The American Taxpayer Relief Act of 2012

Well, better the devil you know than the devil you don’t. After months of bitter partisan debate and intense speculation, Congress averted the “Fiscal Cliff” by passing the American Taxpayer Relief Act of 2012. Now, at least we have clarity. So, what’s changed?

Focusing largely on personal income taxation, the new law extends the Bush-era income tax cuts for 98% of taxpayers. The unlucky 2%, individuals with taxable incomes above $400,000 or families with taxable incomes above $450,000, will see their tax rate of 35% on ordinary income increase to 39.6%. Also, their tax rate on capital gains and qualified dividends, previously 15%, has jumped to 20%. Taxpayers with income below the $400,000/$450,000 thresholds will continue to receive the preferential 15% taxation rate on qualified dividends and capital gains, and those in the bottom two tax brackets will continue to be exempt from these taxes.

However, in spite of the promise of tax relief, the Act, when combined with existing legislation, results in increased taxes for all taxpayers with earned income. That’s thanks to an increase in Social Security and/or FICA withholdings. The former 2.9% tax, split between the employee and employer at 1.45% each, has increased 0.9% on income above various thresholds. For example, a single taxpayer earning $260,000 will pay 1.45% on the first $200,000 in wages, and then 2.35% on $60,000. Also, a temporary 2% reduction on the employee’s share of Social Security passed in 2009 was not extended. Therefore, Social Security withholding for the first $113,700 of earned income will increase by 2%.

Also, the previously enacted Affordable Care Act affects personal income tax. Individuals with incomes above $200,000 (or above $250,000 for couples) now are subject to an additional 3.8% surtax on net investment income, such as interest, dividends, annuity payments, rents, royalties, and capital gains. This means that joint filers with incomes above $250,000 but below $398,350 will see their tax increase from 33% to 36.8% on passive income, and capital gains tax will increase from 15% to 18.8%. Top-tier taxpayers will shoulder increases from 39.6% to 43.4% on passive income and 20% to 23.8% for capital gains.

Additionally, other taxpayers at various income levels will be hit with a hidden tax increase due to phase-outs of previously allowed exemptions and/or deductions. For example, from 2010 through 2012, taxpayers could deduct the full amount of their itemized deductions (such as state and local taxes, mortgage interest, real estate taxes, and charitable contributions) from their taxable incomes. Starting this year, single taxpayers with incomes above $250,000 or married taxpayers filing jointly with incomes above $300,000 will be subject to a limitation that reduces their deductions by the lesser of (a) 3% of the excess of adjusted gross income over the $250,000/$300,000 amount or (b) 80% of the itemized deductions otherwise allowable. For taxpayers filing jointly who itemize, this so-called “Pease limitation” (named after former Congressman Donald Pease who helped create it) effectively increases part of the 33% bracket to a 34.2% tax rate, the 35% bracket to a rate of 36.2%, and the 39.6% bracket to a rate of 40.8%.

The same thresholds apply to the phase out of the personal exemption, set during 2012 at $3,800 per person. The Act reduces the amount of total personal exemptions by 2% for every $2,500 (or portion of $2,500) by which adjusted gross income exceeds the new $250,000/$300,000 threshold. As a result, married taxpayers filing jointly cannot claim any personal exemption if their joint taxable income is greater than $425,000.

I’ll close with some good news in the estate planning arena. The Act extends the $5.12 million unified exemption, which will be increased for inflation to $5.25 million this year (twice that amount for married couples). However, the Act increases the top tax rate on transfers above the unified exemption amount from 35% to 40%. This is certainly better than the 55% rate that would have resulted without any new legislation.

The Act makes the “marriage penalty” relief permanent. That involves increasing the standard deduction for joint filers to twice the amount for single (previously it was only at about 67%) and expanding the 15% bracket for joint filers to twice the amount for single taxpayers. The Act also addresses the Alternative Minimum Tax (AMT). In recent years, Congress increased the AMT exemption levels from $33,750 for single taxpayers and $45,000 for joint filers to $48,450 for single filers and $74,450 for joint filers. The Act makes the “AMT patch” permanent and indexes it for inflation. Exemptions levels for 2013 are $50,600 for single filers and $78,750 for joint filers.

Finally, the Act extends, retroactively through December 31, 2013, tax-free distributions of a maximum of $100,000 from individual retirement accounts (IRAs) to public charities by individuals 70½ years of age or older. Interestingly, although this provision was not extended at the end of 2011 when it first expired, it now permits individuals who took their 2012 required minimum distribution (RMD) during December 2012 to make a charitable contribution prior to February 1, 2013 and apply it to 2012.

There’s no question that the Act has been greeted with a collective sigh of relief from the market. In the first few weeks of 2013, both the Dow and S&P 500 ended at their highest levels since December 2007. Of course, we are thoroughly reviewing all the Act’s provisions in the context of our clients’ portfolios. In the meantime, if you have specific questions, please do not hesitate to call.

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