Individual Tax Changes Included in the Fiscal Cliff Legislation

January 31, 2013

The American Taxpayer Relief Act of 2012 (the Act) was signed into law on 1/2/13. Because the so-called payroll tax holiday was not extended, all workers will pay higher Social Security taxes this year. Thankfully, the Act cancels most other federal income tax increases that would have affected just about every individual. However, starting in 2013, higher-income individuals will pay more federal income taxes. This article summarizes the most important fiscal cliff legislation tax changes for individuals.

Payroll Taxes

For 2011 and 2012, the Social Security tax withholding rate on wages (the employee’s portion of the tax) was temporarily reduced by 2%, from the normal 6.2% to 4.2%. For self-employed individuals, the Social Security tax component of the self-employment tax was also reduced by 2%, from the normal 12.4% to 10.4%. Last year, the Social Security tax hit wages and self-employment income up to $110,100. Thus, 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 payroll tax holiday through 2013.

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.

Lower Rates Made Permanent for Most Individuals

For 2013 and beyond, the Act permanently installs the Bush era federal income tax rates of 10%, 15%, 25%, 28%, 33%, and 35% on ordinary income. Without the new law, these rates would have been replaced by the higher pre-Bush era rates of 15%, 28%, 31%, 36%, and 39.6. The Act also permanently installs the 0% and 15% federal income tax rates on most long-term capital gains and dividends. Without the Act, most long-term capital gains would have been taxed at 10% or 20% and dividends would have been taxed at ordinary rates of up to 39.6%.

The Act also permanently installs the treatment of qualified dividends as investment income for purposes of the investment interest expense limitation if the taxpayer elects to have those dividends taxed at ordinary rates instead of at preferential rates (the same rule applies to long-term capital gains).

Marriage Penalty Relief Made Permanent

Getting married can cause a couple’s combined federal income tax bill to be higher than when they were single. The Bush era tax cuts eased the so-called marriage penalty by tweaking the lowest two tax brackets for married couples and by giving them bigger standard deductions. These fixes were scheduled to disappear after 2012. The Act makes them permanent for 2013 and beyond.

Alternative Minimum Tax Patch Made Permanent

It had become an annual ritual for Congress to “patch” the AMT rules to prevent millions more households from getting socked with this add-on tax. The patch primarily consisted of providing bigger AMT exemptions and allowing nonrefundable personal tax credits to offset the AMT. Amazingly, the Act makes the patch permanent by retroactively increasing the AMT exemptions for 2012 to $50,600 for unmarried individuals, $78,750 for joint filers, and $39,375 for married filing separately; indexing these amounts for inflation beginning in 2013; and permanently allowing nonrefundable personal tax credits to offset the AMT.

Tax Increases for Higher-income Individuals

While most individuals will continue to benefit from the favorable Bush era federal income tax rules for 2013 and beyond, higher-income folks are not so lucky. Here’s the scoop for them.

Rates on Ordinary Income

Starting in 2013, The Act permanently raises the top federal income tax rate for higher-income taxpayers 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.

Higher-income taxpayers 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

Starting in 2013, the Act permanently raises the top rate on long-term capital gains and qualified dividends collected by higher-income individuals 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.

Personal and Dependent Exemption Deduction Phase-out Is Back

The phase-out rule for personal and dependent exemption deductions was itself phased out for 2010–2012, but the Act permanently restores it for 2013 and beyond. As a result, higher-income clients may see their personal and dependent exemption deductions reduced or even completely eliminated. Under this provision, exemptions are reduced by 2% for each $2,500 by which AGI exceeds the applicable threshold. For 2013, the applicable threshold is $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.

Itemized Deduction Phase-out Is Back, Too

The phase-out rule for certain itemized deductions was also phased out for 2010–2012, but it too has been permanently restored starting in 2013. As a result, higher-income clients can potentially lose up to 80% of their otherwise allowable write-offs for mortgage interest, state and local taxes, charitable contributions, and miscellaneous itemized deductions. For 2013, phase-out starts at AGI of $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 after 2013. The total amount of affected itemized deductions is reduced by 3% of the amount by which AGI exceeds the threshold. However, the reduction cannot exceed 80% of the otherwise allowable deductions that your client started off with.

Tax Breaks for Families with Children

Favorable Dependent Care Credit Rules Made Permanent.In recent years, parents could 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 go to work. Lower-income parents can claim larger credits of up to $1,050 and $2,100, respectively. For 2013 and beyond, the maximum credits were scheduled to drop to only $480 and $960 for most parents and to only $720 and $1,440 for lower-income parents. The Act permanently installs the more-generous maximum credit amounts that have applied in recent years. Note that in some cases, the credit can also be claimed for dependents other than under-age-13 children.

Breaks for Adoption Expenses 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 Credit Extended.The American Opportunity credit, worth up to $2,500, can be claimed for up to four years of undergraduate education and is 40% refundable. It was scheduled to expire at the end of 2012 and be replaced by the Hope Scholarship credit, which is smaller, can only be claimed for the first two years of college, and is nonrefundable. The Act extends the more-generous American Opportunity Credit through 2017.

College Tuition Deduction Extended.This write-off, which can be as much as $4,000 at lower income levels and as much as $2,000 at higher income levels, expired at the end of 2011. The Act retroactively restores the deduction for 2012 and extends it through 2013

Favorable Student Loan Interest Deduction Rules Made Permanent.The student loan interest write-off can be as much as $2,500 (whether the taxpayer itemizes or not). Less favorable rules were scheduled to kick in for 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 middle-income taxpayers. The Act permanently extends the more favorable rules that have applied in recent years.

Tax Breaks for the Taxpayer’s Residence

$500 Energy-efficient Home Improvement Credit Extended.In past years, taxpayers could claim the Section 25C 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 Section 25C credits claimed in earlier years. Therefore, many taxpayers who previously claimed credits will be out of the game.

Mortgage Insurance Premium Deduction 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 once AGI exceeds $100,000 ($50,000 for married filing separately).

Deductions and Exclusions That Were Retroactively Restored and Extended

Option to Deduct State and Local Sales Taxes Extended.For the last few years, individuals who paid little or no state income taxes had the option of claiming an alternative itemized deduction for state and local general sales taxes. The sales tax deduction option expired at the end of 2011. The Act retroactively restores it for 2012 and extends it 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 break to cover eligible shares issued in 2013. QSBC shares must be held for more than five years to be eligible for the gain exclusion deal, so we are only talking about sales that will occur well down the road.

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 flat 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). Finally, the Act permanently installs a $5 million generation skipping transfer tax exemption—adjusted annually for inflation. (These changes affect various Code Sections; see Section 101 of the Act.)

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