2013 Income Taxes - What s Old is New Again

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1 Tax Alert Income Taxes - What s Old is New Again OVERVIEW Both the Economic Growth and Tax Relief Reconciliation Act of 2001 ( EGTRRA ) and Jobs and Growth Tax Relief Reconciliation Act of 2003 ( JGTRRA ) included what are commonly referred to as the Bush tax cuts, which provided for significant income and transfer (estate and gift) tax reductions that were in effect for nearly a decade. All of those provisions were scheduled to sunset at the very end of In the waning days of 2010 a lame-duck session of Congress passed, and the President signed into law, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the 2010 Tax Act ). In the waning days of 2012 (and the early hours of 2013) another lame-duck session of Congress passed, and the President signed into law, the American Taxpayer Relief Act of 2012 (the 2012 Tax Act ). The core of the 2012 Tax Act once again extends most, but not all, of the Bush tax cuts for more than 98% of taxpayers. The 2012 Tax Act will permanently extend existing income tax rates for all single taxpayers with taxable incomes below $400,000 and married couples with taxable incomes below $450,000. It is these amounts that now define the wealthiest taxpayers. As for those taxpayers, taxes will increase modestly for some and significantly for others. There are, however, several provisions in the 2012 Tax Act that reach below those thresholds and affect taxpayers at lower levels of income. In this later case, those taxpayers may feel the effect of a tax increase through the limitation of their itemized deductions or personal exemptions. The Act also renews, extends or even makes permanent several other miscellaneous income tax related provisions. The 2012 Tax Act extends on a permanent basis several estate, gift and generation-skipping tax provisions that were enacted over the past several years, but those provisions are described in a separate Tax Alert ( Fiscal Cliff Deal Brings Permanency to Transfer Tax Laws. ) This Tax Alert focuses on income tax provisions of the 2012 Tax Act. INTRODUCTION Effectively, the only change from the rate structure in effect through the end of 2012, is that a new top tax rate of 39.6% which applies to ordinary income will apply to those taxpayers with taxable income over a specified threshold. For taxpayers who file as single, the threshold will be $400,000; for taxpayers who file as head of household, it will be $425,000; for taxpayers who file as married filing jointly, it will be $450,000; and for married couples filing separately it will be $225,000. The new top tax rate also extends to trusts and estates. For trusts and estates the threshold for the 39.6% rate will apply to taxable income in excess of $11, TAX RATES Ordinary Income Rates Until December 31, 2012, the top marginal tax rate for ordinary income and short-term capital gains had been 35%. Under the new tax law, for 1 This $11,950 amount is estimated based upon cost of living inflation calculations. 1

