Tax Law Changes Following the ‘Fiscal Cliff’ Deal

Author: Eric J. Wexler

On January 1, 2013, the United States Congress passed the American Taxpayer Relief Act of 2012 (“the Act”).  The Act resolves aspects of the “fiscal cliff” related to automatic tax increases while delaying the deadline for mandatory sequestration spending cuts (created by the Budget Control Act of 2011) until March 1, 2013.

Income and Payroll Taxes

The Act permanently extends many of the Bush-era tax cuts.  For individuals with taxable annual income of $400,000 or less ($450,000 for married couples filing jointly), the tax rates for income, capital gains, and dividends will remain at their 2012 levels.  For individuals earning more than $400,000 per year ($450,000 for married couples filing jointly), the highest-income tax rate jumps from 35 percent to 39.6 percent.  For those same high earners, the top marginal tax rate on long-term capital gains, as well as on dividends, increases from 15 percent to 20 percent.

In addition, new taxes under the Patient Protection and Affordable Care Act (PPACA) become effective in 2013.  Higher income individuals will be subject to a 3.8 percent Medicare tax on net investment income if modified adjusted gross income (MAGI) exceeds $200,000 for individual filers or $250,000 for married/joint filers. Capital gains are also subject to this tax.  The PPACA also imposes an additional 0.9 percent Medicare tax on wages and self-employment income in excess of $200,000 for single individuals and $250,000 for married taxpayers.  For these individuals, the Medicare tax paid by the employee increases to 2.35 percent from the prior rate of 1.45 percent

The 2 percent payroll tax holiday, which reduced the Social Security portion of the payroll tax withholdings from 6.2 percent to 4.2 percent for workers in 2011 and 2012, was not extended for 2013.  Aggregate Social Security taxes will thus revert to 12.4 percent (6.2 percent withheld from the employee, plus 6.2 percent paid by the employer).

Personal Exemption and Itemized Deduction Phase-outs

Generally, taxpayers are allowed to claim a personal exemption for themselves, qualifying dependents, and in most cases, their spouse.  Where married taxpayers file jointly, they may take two personal exemptions.  The Act reinstates former longstanding phase-out rules that cause the deduction from adjusted gross income (“AGI”) for personal tax exemptions and itemized deductions to be “phased out” if AGI exceeds particular thresholds.  The Act sets the thresholds for the personal exemptions and itemized deductions phase-out rules at $250,000 for single taxpayers and $300,000 for married couples filing jointly.  These amounts are to be adjusted for inflation.  While the income thresholds are the same for itemized deductions as they are for personal exemptions, the phase-out rules themselves are different.

For personal exemptions, once the income threshold is reached, the amount of the exemption is reduced by 2 percent for each $2,500 in AGI in excess of the phase-out threshold.

The “Pease limitation” reduces itemized deductions by the lesser of 1) 3 percent of the amount the taxpayer’s AGI exceeds the threshold, or 2) 80 percent of the itemized deductions otherwise allowable for the tax year, exclusive of medical expenses, investment interest, casualty losses, and certain gambling losses.

Alternative Minimum Tax

Much to the joy of everyone, the Act adopts Alternative Minimum Tax exemption amounts, which will be permanently indexed for inflation.  As you may recall, Congress has had to enact an AMT “patch” each year to avoid the unintended consequence of the AMT affecting middle class taxpayers.  The exemption amounts have been increased to $50,600 for single taxpayers and $78,750 for married taxpayers filing jointly.  The new exemption amounts will apply to tax years beginning after December 31, 2011, and will be indexed for inflation.

Estate Tax

The Act increases the maximum estate tax rate to 40 percent from the previous top rate of 35 percent.  The law preserves the $5.12 million exemption for 2012, with an inflation index to adjust it annually.  Keep in mind that the exemption for Maryland’s estate tax is only $1 million, so estate tax planning may be necessary even if your assets do not yet amount to $5 million.

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