In the early hours of 2013, Congress agreed to a contentious tax deal that ensured the U.S. economy wouldn’t tumble over the so-called fiscal cliff on January 1. That doomsday phrase was coined because, had Congress not acted, many income- and investment-tax rates would have spiked so dramatically as to hamstring domestic spending and potentially send the economy back into recession.
Instead, the American Taxpayer Relief Act (ATRA) makes permanent most of the lower tax rates adopted during the first term of George W. Bush’s administration. Those rates have been in effect for more than a decade, but they always remained temporary. Most of those rates are now permanent, although certain tax rates – particularly aimed at high-income and high net worth individuals – are raised by ATRA. Because of ATRA, the threat of dramatic across-the-board tax rate hikes in the near future is eliminated. Because Americans now know their tax rates, they can plan accordingly.
“We expected there would have to be give and take and compromise, and [the top rate increase] is a case in point.”
“It’s much easier to deal with known facts than a hypothetical. Once people know what they’re dealing with, that’s a huge benefit, whether they’re pleased with the specific outcomes or not,” says Suzanne Shier, senior vice president and director of wealth planning and tax strategy at Northern Trust.
Here’s a look at tax law changes and areas that remain uncertain despite ATRA.
A New Top-Level Income-Tax Rate
In 2012, the highest tax bracket was 35%. Under ATRA, it’s 39.6% for single filers whose taxable income (total gross income minus exclusions, deductions and exemptions) is over $400,000; for couples, the taxable income level is over $450,000.
Although the top rate increases, the good news for moderately high-income individuals is that the tax bracket threshold represents a compromise. President Obama initially sought to apply the 39.6% rate to families with income of $250,000 or more.
“We expected there would have to be give and take and compromise, and this is a case in point,” Shier says.
The new tax bracket thresholds will be adjusted for inflation, meaning the threshold for the highest tax bracket will rise above $450,000 in 2014 and in subsequent years.
Changes to Wealth-Transfer Taxes
Of ATRA’s 59 pages, only six sentences are devoted to wealth-transfer taxes. But the implications are fairly significant and could markedly affect your tax planning, Shier says.
There’s a new top tax rate of 40% on gift, estate and generation-skipping taxes, as well as a $5 million exemption and exclusion limit. Those rates are higher than some in Congress wanted (the former top rate was 35%), but consider that, had Congress not reached a deal, the top rate would have become 55% and the exemption/exclusion would have dropped to $1 million. Also, the amount is indexed for inflation and the $5 million base year was 2010. So in 2013, the exemption/exclusion amount is $5.25 million per person.
“The rate is not as good as last year, but it’s a lot better than it could have been,” Shier says.
It’s also a lot better than historical levels. In 2001, for example, the top rate was 55% and the gift and estate exclusion was just $675,000. At $5.25 million, Shier says most Americans’ estates won’t be affected. She estimates approximately 4,000 taxpayers will owe estate tax in 2013. “It doesn’t take long to get used to favorable circumstances, so there was quite a bit of bipartisan support for continuing the $5 million exclusion level,” she says.
ATRA also continues one important estate-tax provision: portability between spouses. That means if a spouse dies without using the full exclusion amount, the surviving spouse may be able to use the remaining amount.
No More Marriage Penalty
The marriage penalty refers to a component of former editions of the tax code in which joint filers were taxed at a rate higher than that of two singles filing separately. That’s been permanently eliminated, along with a corresponding gap in the standard deduction for joint filers when compared with two single filers.
Long-Term Capital Gains and Qualified Dividends Rates Paired
The tax rates on long-term capital gains and qualified dividends are now paired permanently. In 2013 and beyond, qualified stock dividends and long-term capital gains (profits from investments held for more than a year) will each be taxed at 20% for individuals in the top income-tax bracket; the rates are 15% for individuals with income in the 15% to 35% income-tax brackets.
Alternative Minimum Tax Provisions Codified
The Alternative Minimum Tax (AMT) is designed to ensure that taxpayers, as well as trusts and estates, who benefit from exempting a large portion of their regular income from taxation (investors, for example) nonetheless bear at least a minimum tax burden. Prior to ATRA, a major flaw in the AMT was that threshold levels were not adjusted for inflation. ATRA changed that, saving many middle-class households from exposure to the AMT in 2012 and beyond.
Personal Exemptions and Pease Limitations
The Personal Exemption Phaseout (PEP) and Pease limitation on itemized deductions are provisions in which tax exemptions and deductions are gradually phased out for high-income individuals. Neither limitation was in effect in 2010-2012, but now both are back – permanently. Both limitations kick in for single filers with adjusted gross income (total income minus a few select exemptions such as IRA contributions) above $250,000 for single filers, or above $300,000 for married joint filers. Under PEP, the personal exemption (in 2013, $3,900) is reduced by 2% for each $2,500 of adjusted gross income (AGI) above the threshold. For single filers, the personal exemption is fully phased out when AGI is about $372,500, or about $422,500 for joint filers.
ATRA represents a partial solution to the country’s budget woes rather than the sweeping deal that both political parties hoped for. That means more changes may come.
The Pease limitation works similarly but is focused on itemized deductions. Pease reduces the itemized-deduction maximum by 3% for each dollar of adjusted gross income above the threshold, which is the same as for PEP ($250,000 adjusted gross income for single filers; $300,000 for joint filers). One key difference between PEP and Pease is that while a high-income individual’s entire personal exemption can be fully phased out, the Pease limitation never affects more than 80% of itemized deductions.
For example, consider a single person with a 2013 adjusted gross income of $1 million and $30,000 in itemized deductions. There’s $750,000 of exposed income above the $250,000 threshold; $750,000 multiplied by 3% is $22,500. Instead of deducting the full $30,000, the person is able to deduct $7,500 ($30,000 to $22,500). And if the person’s adjusted gross income had been higher, it wouldn’t have made much difference, because the 80% maximum means the phaseout couldn’t have reduced the deduction amount by more than $24,000.
Certain types of deductions aren’t subject to the Pease limitation: medical expenses, investment interest and casualty/theft losses. Charitable contributions, however, aren’t excluded.
No Change in Medicare Taxes
Experts wondered whether the Medicare taxes scheduled to take effect in January might be revised in ATRA, but they weren’t. That means high earners with wages of more than $250,000 must pay an additional 0.9% in payroll tax; high-income self-employed people must also pay an additional 0.9% toward the health insurance portion of their self-employment taxes.
In addition, there’s a 3.8% Medicare contribution tax on the net investment income of high-income individuals – over $250,000 for joint filers. It affects the lesser of net investment income or modified adjusted gross income in excess of the threshold, yet another means of measuring income. “It’s a little bit more to keep track of, which makes tax preparers that much busier,” says Shier.
Planning for the Future
How many of the ATRA modifications to the tax code are likely to remain in place for years to come? Shier says the tax rates are likely set for the foreseeable future. Somewhat less safe are the exclusions and exemptions. She thinks Congress may tweak those in order to generate more tax revenue by broadening the tax base.
ATRA represents a partial solution to the country’s budget woes rather than the sweeping deal hoped for by both political parties. That means more changes may come. In the short term, however, Americans can plan for the upcoming tax season with a little more certainty.