9 percent on wage income and the new 3.8 percent tax on investment income. The $250,000 or $300,000 mark, for individuals or joint filers respectively, are where the taxpayer becomes subject to the so-called PEP and Pease rules. Finally, the $400,000 or $450,000 mark, for individuals and joint filers respectively, are the triggers for the new ordinary income tax rate of 39.6 percent as well as the new capital gains and dividends rate of 20 percent.
For those taxpayers subject to these new taxes, the Relief Act may not seem to provide that much relief, and the added complexity of keeping track of these various new tax triggers will make income tax planning more challenging.
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