2 2013, the new top marginal rate will be 39.6% on such income. 2 For individuals, there will be seven tax brackets: 10%, 15%, 25%, 28%, 33%, 35% and 39.6%. The 39.6% rate will apply for ordinary taxable income above the above-mentioned thresholds, and will add to the progressivity of the tax code. The inflation adjusted break point for the 35% bracket is scheduled to commence at approximately $398,350 (i.e. where the 33% tax bracket ends and the 35% bracket starts), thus truncating the 35% bracket. As a result, only $1,650 of income for singles and $51,650 of income for married couples will be subject to the 35% rate, before income is then taxed at the new 39.6% higher rate. For trusts and estates, the 35% bracket is eliminated in its entirety. Remember, that even those in the top bracket will get the benefit of the lower tax rates of the Bush tax cuts on income up to $398,350. For those taxpayers above the $400,000/$450,000 thresholds, this effectively translates to a savings of about $11,000 for singles and $13,000 for married couples over what their federal income tax bill could have been had the Bush tax cuts expired completely. For trusts and estates, since the threshold level is much lower (i.e., $11,950), the highest marginal rate will have a significant impact on the taxation of the income. Thus, for those trusts and estates that have traditionally accumulated income, there may be a tax incentive to consider distributions. Capital Gains and Qualified Dividend Rates Until December 31, 2012, the top marginal rate for long-term capital gains and qualified dividends had been 15% (in some instances, capital gains 2 With the imposition of the 3.8% investment surtax imposed by the Health Care and Education Reconciliation Act of 2010 (discussed in our Wealth Strategy Report: The 3.8% Medicare Surtax on Investment Income Individuals) and the limitation on itemized deductions, the effective top marginal rate on ordinary income could be nearly 45%. rates could be 0% on a relatively modest amount of gains). Had there been a sunset of the Bush tax cuts, qualified dividends would have been taxed as they had before 2001: as ordinary income, with rates as high as 39.6%. Under the new 2012 Tax Act, Congress opted to tax qualified dividends at the same preferential rate as long-term capital gains. However, they raised the highest marginal rate from 15% to 20% when income levels are at certain threshold levels. Specifically, under the new law the tax rate for long-term capital gains and qualified dividends will remain at 15% (or even 0% on limited amounts of gain) for married taxpayers filing jointly with taxable incomes below the $450,000 threshold level ($400,000 for single taxpayers). For taxpayers above those levels, the rate will rise to 20% (23.8% with the investment surtax) on amounts in excess of the above thresholds. For trusts and estates, the 20% capital gain rate would apply when taxable income exceeds $11,950. The method for determining how much gain (and qualified dividend income) is to be taxed at either the 15% or 20% is complicated. The 15% rate will apply to long-term capital gains and qualified dividends in an amount equal to the lesser of: i) the actual long-term capital gains plus qualified dividends; or ii) the amount by which the $400,000/$450,000 threshold amounts exceeds the taxpayer s taxable income, excluding long-term capital gains and qualified dividends. For example, if other taxable income (e.g., non long-term gain and non dividend income) exceeds $400,000 for single taxpayer ($450,000 for married filing jointly), then no amount of capital gain or qualified dividends will qualify for the 15% reduced rate. If, however, a married couple has other taxable income (e.g. salary) of $390,000 and dividends and capital gains totaling $85,000, then, under these facts, the $85,000 2

3 would be taxed by applying the tax rate of 15% on the first $60,000 and 20% on the remaining $25,000. If the facts were changed slightly and the taxpayer was a single taxpayer with identical income, that single person would pay a 15% capital gains tax on only $10,000 and the higher rate of 20% on the remaining $75,000. The following chart summarizes some of the changes under the 2012 Tax Act (and after) Top Ordinary Income Tax Rate 35.0% 39.6% Short-Term Capital Gain Rate 35.0% 39.6% Long-Term Capital Gain and Qualified Dividend Tax Rate (for taxpayers with taxable income below $400K/$450K) Long-Term Capital Gain and Qualified Dividend Tax Rate (for taxpayers with taxable income above $400K/$450K) Wage Surtax (for taxpayers with compensation income above $200K/$250K) Investment (Health Care) Surtax (generally for taxpayers with inv. income over $200K/$250k) Limitation on Itemized Deductions (for taxpayers with AGI above $250,000/$300,000) Limitation on personal and dependency exemptions (for taxpayers with AGI above $250,000/$300,000) Payroll Tax Holiday Employee /self-employed 15.0% 15.0% 15.0% 20.0% n/a 0.9% n/a 3.8% None None Two percentagepoint reduction Yes Yes None PAYROLL TAX HOLIDAY ENDS In each of the past two tax years, Congress enacted a temporary payroll tax cut, which reduced the rate of FICA withholding on wages from 6.2% to 4.2% of approximately the first $100,000 of wages. The 2012 Tax Act does not extend this tax break. The end of this so-called payroll tax holiday results in additional FICA taxes of up to approximately $2,000 on every wage earner. A similar 2% (up to approximately $2,000) increase will apply to self-employed individuals. ALTERNATIVE MINIMUM TAX ( AMT ) For many years, Congress has been enacting last minute patches to the AMT exemption amount. The 2012 Tax Act finally eliminates this annual uncertainty by permanently patching the AMT. In a section of the 2012 Tax Act titled: Permanent Alternative Minimum Tax Relief, two permanent changes are made to the AMT tax exemption amount. First, the base exemption amount is permanently increased to $78,750 for married couples filing a joint return and for surviving spouses, $39,375 for a person filing as married filing separately, and $50,600 for all other taxpayers. (Note, the exemption for a trust is no longer the same as for a married person filing separately, but is now fixed at $22,500, adjusted in the future for inflation.) Second, in an attempt to keep pace with inflation (which was the initial problem with the AMT that caused annual patches), the new law provides that the new increased amounts will be adjusted annually for inflation. The estimated cost to permanently patch the AMT exemption is by far the largest cost in the 2012 Tax Act, costing nearly $1.8 trillion over the 10 year budget window. STEALTH TAX INCREASES Not all of the tax increases are borne by those making above the $400,000/$450,000 income thresholds. Several provisions revive the curtailment of deductions and exemptions for taxpayers at lower levels of income. While the result of these changes is not an overt increase in 3

