The bad news is we have no “Grand Bargain” and much remains to be done in order to put our country on solid financial footing. Much of the media seems focused on this perspective. However, what about the good news and, there is a LOT of good news in the compromise known as American Taxpayer Relief Act of 2012 (ARTA).
One major gripe we’ve heard for years is the uncertainty within the IRS tax code. Since the original passage of the Bush era tax cuts in 2001, many of the tax rates and rules had sunset provisions. That is to say, the lower rates were set to go up unless extended or changed. Given this kind of built-in uncertainty, planning for the future becomes more challenging when you don’t know: what tax rates will be, how capital gains will be taxed, what the estate tax rules will look like in the future. As financial planners we certainly agree with this point of contention!!
The good news begins with, that uncertainty is now gone for much of the tax code. Many of the rules in ARTA enact “permanent” changes within the tax code. So, what are some of these permanent rules that provide greater clarity for personal financial planning? Besides keeping the Bush era lower tax rates for all except single filers with taxable income over $400,000 ($450,000 for married filing joint), here is a list of planning related changes enacted by ARTA:
Alternative Minimum Tax (AMT) Relief
- The ongoing series of AMT exemption patches over the past decade are made permanent, and fixed retroactively. The new AMT exemption amount will be $78,750 for married couples and $50,600 for singles in 2012. The AMT exemption amounts will be indexed for inflation in the future.
- The rules that allow nonrefundable tax credits to be used for both regular and AMT purposes are also retroactively patched for 2012 and made permanent going forward.
Capital Gains and Dividends
- ATRA makes permanent the 0% and 15% long-term capital gains tax rates, but increases the tax rate to 20% for any long-term capital gains that fall in the top tax bracket.
- Qualified dividend treatment is also made permanent.
Phase-out of Itemized Deductions and Personal Exemptions
- The phase-out for itemized deductions (also known as the Pease limitation) reduces total itemized deductions by 3% of excess income over an Adjusted Gross Income of $300,000 for married couples and $250,000 for individuals. These amounts are indexed for inflation.
- The personal exemptions phase-out (also known as the PEP), reduces personal exemptions by 2% of the total exemptions for each $2,500 of excess income over the same threshold for the Pease limitation.
New Roth Conversion Flexibility
- In one entirely new rule under the legislation, ATRA will now allow individuals to convert their existing 401(k) plan to a Roth 401(k) plan, if the employer offers designated Roth accounts under the plan. The transaction will be taxed in a similar manner to any other Roth conversion.
- The new rules of ATRA make the current estate tax laws permanent, including the $5,120,000 (in 2012) gift and estate tax exemption (which will rise further to approximately $5.25M with an inflation adjustment for 2013); the Federal gift and estate tax exemptions remain unified. However, the top estate tax (and gift, and GST) rate is increased from the prior 35% to a new maximum rate of 40%.
- The portability rules for a deceased spouse's unused estate tax exemption amount are made permanent, which may significantly impact (i.e., reduce) the use of bypass trusts for all but the wealthiest of families.
“Extender" rules are retroactively patched for 2012 and extended through 2017:
- The American Opportunity Tax Credit (the $2,500 tax credit for college expenses that replaced the prior Hope Scholarship Credit in 2009).
- The Child Tax Credit and the Earned Income Tax Credit were also extended.
- Coverdell Education Savings Accounts: The favorable treatment of Coverdell Education Savings Accounts (so-called "education IRAs") including both the higher contribution limits ($2,000/year), and the ability to use qualified distributions for eligible K-12 expenses, has been extended and made permanent.
Other "extender" rules are retroactively patched for 2012 and extended one year through 2013:
- Deduction for up to $250 expenses for elementary and secondary school teachers
- Exclusion from income of discharged mortgage debt (necessary to prevent a short sale from triggering income tax consequences for the amount of debt that was discharged)
- Deduction of mortgage insurance premiums as qualified residence interest
- Deduction for state and local sales taxes paid (in lieu of state and local income taxes paid, useful in states that have little or no income taxes)
- “Above-the-line” deduction for up to $4,000 of higher-education-related expenses
- Exclusion from income for Qualified Charitable Distributions from an IRA to a charity
Indeed the President and Congress have important remaining fiscal issue to wrestle with, such as spending cuts and addressing the nation’s debt limit. These issues are of critical importance to our nation’s future and will certainly impact our economy and financial outlook. We will be certain to continue to monitor developments and we are here to help navigate the impacts future developments will have on personal financial planning.
Wishing all the best for a happy and health New Year
Jim and Debbie