The recently enacted 2012 American Taxpayer Relief Act (Act) is a sweeping tax package that includes, among many other items, permanent extension of the Bush-era tax cuts for most taxpayers, revised income tax rates on ordinary income and capital gains for high-income individuals, modification of the estate tax, permanent relief from the alternative minimum tax (AMT) for individual taxpayers, limits on the deductions and exemptions of high-income individuals, and a host of retroactively resuscitated and extended tax breaks for individual and businesses. Here’s a look at the key elements of the package:
- Income tax rates. Beginning in 2013, the 10%, 15%, 25%, 28%, 33% and 35% tax brackets from the Bush tax cuts will remain in place and are made permanent. This means that for many Americans their tax rates will stay the same. However, there will be a new 39.6% rate, which will begin at the following thresholds: $400,000 (single), $425,000 (head of household), $450,000 (joint filers and qualifying widow(er)s), and $225,000 (married filing separately). These dollar amounts will be inflation-adjusted for tax years after 2013.
- Estate, gift and GST taxes. The new law prevents steep increases in estate, gift and generation-skipping transfer (GST) taxes that were slated to occur for individuals dying and gifts made after 2012 by permanently keeping the exemption level at $5,000,000 (as indexed for inflation). The exempt amount for 2013 is expected to be $5.25 million. The new law also permanently increases the top estate, gift, and GST rate from 35% to 40% Significantly, the Act permanently continues the portability feature that allows the estate of the first spouse to die to transfer his or her unused exclusion to the surviving spouse. All changes are effective for individuals dying and gifts made after 2012.
- Capital gains and qualified dividends rates. The new law retains the 0% tax rate on long-term capital gains and qualified dividends, modifies the 15% rate, and establishes a new 20% rate. Beginning in 2013, the rate will be 0% if income falls below the 25% tax bracket; 15% if income falls at or above the 25% tax bracket but below the new 39.6% rate; and 20% if income falls in the 39.6% tax bracket. It should be noted, however, that the 20% top rate does not include the new 3.8% surtax on investment-type income and capital gains for tax years beginning after 2012. The new 3.8% surtax applies to investment income for taxpayers with adjusted gross income above $200,000 (single) or $250,000 (joint filers). So actually, the top rate for capital gains and dividends beginning in 2013 will be 23.8% (20% plus 3.8%) if income falls in the 39.6% tax bracket. For lower income levels, the tax will be 0%, 15%, or 18.8%.
- Personal exemption phaseout. Beginning in 2013, personal exemptions will be phased out (i.e., reduced) for taxpayers with adjusted gross income over $250,000 (single), $275,000 (head of household) and $300,000 (joint filers). Taxpayers claim exemptions for themselves, their spouses and their dependents. Last year, each exemption was $3,800 per person.
- Itemized deduction limitation. Beginning in 2013, itemized deductions will also be limited for taxpayers with adjusted gross income over $250,000 (single), $275,000 (head of household) and $300,000 (joint filers).
- AMT relief. The new law provides permanent AMT relief. Prior to the Act, the individual AMT exemption amounts for 2012 would have been $33,750 for unmarried taxpayers, $45,000 for joint filers, and $22,500 for married persons filing separately. Retroactively effective for 2012, the new law permanently increases these exemption amounts to $50,600 for unmarried taxpayers, $78,750 for joint filers and $39,375 for married persons filing separately, indexed for inflation after 2012.
- Tax credits for low to middle wage earners. The new law extends for five years the following items that were originally enacted as part of the 2009 stimulus package and were slated to expire at the end of 2012: (1) the American Opportunity tax credit, which provides up to $2,500 in refundable tax credits for undergraduate college education; (2) eased rules for qualifying for the refundable child credit; and (3) various earned income tax credit (EITC) changes.
- Cost recovery. The new law extends increased expensing limitations and treatment of certain real property as Code Section 179 property. It also extends and modifies the bonus depreciation provisions with respect to property placed in service after Dec. 31, 2012, in tax years ending after that date.
- Tax break extenders. Many of the “traditional” tax extenders are extended for two years, retroactively for 2012 and through the end of 2013. Among many others, the extended provisions include the election to take an itemized deduction for state and local general sales taxes in lieu of the itemized deduction for state and local income taxes, the $250 above-the-line deduction for certain expenses of elementary and secondary school teachers, and the research credit.
- Roth pension provision. For transfers after Dec. 31, 2012, in tax years ending after that date, plan provisions in an applicable retirement plan (which includes a qualified Roth contribution program) can allow participants to elect to transfer amounts to designated Roth accounts with the transfer being treated as a taxable qualified rollover contribution.
- Payroll tax cut is no more. The temporary 2% payroll tax cut was allowed to expire at the end of 2012.
- Medicare Contribution Tax and Medicare Tax. In addition to the foregoing changes implemented in the Act, starting in 2013, high-income taxpayers will face two new taxes – a 3.8% Medicare contribution tax on “net investment income” and a 0.9% additional Medicare tax on wages and self-employment income. Here’s an overview of the two new taxes and what they will mean to you.
3.8% Medicare contribution tax. This new tax will only affect taxpayers whose adjusted gross income (AGI) exceeds $250,000 for joint filers and surviving spouses, $200,000 for single taxpayers and heads of household, and $125,000 for a married individual filing separately. These threshold amounts aren’t indexed for inflation. Thus, as time goes by, inflation will cause more taxpayers to become subject to the 3.8% tax.
Your AGI is the bottom line on Page 1 of your Form 1040. It consists of your gross income minus your adjustments to income, such as the IRA deduction. If you claimed the foreign earned income exclusion, you must add back the excluded income for purposes of the 3.8% tax. For estates and trusts, the tax equals 3.8% of the lesser of undistributed net investment income or AGI over the dollar amount at which the highest trust and estate income tax bracket begins ($11,950 of taxable income).
The tax is imposed on the lesser of your net investment income for the year or the amount by which your AGI exceeds the applicable threshold amount set out above.
Additional 0.9% Medicare tax on wages and self-employment income. Starting in 2013, some high wage earners will pay an extra 0.9% Medicare tax on a portion of their wage income, in addition to the 1.45% Medicare tax that all wage earners pay. The 0.9% tax applies to wages in excess of $250,000 for joint filers, $125,000 for a married individuals filing separately, and $200,000 for all others. The 0.9% tax applies only to employees, not to employers.
For joint filers, the additional tax applies to the spouses’ combined wages. For example, suppose that a married couple earns combined wages of $300,000 in 2013. On a joint return, they will pay Medicare tax of $3,625 ($250,000 × 1.45%) on their first $250,000 of wages plus $1,175 on their combined wages in excess of $250,000 ($50,000 × 2.35%), for a total Medicare tax of $4,800.
Once an employee’s wages reach $200,000 for the year, the employer must begin withholding the additional 0.9% tax from the employee’s wages. However, this withholding may prove insufficient if the employee has additional wage income from another job or if the employee’s spouse also has wage income. To avoid that result, an employee may request extra income tax withholding by filing a new Form W-4 with the employer. The extra withholding can then be applied to the liability for the additional 0.9% tax.
Self-employment tax. An extra 0.9% Medicare tax also applies to self-employment income for the tax year in excess of $250,000 for joint filers, $125,000 for married individuals filing separately, and $200,000 for all others. This 0.9% tax is in addition to the regular 2.9% Medicare tax on all self-employment income. The $250,000, $125,000, and $200,000 thresholds will be reduced by the taxpayer’s wage income.