You know that around New Year’s Day the crowd in Washington finally agreed to a deal to avoid the fiscal cliff, titled the American Taxpayer Relief Act of 2012. In this visit we review the deal in detail. We start with a couple of provisions that haven’t received much media attention but are important to my readers.
Extended through the end of 2013 with special transition rules is the special treatment of charitable contributions made through individual retirement accounts. Normally, a distribution from an IRA to charity is treated as a distribution to the IRA owner, followed by a charitable contribution. The owner includes the distribution in gross income and deducts the charitable contribution. The two might offset, but they might not. The taxpayer might not itemize expenses; if so, he couldn’t deduct the charitable contribution. Or a high-income taxpayer would lose part of the deduction because of the itemized deduction limitation.
Under the special provision, taxpayers ages 70.5 or older can make charitable contributions to public charities directly from their IRAs. The contributions won’t be included in gross income, and the IRA owner won’t receive a charitable contribution deduction.
The provision was in effect for a couple of years and expired at the end of 2011, so special transition rules were created. A qualifying IRA charitable contribution made in January 2013 can be treated as made in December 2012 at the owner’s option. Or a distribution to the IRA owner that was made in December 2012 and transferred to a public charity before Feb. 1, 2013, can be treated as a charitable distribution. This provides some tax planning options for taxpayers who were hoping to use the IRA charitable contribution rule in 2012 but couldn’t do it because Congress hadn’t extended the rule.
Another little-noticed change makes it easier for taxpayers with traditional 401(k) accounts to convert the accounts into Roth 401(k) accounts. Workers of any age or status can move their money from a traditional 401(k) to a Roth 401(k) with their employer, provided the employer plan allows this. While Roth 401(k)s have been allowed for a couple of years, previously only workers who retired, left the employer or were at least age 59.5 could convert a traditional 401(k) to a Roth.
Congress expanded the rule, because there is a tax cost to a conversion or transfer. You’ll have to include the converted amount in gross income. Congress is hoping a lot of people will do this and generate revenue for the government.
To decide whether to convert a 401(k) to a Roth version, consider the same factors as for a Roth IRA conversion. This is discussed in detail in articles in the “IRA Watch” section of the “Archive” on the members’ website and in my books, such as Personal Finance for Seniors for Dummies.
There are several differences for 401(k) conversions. First, your employer must offer a Roth 401(k) and allow an in-plan conversion. Second, there is no recharacterization or reversal option with a 401(k) conversion. Once you make the shift, it’s permanent. That means if your account’s value declines after the conversion, you’ll owe income taxes on the higher value. Third, unlike a Roth IRA, a Roth 401(k) imposes required minimum distributions after age 70.5.
Keep in mind the conversion could put you in a higher tax bracket for a year and cost you tax breaks.
A 401(k) conversion could be a good idea for a worker who has at least 10 years before retirement. It also can be good for someone who anticipates being in a higher tax bracket in the future. But older workers might be better off either converting in stages (so that one year’s conversion doesn’t push them into a higher tax bracket) or waiting until they can move the money from the 401(k) to a traditional IRA and then converting it to a Roth IRA.
The 2 percentage point reduction in Social Security withholding tax was allowed to expire at the end of 2012. Those of you receiving paychecks already learned this, and the self-employed need to realize this and make higher estimated tax payments in 2013.
The George W. Bush income tax cuts of 2001 and 2003 are preserved for most people. A 39.6 percent income tax rate is imposed on married couples filing jointly with taxable incomes exceeding $450,000 and singles with taxable incomes above $400,000. Everyone else retains the tax rate brackets at 10 percent, 15 percent, 25 percent, 28 percent, 33 percent and 35 percent. All the tax brackets are adjusted for inflation annually. A 39.6 percent top tax rate also applies to trust taxable income above $11,950.
There are a host of other provisions in the law.
The deal also extended the marriage penalty relief of a higher standard deduction and broader 15 percent tax bracket for married couples filing jointly.