4 the tax rate, it has the effect of increasing taxes by one percentage point, or perhaps more. Limitation of Itemized Deductions The first indirect tax increase results from the limitation of certain itemized deductions. Under prior law, the limitation on certain itemized deductions (the so-called Pease limitation ) was gradually phased out through That limitation would have come back with the expiration of the Bush tax cuts and would, once again, require certain itemized deductions to be reduced by an amount equal to 3% of the excess of Adjusted Gross Income ( AGI ) over an inflation adjusted threshold amount (projected to be $174,000 for 2013). That threshold would have applied to all taxpayers, except for couples filing separately. Under the 2012 Tax Act the limitation returns but in a more benign way, so that certain itemized deductions will once again be reduced by an amount equal to 3% of the excess of AGI over a threshold amount, adjusted for inflation, but not by more than 80% of the itemized deductions. However, instead of a single AGI threshold for all taxpayers, that threshold amount will now vary by filing status: $300,000 for joint filers ($150,000 for married filing separate), $275,000 for heads of households, and $250,000 for single filers. Each of the above threshold amounts will be adjusted annually for inflation. Most itemized deductions are subject to this limitation including state and local taxes, mortgage interest, property taxes, charitable contributions and miscellaneous itemized deductions. For many taxpayers, the return of the limitation results in an effective tax rate increase of just over 1%. Certain itemized deductions are not subject to this limitation. They include: i) medical expenses, ii) interest expenses, and iii) casualty, theft or wagering losses. With respect to medical expenses alone, the threshold for the deductibility of such expenses as an itemized deduction increases from 7.5% to 10% of AGI in This rule is temporarily relaxed for certain older taxpayers. Limitation of Personal Exemptions Similar to the limitation on itemized deductions discussed above, the second indirect tax results from a phase out of personal and dependency exemptions. The limitation on personal and dependency exemptions that was scheduled to return would have reduced the value of these exemptions by 2% for each $2,500, or part thereof, that AGI exceeded various threshold levels (ranging from $261,500 for married couples to $130,825 for those filing as married filing separately). This limitation returns in 2013 in the same basic form, but with slightly different thresholds that conform to the same thresholds for itemized deductions. Beginning in 2013 the value of personal and dependency exemptions will be reduced by 2% for each $2,500 or part thereof that AGI exceeds the following thresholds: Married filing joint $300,000 Head of household $275,000 Single $250,000 Married filing separately $150,000 Each of the above threshold amounts will be adjusted annually for inflation. STATE SALES TAX DEDUCTION The 2012 Tax Act reinstates a provision that had expired at the end of 2011 relating to itemized deductions for state sales tax. This provision is retroactively renewed for 2012 and will also apply for tax year Under this provision, taxpayers can deduct as an itemized deduction state sales tax, instead of deducting state income taxes. More particularly, a taxpayer can deduct either (i) actual sales tax paid or (ii) an amount allowed under the IRS table. Because taxpayers have to choose between deducting state sales tax or income tax, this sales tax deduction is most beneficial for those who live in states without an income tax. 4

