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Tax Implications of the American Tax Relief Act (aka the Fiscal Cliff Act) for individuals

Congress certainly took its time and waited far too long to enact much anticipated tax legislation as the country neared the so called fiscal cliff. The Senate and House of Representatives passed the American Tax Relief Act late New Year’s Day. This tax legislation will have far reaching implications. While it was once thought that any fiscal cliff legislation would be a basic package, Congress managed to come out with a surprisingly comprehensive set of tax provisions, some with long lasting effects. This act is a sweeping tax package that includes, among many other items “permanent” (not just a temporary extension) income tax rates, permanent estate tax relief, a permanent patch for the alternative minimum tax and a host of retroactively resuscitated and extended tax breaks for individuals and businesses. This article will focus on the key elements of the package as it pertains to individual income taxes.

  • The current income tax rates will be retained (10%, 15%, 25% 28%, 33% and 35%). A new top rate of 39.6% is imposed on taxable income over $400,000 for single filers and $450,000 for married filing joint filers.
  • A 20% rate applies to capital gains and dividends for individuals in the 39.6% bracket; the 15% rate is retained for taxpayers in the 25% to 35% brackets; and, taxpayers in the 10% and 15% brackets will continue to not pay tax on qualified dividends and long-term capital gains. Keep in mind however, due to the Affordable Health Care Act which is effective for 2013, that the true effective rate for capital gains and dividends for taxpayers with incomes exceeding $400,000 for singles and $450,000 for married filing joint, an extra 3.8% Medicare surtax applies pushing the tax rate to 23.8%. Also, the additional 3.8% Medicare surtax applies to taxpayers who are subject to a 25% or greater rate on ordinary income, but whose income level falls below the $400,000/$450,000 thresholds making their effective rate 18.8%.
  • A permanent alternative minimum tax (AMT) “patch” sets the exemption amounts for 2012 at $78,750 for married filing joint taxpayers and $50,600 for single filers. These exemption amounts will be indexed for inflation. Also, relief from nonrefundable credits to offset AMT was kept. Without the patch, an estimated 26 million additional taxpayers would have owed AMT for 2012. This permanent fix will keep Congress from having to extend this year after year.
  • Some key tax credits for working families were extended for five years. Specifically, the new law extends the American Opportunity tax credit which permits eligible taxpayers to claim a credit equal to 100% of the first $2,000 of qualified tuition and related expenses, and 25% of the next $2,0000 of qualified and related expenses and its partial refundability, eased rules for the refundable child credit, and extended various rules related to the earned income credit for eligible taxpayers with three or more children and increased the threshold phaseout amounts for singles, surviving spouses and heads of households.
  • Adoption Credit/AssistanceMany of the “traditional” tax extenders that were set to expire after 2012 were extended another year for 2013. Among many others, the extended provisions include the election to take an itemized deduction for state and local general sales taxes in lieu of the itemized deduction for state and local income taxes; the $250 above-the-line deduction for certain expenses of elementary and secondary school teachers; mortgage insurance premiums treated as qualified residence interest; above the line deduction for qualified tuition and related expenses; tax-free distributions from individual retirement plans for charitable purposes; and, exclusion from gross income of discharge of qualified principle residence indebtedness.
  • Also made permanent was the marriage penalty relief (keeping the size of the 15% bracket and standard deduction for married filing joint filers twice that of single filers) and the liberalized child and dependent care credit rules allowing the credit to be calculated based on up to $3,000 of expenses for one dependent or up to 46,000 for more than one.
  • Personal exemption and itemized deduction phaseouts, which had previously been suspended, is reinstated with a starting threshold for those making $300,000 for joint filers and $250,000 for single filers. Under the phaseout, the total amount of exemptions claimed by a taxpayer subject to the limitation is reduced by 2% for each $2,500 by which the taxpayers adjusted gross income (AGI) exceeds the applicable threshold. Likewise, the total amount of itemized deductions will be reduced by 3% of the amount by which the taxpayers AGI exceeds the threshold amount, with the reduction not to exceed 80% of the otherwise allowable itemized deductions.
  • Remarkably, the estate and gift tax exclusion amount is retained at $5 million and is indexed for inflation but the top rate increases from 35% to 40%. The estate portability election, under which, if an election is made, the surviving spouse’s exemption amount is increased by the deceased spouse’s unused exemption amount, was made permanent by the Act.

Specifically not part of the tax act, but very important, was that Congress let expire the tax break holiday on Social Security payroll tax which was in place for 2011 and 2012. Employees and self-employed workers will see an increase of two percentage points in Social Security payroll tax in 2013, increasing the rate up from 4.2% to 6.2% for employees, and from 10.4% to 12.4% for the self-employed. So while middle income taxpayers will get continued relief under the income tax provisions, this return to higher Social Security tax most likely will reduce any perceived gains.

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