The Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003 implemented a variety of changes to the tax code, most significantly tax rate reductions. Many of the provisions included in those bills are scheduled to expire at the end of 2012. Congress is currently debating whether these rate reductions will be extended beyond the current year, and that debate is contentious for a number of reasons:
- The Congressional Budget Office (CBO) estimates a revenue loss of $5.4 trillion over a 10-year period if the tax cuts are extended until 2022, not including the impact of extending the current payroll tax cut
- These tax cuts predominately affect the top 20 percent of individual taxpayers
- Historically, Congress has extended expiring provisions en mass, which makes extending the tax cuts an all-or-nothing proposition unless legislative protocol changes
President Obama supports extending the marginal rates included in the tax cuts for single filers with adjusted gross incomes (AGIs) of up to $200,000 and for joint filers with incomes up to $250,000, but allowing tax rates to revert to previous levels for taxpayers with AGIs over those amounts. The Republican-controlled House of Representatives opposes any increase in the income tax and wants the tax cuts extended in total.
The highly charged, partisan atmosphere in Washington, coupled with the fact that this is an election year, complicates the possibility of a compromise between the Obama administration and the House of Representatives. If no legislative settlement is reached, most taxpayers face substantial increases in their 2013 personal tax liabilities. Uncertainty about whether the tax cuts will be extended and, if so, whether in part or in total, leaves taxpayers facing considerable questions in planning for 2013.
Following is a summary of the tax provisions set to expire and other important tax changes for 2013, as well as guidance on planning strategies taxpayers should consider to minimize their tax liabilities.
Increases in tax rates and reductions in deductions and exemptions
The following table compares the tax rates, effective Jan. 1, 2013, if the tax cuts are extended with those that would apply if the tax rates expire completely for married taxpayers filing jointly.
|Taxable income||Current tax rates extended||Current tax rates expire|
|$0 – $17,400||10%||15%|
|$17,400 – $59,000||15%||15%|
|$59,000 – $70,700||15%||28%|
|$70,700 – $142,700||25%||28%|
|$142,700 – $217,450||28%||31%|
|$217,450 – $240,800||33%||36%|
Increase in capital gains rates and elimination of qualified dividend treatment
The top capital gains rate would increase from 15 to 20 percent, and all dividends would be taxed at ordinary income tax rates. Under 2012 tax law, qualified dividends are taxed at a 15 percent tax rate if they are:
- Paid between Jan. 1, 2003, and Dec. 31, 2012
- Paid by a U.S. corporation, are otherwise eligible by virtue of an existing tax treaty, or are paid on shares traded on an established U.S. market
- Paid on shares owned by the taxpayer for certain prescribed periods
Phase-out of itemized deductions and personal exemptions
Currently, all taxpayers may take full advantage of personal exemptions and itemized deductions. If the current tax provisions expire, higher-income taxpayers may lose all or part of those items, as follows:
|Reduction||AGI threshold for single filers||AGI threshold for joint filers||Phase-out limit|
|Itemized deductions||Reduced by 3% for every $2,500 in income over the AGI threshold||$169,550||$169,550||The reduction is capped at 80% of the value of itemized deductions|
|Personal exemption||Reduced by 2% for every $2,500 in income over the AGI threshold||$169,550||$254,350||No limit – taxpayers can lose their entire personal exemption|
Reinstatement of the marriage penalty
The expiration of the current tax provisions will result in a loss of tax benefits that otherwise penalize married taxpayers filing jointly.
- Standard deduction. Under the current provisions, joint filers are entitled to a standard deduction of 200 percent of that granted to single filers, allowing both spouses full advantage of the standard deduction. If the tax provisions expire, the standard deduction for joint filers will be reduced to 167 percent of that granted to single filers.
- 15 percent tax bracket. Under the current provisions, the 15 percent tax bracket for joint filers extends to income equal to 200 percent of that for single filers. If the tax provisions expire, the 15 percent tax bracket for joint filers will apply to only 167 percent of the income for single filers.
- Earned income tax credit. Under the current provisions, the earned income credit is phased out starting at an AGI of $17,090 for single filers, but at an AGI of $22,300 for joint filers. If the tax credits expire, the credit phases out beginning at $17,090 for all filers.
