Congress passed the American Taxpayer Relief Act of 2012 on New Year’s Day, enacting important changes to the Internal Revenue Code, including income tax and estate tax rules. This legislation has been signed into law by the President and resolves the tax issues which were discussed as part of the so-called “fiscal cliff” negotiations. In addition, certain changes also are effective beginning in 2013 that were enacted as part of the Patient Protection and Affordable Care Act (Obamacare).
Important changes to the tax laws in 2013 include:
Income Tax Rates
Income tax rates are made permanent for most individual taxpayers. The top marginal income tax rate, however, reverts to 39.6% (from 35%) for single individuals with income over $400,000 and joint filers with income over $450,000 (and a threshold of $425,000 for heads of households). The thresholds for tax brackets are indexed for inflation.
Example: A couple with $600,000 of taxable income (income after permitted deductions) will be subject to the new 39.6% rate only on $150,000 of income ($600,000 - $450,000). The amount of tax owed in 2013 would be $6,900 more than under the 2012 tax rates ($150,000 x (39.6% - 35%)).
Capital gain rates are made permanent for most individual taxpayers. However, the top marginal capital gain rate reverts to 20% (from 15%) for the same higher thresholds as for ordinary income.
Dividend income remains taxable at the same rate as capital gains (including the increase for top bracket taxpayers to 20%). Dividends were scheduled in 2013 to revert to being taxable as ordinary income, but this legislation averts that increase.
The limitation is reinstated on itemized deductions, which reduces itemized deductions by 3% of the amount by which a taxpayer’s adjusted gross income exceeds a threshold (subject to exclusions for certain deductions) up to a maximum reduction of 80%. The threshold is $250,000 for single individuals and $300,000 for joint filers ($275,000 for heads of household). These thresholds also are indexed for inflation.
Example: If a couple filing jointly has $400,000 in adjusted gross income in 2013 and their itemized deductions are $80,000 (and assuming no itemized deduction are in the list of excluded deductions), the couple will have their itemized deductions reduced by $3,000, to $77,000 (($400,000 - $300,000) x 3% = $3,000). The couple will pay an additional $1,050 in income tax (35% of $3,000).
The phase-out of the personal exemption is also reinstated, which reduces a taxpayer’s personal exemption by 2% for each $2,500, or portion thereof, by which the taxpayer’s adjusted gross income exceeds the same thresholds applicable for the limitation on itemized deductions.
Example: If a single individual has $275,000 in adjusted gross income in 2013, the individual’s personal exemption will be reduced by 20% (((275-000 – 250,000) / 2,500) x 2). Thus, the personal exemption is reduced from $3,900 to $3,120.
Permanent Alternative Minimum Tax relief increases the exemption amount to $50,600 for single individuals and $78,750 for joint filers, indexed to inflation.
Investment Income Surtax and Medicare Tax
Under Obamacare, certain non-corporate taxpayers with incomes in excess of $200,000 for non-joint filers and $250,000 for joint filers may be subject to a 3.8% Medicare surtax on certain investment income. Wages in excess of these thresholds also generally are subject to an additional Medicare tax of 0.9%.
Other Individual Income Tax Benefits
Numerous individual income tax benefits have been extended through 2013, including above-the-line deduction for teacher expenses, relief from cancellation of debt income for principal residences, deduction for mortgage insurance premiums as interest, election to deduct state and local sales taxes instead of income taxes, above-the-line deduction for qualified education expenses and tax-free distributions up to $100,000 per year from IRA accounts to public charities.
Other Business Income Tax Benefits
Several business income tax benefits have been extended through 2013, including the research credit, the new markets tax credit, the railroad track maintenance credit, the mine rescue team training credit, the work opportunity credit, the $500,000 expense threshold under Section 179 (allowing immediate expensing of certain capital asset purchases by small businesses), the 100% capital gain exclusion for Section 1202 stock, the 50% bonus depreciation and empowerment zone incentives.
Additional Payroll Tax
The new law does not extend the 2% payroll tax holiday. This results in a reversion of the employee portion of Social Security payroll taxes from 4.2% back to 6.2%. The employer portion remains at 6.2%. The wage base cap for Social Security Taxes also rose to $113,700 in 2013 (up from $110,100 in 2012) under the normal wage adjustment formula.
The combination of these rate and wage base cap increases results in the maximum employee contribution to Social Security withholding increasing by $2,425 ($7,049-$4,624). Medicare payroll taxes remains at 1.45% for the employer portion and 1.45% for the employee portion on all wages (not subject to the wage base cap), plus the new additional 0.9% Medicare tax described above.
Estate and Gift Tax Exemption
The estate and gift tax emption level remains at $5 million, indexed for inflation (rather than reverting to $1 million). Due to the inflation adjustment, in 2013 the exemption level likely will be close to $5.25 million per person ($10.5 million per married couple).
Note: Due to portability (as discussed below), this means that married couples with combined estates of about $10,500,000 will be federal estate tax free. Most married persons now will be able to plan their estates without significant transfer tax considerations.
Estate and Gift Tax Rates
Estate and gift tax rates now increase to a maximum rate of 40% from 35%. Prior to this recent legislation, the rate was scheduled to return to a maximum rate of 55% as of January 1, 2013.
Spousal Estate Tax Portability
Portability of any unused gift and estate tax exclusion between spouses has been made permanent. In other words, if the total exemption level is $10.5 million for a married couple, the exemption can be used between them in any combination.
Example: If a wife makes lifetime or testamentary gifts of $2.5 million (excluding transfers to her husband), then after her death her husband can use his wife’s unused $2.75 million exemption in addition to his own exemption of $5.25 million (as further adjusted for inflation) for his lifetime or testamentary gifts.
Other Estate Tax Changes
The federal deduction for State estate taxes, which was scheduled to expire, was retained. Several technical changes also were made to the generation-skipping transfer tax, mostly relating to valuation and the allocation of the tax exclusion.