In the nick of time, and amid much political drama, Congress passed the American Taxpayer Relief Act on New Year's Day—averting massive tax increases for nearly all earners that were slated to take effect Jan. 1.
Even so, millions of people soon will feel something less than relief from the new law.
While the top 1% of taxpayers will bear the biggest burden, many other families, affluent and poor, will pay more as well.
The most immediate change affects nearly all workers: Congress allowed a two-percentage-point cut for the employee portion of the Social Security tax to expire. As a result, each will owe up to $2,425 more in payroll tax this year than in 2012.
Beyond that, the new law's effects will be highly individualized—and in some cases highly painful.
"Many affluent people in exactly the same financial position as last year will see a substantial tax increase," says David Kautter, a director of the Kogod Tax Center at American University.
But there are two backdoor tax increases that will apply to people earning far less—$250,000 for singles and $300,000 for couples.
The first concerns the personal exemption, or the amount of money a taxpayer can deduct for him or herself and dependents. In 2013, this exemption is expected to be $3,900, so a couple with three children could deduct $19,500.
In 2013 the exemption phases out for people starting at the $250,000/$300,000 income thresholds, and vanishes completely for couples at $422,500 of "adjusted gross income," or income before itemized deductions, and at $372,500 for singles. So, a couple with three children and adjusted gross income of $300,000 or more will lose some or all of their $19,500 exemption.
The other new provision is called Pease, named after former Rep. Donald Pease (D., Ohio). It is a complex limitation on all itemized deductions—including charitable donations and mortgage interest—that will eliminate up to 80% of deductions for taxpayers above the $250,000/$300,000 income thresholds. Experts say this phaseout effectively adds about one percentage point to the top tax rate, including the top rate on capital gains.
The overall result is that, for many families, 2013 tax rates won't be as advertised. While a retired couple with $180,000 of income and $25,000 of deductions could see no change in their federal tax next year, a single parent of two children earning $260,000 with $30,000 of deductions could see a $3,300 increase.
And the Pease limit's effect will vary depending on individual circumstances. For example, people who live in high-tax states may find their charitable deductions are just as valuable as last year, if not more so, says Robert Gordon, president of Twenty-First Securities in New York. But people in low- or no-tax states such as Washington or Nevada could find their charitable deductions cost considerably more, Mr. Gordon says.
In essence, the new law "replaces uncertainty with confusion," says David Lifson, an accountant at Crowe Horwath in New York. "Only tax wizards can understand the entirety, especially for people earning between $200,000 and $450,000."
To help you get a grasp of your own 2013 taxes, the Tax Policy Center, a nonpartisan group in Washington, has devised a calculator, available on its website at http://calculator.taxpolicycenter.org/, that can help you crunch the numbers.
To be sure, one thorny issue did become clearer and more predictable as a result of the new law: estate taxes. Lawmakers retained the $5 million individual exemption for gift and estate taxes and kept it indexed for inflation, while raising the tax rate to 40% from 35%—about the best outcome many could have hoped for. And these changes are permanent, so advisers and families won't have to think for a moment about a relative dying in one year versus another.
While there still is plenty to digest, here is an early assessment of how the most important provisions could affect you:
Individual income-tax rates. For most people these rates remain the same as last year, but for the wealthiest there is a new permanent top rate of 39.6%, compared with 35% for 2012. The threshold for the top rate is $450,000 of taxable income for married couples filing jointly and $400,000 for single filers.
Oddly, the 35% rate seems to remain in effect for people with taxable income between about $398,000 and the new top-rate thresholds. So, for singles, the 35% bracket would span only from about $398,000 to $400,000, and to $450,000 for couples.
Investment income. The new law doesn't tax dividends at the same rate as wages and other ordinary income, a change that was set to occur this year before the deal was struck.
Instead, the new law leaves dividends in the same category as capital gains on investments held longer than a year, known as long-term gains.
But the law permanently raises rates on long-term gains and dividends for top-bracket taxpayers. People who have enough income to pay tax at 39.6% will owe 20% on their net long-term gains, as opposed to 15% in 2012.
