How the American Taxpayer Relief Act Affects You
At the last possible moment, President Obama and Congress worked out a bipartisan compromise that managed to avert the ominous Fiscal Cliff. Although the agreement was far from the so-called “Grand Bargain” that was expected to put all of these issues to rest — we will have an unfortunate case of deja vu in two months with respect to both sequestration and the debt ceiling — the American Taxpayer Relief Act of 2012 will at least provide some certainty concerning future tax rates.
While the economy as a whole will appreciate the fact that tax policy will no longer hold the country hostage — all the major stock indicies were up more than 2% after the deal was announced — the same can not necessarily be said for those who will bear the brunt of the new tax increases. However, like any good compromise, the new law will spread the pain around just enough to make everyone a bit upset.
In the months leading up to the eventual deal, much of the focus was on future income tax rates. After President Obama’s relatively easy reelection victory in November, the issue was no longer in doubt; some Americans would definitely be paying more in taxes in 2013. The only question was the threshold beyond which the initial Bush-era tax cuts would not be extended.
As it ultimately turned out, that threshold is $400,000 for single filers and $450,000 for couples filing jointly. Not only will this affluent group of taxpayers see their top marginal income tax rate revert to 39.6%, but they will also be subject to a five percentage point tax increase on their long-term capital gains and dividends. This new 20% tax rate on long-term capital gains and dividends doesn’t account for the additional 3.8% tax increase on all sources of unearned income, including capital gains and dividends, that will be imposed on single filers who make more than $200,000 and married couples who make more than $250,000, as part of President Obama’s health care initiative.
Unfortunately, the fun doesn’t end there. Single filers who make more than $250,000 and married couples who make more than $300,000 will have a more difficult time avoiding tax increases through the use of exemptions and deductions, both of which will be curtailed under the new tax regime. Specifically, personal exemptions will be reduced by 2% for every $2,500 of income above the threshold, while the total of all itemized deductions, for things like mortgage interest and charitable contributions, will be reduced by 3% of the difference between an adjusted gross income and the threshold that’s applicable to the individual.
If your head is spinning by now, fear not. For those who fail to make a high six-figure salary, your income, capital gains, and dividend tax rates will not change at all. However, before you go celebrate your good fortune, note that one of the least-debated provisions of the new tax law is the elimination of the payroll tax “holiday,” which means Social Security taxes will be increasing by 2% in 2013.
Although 2% may not seem like a lot, it adds up to an additional $1,000 in taxes for those who make $50,000 per year, which will essentially negate the benefit of lower income tax rates. Even worse, unlike income taxes, which can often be reduced through many deferral strategies and deductions, payroll taxes are taken immediately out of your paycheck and are impossible to avoid. (Refundable tax credits, like the Earned Income Tax Credit, can help to reduce its burden for low-income families.)
Obviously, there are many other features of this new 157-page tax law that aren’t mentioned above, such as the permanent indexing of the alternative minimum tax to inflation, the increase in the estate tax from 35% to 40%, and the extension of certain tax credits like the American Opportunity Tax Credit. Given the inherent complexity of the tax code, you should consider meeting with a qualified tax professional to understand all of the possible ramifications of this tax deal on your personal financial situation. Thankfully, now that many features of the tax code are permanent, Pathway Financial Planning can also provide better guidance in making your future tax planning as efficient as possible.