The Fiscal Cliff and You
By Joel I. Levy, CPA®, PLLC
The American Taxpayer Relief Act of 2012 (better known as the fiscal cliff legislation) became law on 1/2/2013. Due to the expiration of the so-called payroll tax holiday, all workers will pay higher federal taxes this year, but the Act cancels sot other income ax increases at would have resulted in added misery for just about every individual taxpayer. In addition, many popular tax breaks for individuals were extended. The bad news is that, starting n 2013, higher-income folks will face higher taxes. The Act also extended lots of business tax breaks (some with modifications).
Here is a quick summary of most-important tax changes - starting with those that affect individuals.
Payroll Tax Holiday Is Dead (So Far)
For 2011 and 2012, the Social Security tax withholding rate on your salary was temporarily reduced by 2%, from the normal 6.2% to 4.2%. If you’re self-employed, the Social Security tax component of the self-employment tax was reduced by 2%, from the normal 12.4% to 10.4%. Last year, this so-called payroll tax holiday could have saved one person up to $2,202 or a working couple up to $4,404. Somewhat surprisingly, the Act does not extend the holiday through 2013.
Note: For 2013, the Social Security tax can hit up to $113,700 of salary or self-employment income. Thus, loss of the 2% payroll tax holiday could cost one person up to $2,274 or a working couple up to $4,548.
Tax Increases for Higher-income Individuals
Rates on Ordinary Income. For most individuals, the federal income tax rates for 2013 will be the same as last year: 10%, 15%, 25%, 28%, 33%, and 35%. However, the Act increases the maximum rate for higher-income folks to 39.6% (up from 35%). For 2013, this change only affects singles with taxable income above $400,000, married joint-filing couples with taxable income above $450,000, heads of households with taxable income above $425,000, and married individuals who file separate returns with taxable income above $225,000. After 2013, these taxable income amounts will be adjusted for inflation. These changes are permanent (until further notice).
Note: Higher-income folks may also get hit by the new 0.9% Medicare tax on wages and self-employment income and the new 3.8% Medicare contribution tax on net investment income. If so, they can face combined tax rates in excess of the advertised rates.
Rates on Long-term Gains and Dividends. The tax rates on long-term capital gains and dividends will also remain the same as last year for most individuals. However, the Act increases the maximum rate for higher-income folks to 20% (up from 15%). For 2013, this change only affects singles with taxable income above $400,000, married joint-filing couples with taxable income above $450,000, heads of households with taxable income above $425,000, and married individuals who file separate returns with taxable income above $225,000. After 2013, these taxable income amounts will be adjusted for inflation. These changes are permanent (until further notice).
Note: Higher-income folks may also get hit by the new 3.8% Medicare contribution tax on investment income, which can result in a maximum 23.8% federal tax rate on long-term gains and dividends instead of the advertised 20%.
Personal and Dependent Exemption Deduction Phase-out. The last time we saw a phase-out rule for personal and dependent exemption deductions was 2009. Sadly, the Act brings back the phase-out deal. As a result, your personal and dependent exemption write-offs can be reduced or even completely eliminated. For 2013, phase-out starts at the following Adjusted Gross Income (AGI) thresholds: $250,000 for singles, $300,000 for married joint-filing couples, $275,000 for heads of households, and $150,000 for married individuals who file separate returns. After 2013, these threshold amounts will be adjusted for inflation. This change is permanent (until further notice).
Itemized Deduction Phase-out. The last time we saw a phase-out rule for itemized deductions was also in 2009. Unfortunately, this phase-out provision is back too, thanks to the Act. As a result, you can potentially lose up to 80% of your mortgage interest, state and local taxes, charitable contributions, and miscellaneous itemized deductions if your AGI exceeds the applicable threshold. For 2013, the thresholds are $250,000 for singles, $300,000 for married joint-filing couples, $275,000 for heads of households, and $150,000 for married individuals who file separate returns. After 2013, these threshold amounts will be adjusted for inflation. This change is permanent (until further notice).
Alternative Minimum Tax Patch Made Permanent
It had become a tiresome annual ritual for Congress to “patch” the Alternative Minimum Tax (AMT) rules to prevent millions more households from getting socked with this add-on tax. The patch job consisted of allowing larger inflation-indexed AMT exemption amounts and allowing various personal tax credits to offset the AMT. The Act makes the patch permanent, starting with 2012. As a result, about 30 million households a year will be kept out of the dreaded AMT zone. For 2012, the AMT exemption amounts are $50,600 for unmarried individuals, $78,750 for married joint-filing couples, and $39,375 for married individuals who file separate returns. For 2013 and beyond, the AMT exemptions will be adjusted for inflation.
Tax Breaks for Families with Children
Larger Child Tax Credit Made Permanent. The $1,000 maximum credit for each eligible under-age-17 child was made permanent. Without the Act, the maximum credit would have dropped to only $500 for 2013 and beyond. In addition, provisions that allow the child credit to be refundable for more households were extended through 2017.
Favorable Child and Dependent Care Tax Credit Rules Made Permanent. Thanks to the Bush era tax cut legislation, most parents have been able to claim a credit of up to $600 for costs to care for one under-age-13 child, or up to $1,200 for costs to care for two or more under-age-13 kids, so the parents can work. Lower-income parents have been able to claim larger credits of up to $1,050 and $2,100, respectively. The Act makes these credit amounts permanent for 2013 and beyond (without the Act, they would have dropped to $480 and $960 for most parents; $720 and $1,440 for lower-income parents).