5 IRA CHARITABLE CONTRIBUTIONS The 2012 Tax Act also reinstates a charitable provision often referred to as the Qualified Charitable Distribution (sometimes also referred to as a charitable rollover ) retroactive to tax year 2012 and will be effective for 2013 as well. See our separate Tax Alert on this topic for more information (Special Rule for Retroactive Treatment of Lifetime Transfers from IRAs to Qualified Charities). This provision allows taxpayers who are over 70-1/2 to withdraw up to $100,000 from an IRA by paying an amount directly to a charity, thus bypassing the IRA owner s gross income on his or her tax return. That amount will not be considered taxable income, nor may the taxpayer take an itemized charitable deduction for it. Taxpayers, who are over 70-1/2 and are required to withdraw Required Minimum Distributions (RMDs) from their IRAs, may use this direct transfer to charity to satisfy a portion of that RMD. Because we are already into 2013, Congress devised a fix to allow taxpayers to take advantage of this provision for the 2012 tax year. To do this, the 2012 Tax Act added two provisions that allow taxpayers to take advantage of the retroactive feature: i) a taxpayer may make such a direct transfer to charity before February 1, 2013 and treat the transfer as if it had been made last year (2012); or ii) to the extent that an eligible taxpayer received distributions from an IRA in December of 2012, he or she can make a cash contribution (not stock or other appreciated asset) of an equivalent amount to a qualified charity out of his or her own pocket this year, before February 1, 2013 and have those December distributions treated as if they had been made directly to charity. In addition to the retroactive features for 2012 described above, this provision will be in effect for all of SILVER LINING If there is ever any good news when it comes to tax increases, it is that the proposal being discussed to limit the tax benefit of certain itemized deductions to the 28% bracket is not included in the 2012 Tax Act. Such a proposal could have also resulted in the taxation of a portion of municipal bond income. Thus, for those who will be subject to the new higher tax rate of 39.6%, all itemized deductions will have a concomitant increased value, with the exception of those deductions disallowed by the so-called Pease limitation. Similarly, personal and dependency exemptions could also become more valuable. But, even the potential tax savings to be derived from any deduction or exemption can be offset partially (and sometimes completely), by the alternative minimum tax rules. MISCELLANEOUS Roth IRAs A provision unrelated to the continuation of modification of the Bush tax cuts, but designed to raise revenue to partially pay for the delay of the sequestration provision is the loosening of the rules for Roth savings accounts. A provision of the 2012 Tax Act now allows a direct rollover from a traditional 401(k) plan to a Roth 401(k) plan under that plan without the need for any actual distribution. Other extenders The 2012 Tax Act also contains over fifty tax provisions, both personal and business, that have been extended retroactively to 2012 and prospectively to the end of 2013, for most, when they will once again expire. While we do not discuss each extended provision, the 2012 Tax Act extends the following refundable tax credit provisions for lower income working families and students: Child Tax Credit, Earned Income Credit, and American Opportunity Tax Credit. 5

6 Other provisions that have been extended for individuals include: Qualified tuition deductions, Parity for exclusion from income for employer-provided mass transit and parking benefits, and Special rule for charitable contributions of real estate conservation easements. Provisions that have been extended for businesses include: Increased expensing limitations and treatment of certain real property as section 179 property, Bonus depreciation, Work opportunity tax credit, Research credits, Temporary exclusion of 100% of gain on the sale of certain small business stock, Reduction of the S-corporation recognition period for built-in gains tax, and Credits for energy-efficient existing homes CONCLUSION Where do we go from here? The 2012 Tax Act may not be the only tax changes or tax increases that we see in The overall tax revenue derived from the 2012 Tax Act is estimated to be about $618 billion, far from the President s ask of well over $1 trillion and below Speaker Boehner s preliminary give of $800 billion. Indeed, in the White House s description of the 2012 Tax Act it states that the Act... sets the stage for future balanced approaches to deficit reduction... Looking at the current administration s budget from last year, it is possible that there is a resurgence to raise further revenue by trying to implement proposals such as limiting the tax benefit of itemized deductions to a 28% tax rate, trying to eliminate the tax free nature of municipal bonds, and perhaps implement further tax reforms that may translate to higher taxes. We will have to see what the year brings, and we will update you on any such changes. National Wealth Planning Strategies Group Any examples are hypothetical and are for illustrative purposes only. Note: This is not a solicitation, or an offer to buy or sell any security or investment product, nor does it consider individual investment objectives or financial situations. Information in this material is not intended to constitute legal, tax or investment advice. You should consult your legal, tax and financial advisors before making any financial decisions. If any information is deemed written advice within the meaning of IRS Regulations, please note the following: IRS Circular 230 Disclosure: Pursuant to IRS Regulations, neither the information, nor any advice contained in this communication (including any attachments) is intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax related penalties or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. While the information contained herein is believed to be reliable, we cannot guarantee its accuracy or completeness. U.S. Trust operates through Bank of America, N.A. and other subsidiaries of Bank of America Corporation. Bank of America, N.A., Member FDIC. Jan 2013 AR0F5138 6

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