The maximum tax rate on long-term capital gains and qualified dividends on the top income-tax bracket rises to 20 percent from 15 percent. Everyone else still has a maximum 15 percent rate on capital gains and dividends. Those in the 15 percent income tax bracket and below have a 0 percent long-term capital gains and dividend rate.
The 0 percent tax rate on long-term capital gains and dividends is made permanent. Anyone below the top of the 15 percent income tax bracket qualifies for the 0 percent bracket. After the inflation indexing, the 0 percent bracket will apply to married couples filing jointly with taxable incomes below $72,500 and singles with taxable incomes below $36,250.
The long-term capital gains rate continues to apply to assets held for longer than one year, and ordinary income tax rates apply to short-term gains.
A flat 28 percent tax rate continues to apply to gains from the sale of collectibles.
Keep in mind that the fiscal cliff deal doesn’t change the taxes imposed by Obamacare. There still is a new 3.8 percent net investment income tax for married couples with incomes over $250,000 and singles over $200,000. This tax is in addition to other taxes imposed on that income. Higher income taxpayers also pay the additional 0.9 percent withholding tax on salaries or self-employment taxes.
Also extended was a provision known as the Pease limitation, which limits itemized deductions for higher-income taxpayers. For 2013, it’s imposed on marrieds filing jointly with adjusted gross incomes of $300,000 or more and singles with AGIs of $250,000 or more. The Pease limitation reduces itemized deductions by 3 percent of the amount by which AGI exceeds the threshold amount, but it can’t reduce the itemized deductions by more than 80 percent. Exempt from the limit are deductions for medical expenses, investment interest and casualty, theft and wagering losses.
Likewise, the reduction in personal and dependent exemptions is extended at the same levels. Under this provision, the exemptions claimed are reduced by 2 percent for each $2,500 AGI exceeds the threshold. The thresholds for both the Pease limitation and exemption phaseout will be indexed for inflation.
The deal also made permanent the Alternative Minimum Tax patch. The patch increases the exemption amount to $50,600 for singles and $78,750 for marrieds filing jointly, and indexes the amounts for inflation. This keeps about 60 million people from being hit by the AMT. After the inflation adjustments, the exemptions for 2013 are likely to be $51,900 and $80,750, respectively.
Estate tax uncertainty finally ends. The law establishes the estate tax exemption at $5 million, indexed for inflation, which puts the 2013 exemptions at $5.25 million. In addition, the portability provision of the 2010 tax deal that gives married couples a $10 million joint exemption also was made permanent.
An overlooked part of the estate tax changes is that the estate and gift tax are unified again. That means the exemption is a lifetime amount. You can apply it to gifts made during life or the estate. We no longer have to deal with the $1 million lifetime gift tax exemption that was in place for a few years. The top tax rate on gifts and estates rises to 40 percent from 35 percent.
The generation-skipping tax also was made permanent at $5 million and with a 40 percent rate.
A number of other estate tax provisions were extended, including qualified conservation easements, special terms for qualified family-owned business interests and installment payments of estate taxes on closely-held business interests.
Many income provisions that have been expiring every year or two again received temporary extensions. These include the State and local sales tax deduction, child tax credit, earned income tax credit, child and dependent care credit, adoption assistance, American Opportunity tax credit, deductions for tuition expenses, teachers’ classroom expense deduction, and deduction for mortgage insurance.
There were many other provisions in the new tax law.
Businesses received another one-year extension of a number of tax provisions that expire each year or two. In addition, the 50 percent bonus depreciation and increased Section 179 expensing of new equipment were extended for one year.
Many of the energy tax incentives that were enacted in recent years also were extended through the end of 2013. These include tax credits for home improvements and appliances that meet certain requirements.
It’s likely that over time we’ll discover some provisions that were lost in the early readings of the law and some interactions or effects of the provisions will become clear. I’ll cover those here or in Retirement Watch as they arise.