American Taxpayer Relief Act of 2012: The Ins, Outs, and Threshold Amounts

Towards the end of 2012, it was almost impossible to tune in to any news media without hearing mention of the imminent “fiscal cliff.” In an effort to avoid the looming doom, Congress and the President reached an agreement in early January of this year and enacted the American Taxpayer Relief Act of 2012 (the “Act”). Now you might be asking, “What does this Act do?”

The Act permanently extends the Tax Act provisions of 2001 and 2003. As you might know, previously the 2001/2003 tax provisions were scheduled to end after 2009 (See “I Don’t Need To Worry About The Estate Tax – Or Do I?”). In 2010, Congress extended the provisions for an additional two years. The new Act extends the provisions indefinitely (or in some cases, for a year or five), with a few modifications.

Income

First, the Act raises income taxes for wealthier individuals. For most Americans, their income tax rates will stay at their current levels (10%, 15%, 25%, 28%, 33%, and 35%). However, if your income is above $450,000 for joint filers and surviving spouses, $425,000 for heads of household, $400,000 for single filers, or $225,000 for married taxpayers filing separately (one-half of the joint filers threshold), your top income tax rate will be 39.6%. The increase to 39.6% also applies to the top income tax bracket for trusts and estates.

This is still good news compared to what might have been! The initial proposals included a $250,000/$200,000 threshold for the 39.6% rate. If you find yourself thinking that this doesn’t do you much good because the 39.6% still applies to you, remember that your income is taxed progressively and everything below the threshold is taxed at the equivalent lower rate. In other words, because anything below $17,850 for joint filers is taxed at a 10% rate, the first $17,850 of your income is taxed at that same 10%, despite your overall income pushing you into a higher tax rate bracket.

Estate, Gift, and Generation Skipping Transfers

What other gifts does the new Act bestow? The Act makes permanent the $5,000,000 estate and gift tax exemption, the $5,000,000 generation skipping transfer tax exemption and the portability of a deceased spouse’s estate tax exemption. The exemption amount is indexed to inflation and is $5,250,000 for 2013. Portability allows a surviving spouse to take advantage of any of the deceased spouse’s unused estate tax exemption. However, while portability is a safety net for individuals without an estate plan, it should not be relied on in lieu of a proactive and conscious estate plan that accomplishes more than just an exemption save.

Is the extension of the high exemption amount too good to be true? Perhaps, because the Act further increases the top estate and gift rate from 35% to 40%. The generation skipping transfer tax rate is increased to 40% as well because it is tied to the estate tax rate.

Capital Gains

The capital gains rates are also increased under the Act. For taxpayers in the new 39.6% income tax rate bracket, the long term capital gains rate increases from the previous 15% to 20%, the same rate as without new legislation. Remember the new Medicare Tax we mentioned previously? (See “The New 3.8% Medicare Tax on Unearned Income: What you need to know”) Don’t forget to take this additional 3.8% into account, making the overall tax applied to your investment-like income equivalent to 23.8%. Thankfully, dividends continue to be taxed at the same rate as capital gains (as opposed to ordinary income rates). Short term capital gains remain taxed as ordinary income.

If your income is taxed at a rate lower than 25%, your capital gains and dividends tax rate is 0%. If you fall somewhere in the middle of these two categories, your capital gains and dividends will continue to be taxed at a 15% tax rate (equivalent to an 18.8% rate if you are subject to the Medicare Tax).

How do all these numbers interrelate? Consider the following example of a married couple reporting $500,000 of taxable income (after all deductions and exemptions) on their joint return. Suppose $75,000 of this income was attributable to long term capital gains. The couple’s income is $50,000 over the 20% rate threshold amount of $450,000, so $50,000 of the long term capital gains are taxed at the 20% rate. The $25,000 remaining is taxed at the next lowest rate of 15%. Capital gains are considered to be added at the “top” of your income; the highest rates are applied to anything over the highest threshold and the next highest rates are applied to the remainder up to the next threshold, working your way down to the 0% rate if you have any capital gains remaining.
If you are able to choose your timing, it is beneficial to incur capital gains in years when your overall income is lower. For instance, consider the same couple with $75,000 of their income attributable to long term capital gains. However, this time, the couple only has $400,000 of taxable income total. All $75,000 of the long term capital gains will be taxed at 15% because they are no longer over the threshold amount of $450,000. By simply waiting for a year with less income, the couple is able to reduce their overall tax.

Social Security

The Act does not extend the employee social security tax reduction from 6.2% to 4.2 %, meaning smaller paychecks all around. If this 2% increase does not seem substantial, for a family with $100,000 of earnings, it means losing $2,000. For a family that earns even less, the impact, though proportional, may be harder to balance among their necessities and costs.

Exemptions and Deductions

The Act further provides for an increase in the alternative minimum tax exemption. The exemption increase will retroactively apply to 2012. The amount is $78,750 for joint filers, $50,600 for unmarried taxpayers, or $39,375 for married persons filing separately (as was true for the income tax, this is one-half of the joint filers’ exemption).

The Act also brings back the “Pease” limitation on itemized deductions, although this time with higher threshold amounts: $300,000 for joint filers and surviving spouses; $275,000 for heads of households; $250,000 for single taxpayers; and $150,000 for married taxpayers filing separately. The “Pease” limitation serves to reduce the amount of your itemized deductions you are able to use by 3% for every dollar over the threshold limitation.

The “Pease” limitation is not the only graduated deduction reduction many of you might encounter. The Act also brings back the personal exemption phaseout, but with higher limits than the past. Your personal exemption will gradually be reduced by 2% for every $2,500 over the threshold amount of $300,000 for joint filers and surviving spouses; $275,000 for heads of households; $250,000 for single taxpayers; and $150,000 for married taxpayers filing separately. For example, if a married couple jointly reports $375,000 of income, they are $75,000 over the threshold limit, which is 30 times $2,500. The couple will lose 30 multiplied by 2%, or 60% of their personal exemption. The personal exemption in 2013 is $3,900, therefore the couple has lost $2,340 of exemption.
Congress did make it easier to rollover your 401(k) account into a ROTH IRA by eliminating many of the timing limitations. The Act also extends many of the education, child-related, and business deductions and credits, although only until the end of 2013 in most cases. To help with all the homeowners out there who are still finding it difficult to make their mortgage payments, they might find some relief during 2013 if their lenders have forgiven any of or reduced their mortgage’s principal.

So what’s the takeaway from all this information? Taxpayers should be able to better plan using these laws versus the previous self-terminating ones. Keep in mind, however, there is nothing to stop Congress from revising and issuing new updates in the (perhaps very near) future. While nothing is certain except death and taxes, the timing, amount, and method of the latter is far from permanent.