Meanwhile, the 15% rate will continue to apply to taxpayers in the 25%, 28%, 33% and 35% income-tax brackets, and people in the 10% and 15% brackets will continue to have a zero rate on capital gains and dividends.
Another new tax on investment income, passed in 2010 as part of the Affordable Care Act, takes effect as well. The new 3.8% levy applies to net investment income above a threshold of $250,000 for couples ($200,000, singles).
Alternative minimum tax. Lawmakers adjusted the 2012 threshold for this complex tax and permanently indexed for inflation three of the variables that determine it.
The AMT was originally passed in 1969 to apply to wealthy people using many tax strategies. Over time its reach has spread, especially to residents of high-tax states, and Congress has passed many temporary "patches" over the years to reduce the pain.
If this fix hadn't been made, the AMT would have applied to 34 million taxpayers in 2012 instead of about 4 million. That could have severely disrupted the coming filing season because the IRS would have had to reprogram its computers at the last minute.
IRA charitable donations. This highly popular provision has been extended retroactively, running from the beginning of 2012 to the end of 2013. It allows taxpayers age 70½ and older to donate up to $100,000 of individual-retirement-account assets directly to a charity and count the contribution as part of the person's required withdrawals from the account, which kick in after 70½.
While the taxpayer can't take a deduction for the gift, neither does the gift count as income to him or her. So this donation can help reduce adjusted gross income and thus minimize Medicare premiums or taxes on Social Security benefits.
IRA owners were supposed to take required payouts for 2012 by Dec. 31, and the new law wasn't signed until Jan. 2. But taxpayers who took IRA withdrawals in December can give up to $100,000 of that payout to one or more qualified charities and take the charitable IRA donation. In addition, taxpayers can make 2012 IRA donations through Jan. 31. Details should be coming soon in IRS guidance, according to an agency spokesman.
Other "extenders." This term refers to a host of temporary provisions, some of which expired at the beginning of 2012 and some at the end.
Several popular expired provisions were made retroactive to the beginning of 2012 and now will be in effect to the end of 2013. They include the deduction for state sales tax in lieu of state and local income taxes; the $250 deduction for teachers' classroom expenses; and a benefit for employer assistance with mass-transit and vanpool costs.
The law also extended for five years the American Opportunity Tax Credit; for many taxpayers this is the most valuable education benefit, worth up to $2,500 per college student per year.
Lawmakers also included a one-year extension of current "bonus" depreciation rules, which allow businesses to deduct up to 50% of the cost of a wide variety of property and equipment, excluding real estate.
Estate and gift tax. The estate- and gift-tax exemption will remain at $5 million per individual—not the $3.5 million sought by President Barack Obama. But the current 35% top tax rate on amounts above the exemption will increase to 40%. These changes are permanent.
The exemption will also remain indexed for inflation, so the 2013 amount will be more than the 2012 exemption of $5.12 million. The IRS hasn't announced the 2013 adjustment.
In addition, the estate and gift tax will remain "unified," meaning an individual can use his or her entire exemption to make gifts while alive instead of waiting until death.
In past years, the gift-tax exemption was often much smaller than the estate-tax exemption, which limited the early transfer of assets that were growing in value. The large gift-tax exemption provides many planning opportunities to the wealthy.
The recently added "portability" provision also is permanent now. It allows a dead spouse's estate to transfer to the survivor any unused portion of the $5 million exemption. This means a married couple doesn't lose out on their total $10 million exemption simply because they didn't engage in predeath legal planning.
Several restrictions advocated by the Obama administration also didn't make it into the law. Long-running "dynasty trusts"—which can shelter assets from estate taxes for hundreds of years—weren't limited to a maximum term of 90 years. "Defective grantor trusts," another estate-planning technique, don't have new limits, either.
And the minimum term remains two years for another estate-and-gift-minimizing technique called a "grantor-retained annuity trust." The Obama administration and others wanted to trim its benefits by lengthening the term to 10 years.