Favorable Earned Income Tax Credit Extended. Legislation enacted in previous years increased the earned income credit for families with three or more qualifying children and allowed married joint-filing couples to earn more without having their credits reduced. These changes, which help lower-income families, were extended by the Act through 2017.
Liberalized Tax Breaks for Adoptive Parents Made Permanent. The Bush tax cut package included a major liberalization of the adoption tax credit and also established tax-free employer adoption assistance payments. These taxpayer-friendly provisions were scheduled to expire at the end of 2012. The credit would have been halved and limited to special needs children only. Tax-free adoption assistance payments from employers would have disappeared. The Act permanently extends the more-favorable Bush-era rules.
Tax Breaks for Education Expenses
American Opportunity Higher Education Tax Credit Extended. The American Opportunity Credit, which can be worth up to $2,500 and can be claimed for up to four years of undergraduate education, was extended by the Act through 2017.
College Tuition Deduction Extended. This write-off, which can be as much as $4,000 or $2,000 for higher-income folks, expired at the end of 2011. The Act retroactively restores it for 2012 and extends it through 2013.
Favorable Student Loan Interest Deduction Rules Made Permanent. This write-off, which can be as much as $2,500 (whether you itemize or not) was scheduled to fall under less-favorable rules in 2013 and beyond. There would have been a 60-month limit on deductible interest, and a stricter phase-out provision would have reduced or eliminated the deduction for many more middle-income taxpayers. The Act permanently extends the favorable rules that have applied in recent years.
Favorable Coverdell Education Savings Account Rules Made Permanent. For 2013 and beyond, the maximum annual contribution to these federal-income-tax-free college savings accounts was scheduled to drop from $2,000 to a paltry $500, and a stricter contribution phase-out rule would have applied. The Act makes permanent the favorable rules that have applied in recent years.
Tax Breaks for Your Residence
Tax-free Treatment for Forgiven Principal Residence Mortgage Debt Extended. For federal income tax purposes, a forgiven debt generally counts as taxable Cancellation of Debt (COD) income. However, a temporary exception applied to COD income from cancelled mortgage debt that was used to acquire a principal residence. Under the temporary rule, up to $2 million of COD income from principal residence acquisition debt that was cancelled in 2007–2012 was treated as a tax-free item. The Act extends this break to cover eligible debt cancellations that occur in 2013.
$500 Energy-efficient Home Improvement Credit Extended. In past years, taxpayers could claim a tax credit of up to $500 for certain energy-saving improvements to a principal residence. This break expired at the end of 2011, but the Act retroactively restores it for 2012 and extends it through 2013. The credit equals 10% of eligible costs for energy-efficient insulation, windows, doors, and roof, plus 100% of eligible costs for energy-efficient heating and cooling equipment, subject to the $500 cap. Note that the cap is reduced by any energy credits you claimed in prior years.
Mortgage Insurance Premium Write-off Extended. Premiums for qualified mortgage insurance on debt to acquire, construct, or improve a first or second residence can potentially be treated as deductible qualified residence interest. Before the Act, this break was only available for premiums paid through 2011. The Act retroactively restores the break for premiums paid in 2012 and extends it to cover premiums paid in 2013. However, the deduction is only available for premiums for qualifying policies issued after 12/31/06 and premium amounts allocable to periods before 2014 and it is phased out for higher-income taxpayers.
Other Individual Tax Breaks
Option to Deduct State and Local Sales Taxes Extended. In past years, individuals who paid little or no state income taxes were given the option of instead claiming an itemized deduction for state and local sales taxes. The option expired at the end of 2011, but the Act retroactively restores it for 2012 and extends it through 2013.
Charitable Donations from IRAs Extended. In past years, IRA owners who had reached age 70½ were allowed to make tax-free charitable donations of up to $100,000 directly out of their IRAs. The donations counted as IRA required minimum distributions. Thus, charitably inclined seniors with more IRA money than they need could reduce their income taxes by arranging for tax-free IRA donations to take the place of taxable IRA required minimum distributions. This break expired at the end of 2011, but the Act retroactively restores it for 2012 and extends it through 2013. To take advantage of the retroactive deal, you can treat donations from your IRA made in January of this year as having been made in 2012. You can also treat IRA distributions taken in December of last year as 2012 IRA donations if you transfer the money to qualifying charities by 1/31/13.
$250 Deduction for K-12 Educators’ Expenses Extended. The $250 deduction for teachers and other K-12 educators for school-related expenses paid out of their own pockets was retroactively restored for 2012 and extended through 2013.
100% Gain Exclusion for Qualified Small Business Corporation Stock Extended. The Act retroactively restores the temporary 100% gain exclusion (within limits) for sales of Qualified Small Business Corporation (QSBC) stock issued in 2012 and extends the deal to cover eligible shares issued in 2013. Note that you must hold QSBC shares for more than five years to be eligible for the 100% gain exclusion privilege.
Relatively Favorable Gift and Estate Tax Rules Made Permanent
For 2013 and beyond, the Act permanently installs a unified federal estate and gift tax exemption of $5 million—adjusted annually for inflation—and a 40% maximum tax rate (up from last year’s 35% rate). For 2013, the inflation-adjusted exemption amount is expected to be around $5.25 million. The Act also makes permanent the right to leave your unused federal estate and gift tax exemption to your surviving spouse (the so-called exemption portability deal).
Joel I. Levy is a CPA® at Joel I. Levy, CPA®, PLLC with over 35 years of experience serving individuals and businesses of varying types and sizes, from New York to South Florida to North Carolina. Located in Chapel Hill, NC, he is known as the “Entrepreneur’s CPA®”. He can be reached at www.jilcpanc.net
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