With a “fiscal cliff deal” finally made, taxpayers should be aware of and prepare for new tax provisions and limitations.
Passed on January 1, 2013, the American Taxpayer Relief Act of 2012 is 157 pages long. The following is a synopsis of what we consider to be its most relevant provisions, as well as some tips to help you reduce your taxes under this new Act.
Estate and Gift Tax
The $5 million exemption (lifetime gifting amount) per person has been made permanent. Per couple, the exemption is $10 million, and the "portability" provision is also now permanent. Portability is the "deceased spouse unused exemption amount," which means that a special trust is not necessary to preserve the $5 million exemption of the first spouse to die.
Additionally, the tax rate on estates in excess of $5 million ($10 million for couples) is increased from 35 percent to 40 percent, and the annual gift exclusion is $14,000 per person for 2013.
Individual Income Tax Rates
Beginning this year, the 10, 15, 25, 28, 33 and 35-percent tax brackets will remain in place, but a new 39.6-percent rate will begin at the following levels:
- Married filing jointly: $450,000 of taxable income
- Qualifying widow(er): $450,000 of taxable income
- Head of household: $425,000 of taxable income
- Single: $400,000 of taxable income
- Married filing separately: $225,000 of taxable income.
As you probably know, the 39.6-percent rate does not apply to all income for high earners, only the portion of taxable income that is above these amounts. Taxable income is your income after all deductions and personal exemptions. It is not your gross income, and it is not adjusted gross income (AGI).
Limitations on Itemized Deductions
Limitations on the total amount of itemized deductions are reinstated for 2013. Itemized deductions are reduced by the lesser of either three percent of your adjusted gross income over the threshold amount, or by 80 percent of otherwise allowable itemized deductions (a provision known as the Pease limitation). The AGI amounts at which itemized deductions would start to be reduced are:
- Married filing jointly: $300,000 of AGI
- Qualifying widow(er): $300,000 of AGI
- Head of household: $275,000 of AGI
- Single: $250,000 of AGI
- Married filing separately: $150,000 of AGI.
If your AGI is below the respective threshold, your itemized deductions will not be reduced. These threshold amounts will be indexed for inflation for years after 2013.
Limitations on Personal Exemptions
The bill also reinstates the personal exemption phase-out, or PEP. Your personal exemption amount will be reduced by two percent for each $2,500 (or fraction thereof) by which your adjusted gross income exceeds the amount below for your filing status:
- Married filing jointly: $300,000 of AGI
- Qualifying widow(er): $300,000 of AGI
- Head of household: $275,000 of AGI
- Single: $250,000 of AGI
- Married filing separately: $150,000 of AGI.
These threshold amounts will be indexed for inflation for years after 2013 as well. Note that there is no cap on itemized deductions, such as charitable donations or mortgage interest.
Capital Gains and Dividends
It’s important to know your tax bracket, because your tax rate on capital gains and dividends now depends on your ordinary income tax bracket. The new tax law retains the zero-percent tax rate on long-term gains, modifies the 15-percent rate, and proposes a new 20-percent rate. Beginning this year, the tax rates on long-term gains and qualified dividends will be:
- 10 and 15-percent brackets: zero percent
- 25, 28, 33 and 35-percent brackets: 15 percent
- 39.6-percent bracket, income over $450,000: 20 percent.
Short-term capital gains will continue to be taxed as ordinary income. Keep in mind that selling an asset you‘ve held for one year or less is considered a short-term gain or loss.
Alternative Minimum Tax
For years, Congress had to pass an "AMT patch" every December so that millions of middle-income Americans would not get hit with this tax. But there were two problems with this solution: the exemption amount would expire, and the exemption was not indexed for inflation. Both of these problems have been fixed—the exemption amount is now permanent, and the amounts are indexed for inflation. The following are the AMT exemption amounts for 2012:
- Married filing jointly: $78,750
- Qualifying widow(er): $78,750
- Single: $50,600
- Head of household: $50,600
- Married filing separately: $39,375.
Roth 401(k) Conversions
Roth 401(k) conversions within traditional 401(k) plans are now available to all employees under a plan with the Roth option. Previously, it was limited to employees age 59.5 or older.
Miscellaneous Provisions
Through 2013 only, "tax extenders" are extended. These are the more popular tax extenders:
- Educator expenses deduction
- Exclusion for cancellation of debt on primary residences
- Mass transit and parking benefits excluded from income set at maximum of $175 per month
- Mortgage insurance premium deduction
- Deduction for state and local sales taxes
- Charitable deduction for donating real property for conservation purposes
- Tuition and fees deduction.
However, the Social Security payroll tax reduction of two percent was not extended. The following tax provisions will be extended through the end of 2017:
- American Opportunity Tax Credit
- Child tax credit at $1,000 maximum and partially refundable
- Earned income credit for three or more dependents.
QCD in 2013
Taxpayers wishing to make donations to charity can make direct distributions from their IRA anytime in 2013. You can distribute your full required minimum distribution (RMD) or a portion of RMD, as long as the amount to charity does not exceed $100,000.
Health Bill Taxes
Don’t forget, there is a 0.9-percent tax increase on ordinary income over $200,000 (singles) or $250,000 (married couples) already set to begin this year as a result of the Affordable Care Act. There is also a 3.8-percent tax on "net investment income" due to the health bill.
Strategies to Help Reduce Taxes
Now more than ever, it’s important to reduce your AGI. There are a variety of strategies for doing this, including:
- Deferrals to a deductible qualified retirement plan, e.g. 401(k), 403(b), 457
- Deductible traditional IRA contributions (If eligible, traditional IRA contributions are increased to $5,500 for 2013, and if you’re over age 50, you can contribute an additional $1,500 for the catch-up deferral.)
- Contributions to a health savings account (HSA)
- Replace taxable interest with tax-exempt municipal bond interest
- Capital loss carry-forward (This can only reduce AGI by $3,000 per year, but is still valuable.)
- Harvesting losses when possible
- Business losses from a sole proprietorship, partnership or S-corporation.
Other factors to keep mind:
- Real estate losses do not reduce AGI, unless your income is already low enough that you won’t be affected by the 39.6-percent tax rate.
- Timing deductions and taking capital gains is critical if your income fluctuates from year to year.
- Charitable contributions are still an effective way to reduce taxes and promote the greater good in society.
- Mortgage interest deductions and rules are unchanged.
There are probably several provisions of this bill you’re unhappy with. One of its greatest benefits, though, is that it clarifies much of the tax code, and most provisions are now permanent—that is, until Congress changes them again. At least most of the major provisions will not automatically expire as they did in the recent past. Of course, be sure to check with your tax professional or financial advisor before taking any action. iBi
Daryl Dagit is a financial advisor with Savant Capital Management, located at 7535 N. Knoxville Avenue, Suite C in Peoria.