—Email: taxreport@wsj.com Write to Laura Saunders at laura.saunders@wsj.com
Even so, millions of people soon will feel something less than relief from the new law.
Tim Foley
The bill approved in Congress to avert the fiscal cliff would bring the first major tax increase on high earners in 20 years. Laura Saunders breaks down how new tax increases will impact across different tax brackets. Photo: AP.
The most immediate change affects nearly all workers: Congress allowed a two-percentage-point cut for the employee portion of the Social Security tax to expire. As a result, each will owe up to $2,425 more in payroll tax this year than in 2012.
Beyond that, the new law's effects will be highly individualized—and in some cases highly painful.
"Many affluent people in exactly the same financial position as last year will see a substantial tax increase," says David Kautter, a director of the Kogod Tax Center at American University.
Back-Door Tax Increases
At first glance the law appears simple. In terms of income tax, for example, only the highest tax rate in 2012—the 35% bracket—will increase in 2013, to 39.6%. And that applies only to individuals with at least $400,000 of taxable income or couples with at least $450,000.The first concerns the personal exemption, or the amount of money a taxpayer can deduct for him or herself and dependents. In 2013, this exemption is expected to be $3,900, so a couple with three children could deduct $19,500.
In 2013 the exemption phases out for people starting at the $250,000/$300,000 income thresholds, and vanishes completely for couples at $422,500 of "adjusted gross income," or income before itemized deductions, and at $372,500 for singles. So, a couple with three children and adjusted gross income of $300,000 or more will lose some or all of their $19,500 exemption.
Associated Press
House Speaker John Boehner (R., Ohio), left, and House Ways andMeans Chairman Dave Camp (R., Mich.) confer Jan. 1 as the House weighed the tax bill.
The overall result is that, for many families, 2013 tax rates won't be as advertised. While a retired couple with $180,000 of income and $25,000 of deductions could see no change in their federal tax next year, a single parent of two children earning $260,000 with $30,000 of deductions could see a $3,300 increase.
Unanswered Questions
Adding to the frustration, many issues remain unanswered. The Internal Revenue Service hasn't released the new inflation-adjusted tax brackets for 2013, making it difficult for taxpayers to plan, though an IRS spokesman says the agency hopes to publish them soon.How the Tax Law Might Affect You
See some scenarios for how different groups of people may be affected by the tax changes that will take place under the new law passed to avert the so-called fiscal cliff.
In essence, the new law "replaces uncertainty with confusion," says David Lifson, an accountant at Crowe Horwath in New York. "Only tax wizards can understand the entirety, especially for people earning between $200,000 and $450,000."
To help you get a grasp of your own 2013 taxes, the Tax Policy Center, a nonpartisan group in Washington, has devised a calculator, available on its website at http://calculator.taxpolicycenter.org/, that can help you crunch the numbers.
To be sure, one thorny issue did become clearer and more predictable as a result of the new law: estate taxes. Lawmakers retained the $5 million individual exemption for gift and estate taxes and kept it indexed for inflation, while raising the tax rate to 40% from 35%—about the best outcome many could have hoped for. And these changes are permanent, so advisers and families won't have to think for a moment about a relative dying in one year versus another.
While there still is plenty to digest, here is an early assessment of how the most important provisions could affect you:
Individual income-tax rates. For most people these rates remain the same as last year, but for the wealthiest there is a new permanent top rate of 39.6%, compared with 35% for 2012. The threshold for the top rate is $450,000 of taxable income for married couples filing jointly and $400,000 for single filers.
Oddly, the 35% rate seems to remain in effect for people with taxable income between about $398,000 and the new top-rate thresholds. So, for singles, the 35% bracket would span only from about $398,000 to $400,000, and to $450,000 for couples.
Investment income. The new law doesn't tax dividends at the same rate as wages and other ordinary income, a change that was set to occur this year before the deal was struck.
Instead, the new law leaves dividends in the same category as capital gains on investments held longer than a year, known as long-term gains.