Reduction of family tax credits
Expiration of the current tax provisions would reduce children and family credits as summarized below.
|Current tax provisions extended||Current tax provisions expire|
|Child tax credit||$1,000 per child, refundable to $3,000||$500 per child and nonrefundable|
|Dependent care credit||
Reduced deductions for education benefits
Similar to the loss of family tax benefits, the phase-out of the education benefits will have an impact on the middle class. Provided below is a chart that summarizes these impacts.
|Current tax provisions extended||Current tax provisions expire|
|Employer-provided education assistance||Up to $5,250 excluded from income||Fully taxable|
|Student loan deduction||
Loss of the Alternative Minimum Tax (AMT) patch
The AMT was initially enacted to prevent high-income taxpayers from using tax preferences to eliminate or dramatically reduce their income tax liabilities. Over time, the AMT has begun to affect middle income taxpayers as well. The current tax provisions increased the AMT exemption to $74,450 for joint filers and $48,450 for single filers in 2011 and to $45,000 and $33,750, respectively, for subsequent years. Also, beginning in 2011, taxpayers were able to offset their AMT liabilities with certain credits, including the dependent care credit and the credit for the elderly and disabled. These offsets have been eliminated effective 2012.
Other tax changes for 2013
The possible expiration of the current tax provisions is not the only tax planning concern for 2013. In addition, some of the tax ramifications of the Patient Protection and Affordable Care Act (PPACA) go into effect starting on Jan. 1, 2013. Estate and gift tax exemptions and rates are also scheduled to revert to considerably less favorable levels. An overview of those issues appears below.
New Medicare tax
Payroll taxes have been reduced in recent years as an economic stimulus measure. The 2012 payroll tax rates are:
- 4.2 percent Social Security tax rate for employees
- 6.2 percent Social Security tax rate for employers
- 10.4 percent Social Security tax rate for the self-employed
- 1.45 percent Medicare tax rate for employees and employers
- 2.9 percent Medicare tax rate for the self-employed
As of Jan. 1, 2013, a variety of changes to Medicare taxes and other healthcare-related tax provisions go into effect. These include:
- New Medicare tax on investment income. Beginning in 2013, a new 3.8 percent tax will be imposed on interest, dividends, capital gains and other investment income for individuals with AGIs of more than $200,000 a year and joint filers with AGIs of more than $250,000.
- A 0.9 percent increase in the Medicare payroll tax. The Medicare payroll tax will increase by 0.9 percentage point to 2.35 percent on wages above $200,000 for individuals and above $250,000 for joint filers.
- Increase in the medical deduction floor. Medical expenses will have to total more than 10 percent of AGI before they are deductible, up from 7.5 percent.
- A $2,500 limit on employer-sponsored Flexible Spending Accounts (FSAs). FSAs have historically been used to allow employees to withhold funds on a pre-tax basis, and then use those funds to pay for certain qualifying expenses, including healthcare expenses. Currently, there is no cap on the amount that an employee can contribute to a medical FSA account. Effective Jan. 1, 2013, contributions to a medical FSA account will be limited to $2,500. Other FSAs, such as those used for child care or commuting expenses, are not affected by PPACA.
Sunset of the 2012 estate and gift tax laws
The current law, which sets a $5.12 million lifetime estate and gift tax exemption and a top estate and gift tax rate of 35 percent, will expire at the end of 2012. Unless Congress acts, estate and gift tax exemptions and rates will revert back to 2001levels – a $1 million lifetime estate and gift tax exemption and a top rate of 55 percent. Failing to plan in 2012 could result in an increased transfer tax liability of up to $2,111,000.
How to take advantage of favorable 2012 tax law
Unless Congress and the White House reach compromises on the expiring tax cuts and other issues, many favorable income tax and estate tax provisions will expire at the end of the current year. Following are some tax strategies taxpayers should consider to take advantage of the current, more favorable tax regime:
- Accelerate income into the current tax year using the following methods, among others:
o Roth conversion
o Accelerating S corporation activity
o Section 83(b) elections on restricted stock grants
- Accelerate capital gains activity
- Accelerate itemized deductions to avoid phase-out limitation
o Establish a gift planning strategy to take advantage of the current $5.12 million lifetime credit
More importantly, taxpayers should seek guidance from qualified tax advisors to ensure appropriate steps have been taken to address the numerous tax issues that may confront them in the coming year. Advisors can diagnose a taxpayer’s overall tax position, quantify current and projected tax liabilities, provide an executive summary of the strategies that could mitigate tax costs and project the possible savings associated with proper tax planning.
Information taken from Washington Post