How Will New Tax Changes Affect You?

With the recent passage of the American Taxpayer Relief Act of 2012, many of our clients are asking us what tax changes they should be aware of and how these changes will affect them. Here is a look at some of the new tax provisions affecting individuals:

 Qualified Charitable Distributions

Ordinary Income

Ninety-eight percent of Americans will continue to see lower tax rates as a result of the permanently extended Bush-era tax cuts. Tax rates will remain at 10%, 25%, 28%, and 33% on incomes below $400,000 for single individuals ($450,000 if married filing jointly). The top tax rate on ordinary income will increase from 35% to 39.6% on income over $400,000 ($450,000 for married taxpayers filing jointly). In addition, the 3.8% net investment income tax will apply to ordinary investment income, such as taxable interest and rental income, for a combined top rate of 43.4%.

Long-Term Capital Gains

For higher-income taxpayers, the rate will jump from 15% to 20%, restoring the rate in effect prior to the Bush-era tax cuts. When combined with the 3.8% net investment income tax, the top rate on long-term gains is now 23.8%.

Qualified Dividends

Investors were pleased that Congress retained a preferential tax rate on qualified dividends. The prior rate of 15% will increase to 20% for taxpayers in the highest income tax bracket. When combined with the 3.8% net investment income tax, this will result in a top rate of 23.8%, the same level as long-term gains. Other taxpayers will continue to be taxed at a maximum rate of 15% for capital gains and dividends.

Return of the Stealth Tax/Pease Provision

The Pease provision, or “stealth tax,” increases tax liability without increasing tax rates. It operates as an income-based reduction in the amount of itemized deductions higher-income taxpayers can claim. This provision had been phased out as part of the Bush-era tax cuts, but is now restored for individual taxpayers with income over $250,000 ($300,000 for married taxpayers filing jointly). Itemized deductions are reduced by an amount equal to 3% of income beyond these thresholds, with a maximum reduction of 80%.

Personal Exemption Phaseout (PEP)

Like the Pease provision, the personal exemption phaseout (PEP) had been eliminated as part of the Bush-eratax cuts, but has now returned for individual taxpayers making at least $250,000 and couples making at least $300,000. The PEP gradually reduces the amount that taxpayers can deduct for themselves and their dependents.

The Alternative Minimum Tax (AMT)

The AMT patch was permanently extended, which is good news for millions of middle-income families who won’t be subject to the tax. The AMT has been around for decades, but it was never indexed for inflation until now. It was originally designed to eliminate deduction loopholes the wealthy could use to pay less in taxes, but the income levels outlined in the original legislation did not keep pace with current income levels, potentially subjecting millions more Americans to the tax.

Estate, Gift, and Generation-Skipping Transfer (GST) Tax Provisions

• Same exemptions, new tax rate. The final compromise extends and makes permanent the previous law’s historically large exemption amounts: $5 million combined for gift and estate tax, and $5 million for GST tax (both indexed for inflation). The inflation indexed amount was $5.12 million for 2012 and is expected to be $5.25 million for 2013. However, the new legislation raises the top tax rate on transfers from 35% to 40%.  This top rate will apply to all transfers over the exemption amount.
• Portability. When a spouse dies without having used his or her full estate and gift tax exemption, that unused amount will continue to be “portable” to the surviving spouse, augmenting the surviving spouse’s remaining exemption amount.

State and Local Sales Tax Deduction

 The new law extends the election to claim an itemized deduction for state and local general sales taxes in lieu of state and local income taxes.

Mortgage Debt Relief

Finally, there’s some relief for those who lost their homes to foreclosure or short sales. Previously, if mortgage debt was canceled or forgiven after 2012, homeowners would be required to pay taxes on the canceled or forgiven debt. Now, up to $2 million of forgiven debt is eligible to be excluded from income in 2013.

Energy Tax Breaks

Homeowners who made qualified energy-efficient improvements to their residences in 2012 will still be able to claim the Residential Energy Property Credit up to $500.

Education Deductions

Teachers now can claim up to $250 of expenses for school supplies, materials, books, and software. College students can deduct certain education expenses, including tuition, books, and other supplies up to $4,000.

Tax Relief for Families and Children

• Child Tax Credit. The Act permanently extends the $1,000 tax credit for each dependent child you are able to claim under the age of 17.
• Earned Income Tax Credit (EITC). If you have three children and are married, you can continue to receive a maximum tax credit worth more than $5,700.
• Dependent Care Credit. You can still claim up to $6,000 of your eligible dependent care cost for two or more dependents.

If you have any questions about the American Tax Relief Act of 2012 and how your finances may be affected by these tax changes, please contact us.