But the law permanently raises rates on long-term gains and dividends for top-bracket taxpayers. People who have enough income to pay tax at 39.6% will owe 20% on their net long-term gains, as opposed to 15% in 2012.
Meanwhile, the 15% rate will continue to apply to taxpayers in the 25%, 28%, 33% and 35% income-tax brackets, and people in the 10% and 15% brackets will continue to have a zero rate on capital gains and dividends.
Another new tax on investment income, passed in 2010 as part of the Affordable Care Act, takes effect as well. The new 3.8% levy applies to net investment income above a threshold of $250,000 for couples ($200,000, singles).
Alternative minimum tax. Lawmakers adjusted the 2012 threshold for this complex tax and permanently indexed for inflation three of the variables that determine it.
The AMT was originally passed in 1969 to apply to wealthy people using many tax strategies. Over time its reach has spread, especially to residents of high-tax states, and Congress has passed many temporary "patches" over the years to reduce the pain.
If this fix hadn't been made, the AMT would have applied to 34 million taxpayers in 2012 instead of about 4 million. That could have severely disrupted the coming filing season because the IRS would have had to reprogram its computers at the last minute.
While the taxpayer can't take a deduction for the gift, neither does the gift count as income to him or her. So this donation can help reduce adjusted gross income and thus minimize Medicare premiums or taxes on Social Security benefits.
IRA owners were supposed to take required payouts for 2012 by Dec. 31, and the new law wasn't signed until Jan. 2. But taxpayers who took IRA withdrawals in December can give up to $100,000 of that payout to one or more qualified charities and take the charitable IRA donation. In addition, taxpayers can make 2012 IRA donations through Jan. 31. Details should be coming soon in IRS guidance, according to an agency spokesman.
Other "extenders." This term refers to a host of temporary provisions, some of which expired at the beginning of 2012 and some at the end.
Several popular expired provisions were made retroactive to the beginning of 2012 and now will be in effect to the end of 2013. They include the deduction for state sales tax in lieu of state and local income taxes; the $250 deduction for teachers' classroom expenses; and a benefit for employer assistance with mass-transit and vanpool costs.
The law also extended for five years the American Opportunity Tax Credit; for many taxpayers this is the most valuable education benefit, worth up to $2,500 per college student per year.
Lawmakers also included a one-year extension of current "bonus" depreciation rules, which allow businesses to deduct up to 50% of the cost of a wide variety of property and equipment, excluding real estate.
Estate and gift tax. The estate- and gift-tax exemption will remain at $5 million per individual—not the $3.5 million sought by President Barack Obama. But the current 35% top tax rate on amounts above the exemption will increase to 40%. These changes are permanent.
The exemption will also remain indexed for inflation, so the 2013 amount will be more than the 2012 exemption of $5.12 million. The IRS hasn't announced the 2013 adjustment.
In addition, the estate and gift tax will remain "unified," meaning an individual can use his or her entire exemption to make gifts while alive instead of waiting until death.
In past years, the gift-tax exemption was often much smaller than the estate-tax exemption, which limited the early transfer of assets that were growing in value. The large gift-tax exemption provides many planning opportunities to the wealthy.
The recently added "portability" provision also is permanent now. It allows a dead spouse's estate to transfer to the survivor any unused portion of the $5 million exemption. This means a married couple doesn't lose out on their total $10 million exemption simply because they didn't engage in predeath legal planning.
Several restrictions advocated by the Obama administration also didn't make it into the law. Long-running "dynasty trusts"—which can shelter assets from estate taxes for hundreds of years—weren't limited to a maximum term of 90 years. "Defective grantor trusts," another estate-planning technique, don't have new limits, either.
And the minimum term remains two years for another estate-and-gift-minimizing technique called a "grantor-retained annuity trust." The Obama administration and others wanted to trim its benefits by lengthening the term to 10 years.
—Email: taxreport@wsj.com Write to Laura Saunders at laura.saunders@wsj.com
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