Higher taxes for upper-income clients were certainly part of the American Taxpayer Relief Act, enacted on January 2 to stave off Washington’s trip off the fiscal cliff. But the hikes are not as bad as some of the worst-case scenarios that were floated. And many things taxpayers like were made, finally, permanent.
From a planning perspective, the taxpayer relief act seals the fate of the Bush tax cuts after 12 years of uncertainty. The six ordinary tax brackets established by the 2001 law––ranging from 10% to 35%––plus the Bush-era marriage-penalty relief, enhanced tax credits and more—are now etched into the Internal Revenue Code. That means they are permanent (unless Congress changes the law, which it could always do someday).
But for now, the new legislation keeps qualified dividends taxed as long-term capital gains, rather than ordinary income. “Making that permanent is huge” for both investors and clients who own C corporations, says Isaac Hirsch, a business tax attorney and associate at Lowenstein Sandler LLP in Roseland, N.J.
Back To The Future
But there are some new wrinkles for high earners. As the table shows, beginning in 2013 some clients face a 39.6% ordinary bracket and a 20% long-term cap-gains rate (these rates were in place before the Bush tax cuts in 2001). And clients earning somewhat lower six-figure incomes are subject to two other 20th century throwbacks: the so-called “Pease limitation” on itemized deductions and the phase-out of personal exemptions.
The alternative minimum tax received some enduring fixes that will save millions of Americans from its reach. An important fix enables taxpayers to use nonrefundable personal credits to the full extent of their alternative tax liability, according to CCH Inc., a business information and software company in Riverwoods, Ill. This provision is retroactive to 2012.
Elsewhere, the alternative tax system finally gets indexed this year. With an adjustment for inflation, the exemption from the AMT in 2013 is $51,900 for those who are single and $80,800 for married couples. Other parameters, such as the income level that separates the alternative minimum tax’s 26% and 28% brackets, are also now indexed. Without indexing, the AMT has been allowed to catch more taxpayer money in its ever-widening grasp.
In the transfer-tax arena, the taxpayer relief act increases the top estate tax rate to 40% in 2013 from its previous 35%. There are new 37% and 39% brackets, too. The exemption did not revert to its low $1 million, as many feared it would, but was instead given a bump for inflation that allowed it to increase to $5,250,000 per person for 2013 from $5,120,000 last year. So clients who previously used up their full exemption can make additional tax-free gifts of $130,000 today. And because the exemption is now permanently indexed, these clients will have recurring opportunities to distribute additional wealth free of gift taxes.
The taxpayer relief act also makes spousal portability permanent, letting widows and widowers use their deceased spouses’ unused estate and gift tax exemption.
Roth 401(k)s, first available in 2006, continue to evolve with an unexpected but welcome change. According to Barak Cowling, compliance manager at The Online 401(k), a retirement-plan provider in San Francisco, the new rules allow plan participants to convert their pretax money in a 401(k) plan to a Roth plan without leaving their jobs or reaching age 59 and a half.
Until now, only such transitions allowed you to make in-plan Roth conversions, which effectively prevented most participants from converting their accounts while still employed with the plan sponsor. But employers must amend their plans to permit the new type of conversion, Cowling says.
Employee and vested employer contributions may be converted, but any amount converted also counts toward income––which is precisely why Congress authored this provision. It’s a revenue raiser, and how.
Not only is the conversion taxed at ordinary rates, but adding it to income could also subject the client to the new 3.8% Medicare surtax that takes effect this year. The surtax applies to the smaller of the client’s income above a stated threshold ($200,000 for single people and $250,000 for couples) or net investment income.
Besides the hailed permanent changes, CCH notes that the taxpayer relief act temporarily extends numerous other popular breaks into 2013. One of these is the credit taxpayers can receive for making energy-efficiency improvements to their residences. Also extended is the above-the-line deduction for college tuition. And people can make tax-free payments to charity from traditional individual retirement accounts if they are 70 and a half or older. Some of these breaks are retroactive to 2012.
Hirsch says businesses will enjoy a temporary extension of the research and development tax credit and an extension of the 15-year life for depreciating qualified leasehold improvements and restaurant property. Also extended is the maximum Section 179 depreciation deduction of $500,000. He adds that in 2013 only, businesses can accelerate the use of their pre-2006 AMT credits instead of taking a 50% bonus depreciation.
Owners of large operations (say, 100 or more workers) will generally benefit most from the extension of the work opportunity tax credit, says CPA Blake E. Christian, a tax partner at HCVT LLP in Long Beach, Calif. “Many business owners completely overlook it, but it can be a valuable credit, particularly with the retroactivity and expanded eligibility tests” the new law provides. For 2013, the credit is available for hiring most returning veterans and other hard-to-employ individuals from certain targeted groups.
Lastly, the taxpayer relief act’s enactment has allowed the IRS to finalize its inflation adjustments for 2013. For instance, this year’s standard deduction is now set at $6,100 for single taxpayers and twice that amount for joint filers.
Time will tell how long the latest rules will last. Until then, advisors can till the steadiest ground in years.