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What The American Taxpayer Relief Act (ATRA) 2012 Means for You

Share current LOB: WealthManagement

According to many headlines, the uncertainty surrounding the fiscal cliff appears to have been negotiated, agreed upon and signed into law. Regardless of the clarity provided with many provisions in the act, there remains a list of open fiscal and policy issues to be discussed over the coming months and years, and many Americans are still left with personal uncertainty around what exactly was the agreement, what does it mean, and more importantly, should I be doing anything as a result of it?

What follows are some of the more wide-ranging personal impacts from ATRA 2012, factors to consider and a few potential courses of action. Each tax specific consideration should be weighed carefully within the context of your overall plan and with your tax advisor before taking action.

1. INCOME TAX RATES:

For 2013, and beyond on an indexed basis, a new 39.6% top marginal tax bracket applies to taxable income over $400,000 filing single/$450,000 filing jointly.

What does it mean? For the most part, the tax rates in effect prior to the deal are the same after the deal with the exception of the new top bracket of 39.6% for high-income earners. If your taxable income does not exceed the amounts above, this part of ATRA 2012 will likely not impact you.

What could I consider? It is hard to disagree with the benefit of continuing or increasing how much you save on an annual basis. You should continue to consider increasing income deferrals through tax favored retirement plans such as 401(k)s, deferred compensation plans, and health savings accounts (HSAs); utilizing tax-deferred vehicles such as annuities (while continuing to consider the income tax impact at withdrawal); adjusting investments to utilize more tax-free returns, such as with municipal bonds, and being mindful as your income approaches new tax brackets.

2. PAYROLL TAXES:

The Social Security “payroll tax holiday” ends and the standard 6.2% (vs. 4.2%) withholding rate (12.4% for self-employed) resumes for the OASDI (old age, survivor and disability insurance) portion of Social Security taxes (on the first $113,700 of compensation type income).

What does it mean? Every wage earner will see their Social Security payroll taxes increase by 2%.

What could I consider? Business owners, especially S-Corps may have more options here, but in general, it impacts everyone largely the same.

3. DIVIDENDS AND LONG-TERM CAPITAL GAINS:

Rates increase from 15% to 20% for those with taxable incomes over $400,000 filing single/$450,000 filing jointly. A 0% tax rate now applies if your federal marginal tax bracket is below 25%. Last year’s 15% federal rate continues for all other filers.

What does it mean? This one is a bit more involved. In addition to the various rates and bands, an additional consideration comes from the new healthcare law in the form of a 3.8% Medicare surtax on certain levels of taxable income. See the following chart for joint filers as an example:

Tax Bracket

CG/Dividend Tax

Health Care Tax Add-on

Total

39.6%

20%

Plus 3.8%

23.8%

25% through 35%

15%

Plus 3.8%*
*Begins when modified adjusted gross income
exceeds $200k single/$250k joint

18.8%

10% and 15%

0%

0%

0%

What could I consider? While an increase on some earners, these rates are still historically fairly low in comparison. Dividends continue to be a potentially attractive income source, especially for retirees, but you should also consider options such as annuities and low-turnover growth assets such as real estate and long-term growth stocks in taxable accounts. Additional attention may need to be paid here if you contemplate converting Roth assets as it may push you into a higher rate band.

4. PERSONAL EXEMPTIONS AND ITEMIZED DEDUCTIONS:

If your adjusted gross income (AGI – the bottom of page 1 of a standard 1040 tax form) is over $250,000 filing single/$300,000 filing jointly, a portion of your personal exemptions and itemized deductions will be reduced. Your personal exemptions will be reduced 2% for each $2,500 of income over the threshold. Your itemized deductions will be reduced 3% of the excess of AGI over the threshold. Itemized deduction reductions are limited to 80% of the overall deduction amount.

What does it mean? An example is probably the best way to illustrate the potential impact of this.

Assume a couple files jointly and has $350,000 in AGI. This exceeds the threshold for filing jointly by $50,000. $50,000 divided by $2,500 = 20. This couple’s personal exemptions would be reduced by 40% (20 x 2%) and their itemized deductions reduced by $1,500 (3% x $50,000).

For those above the thresholds, the implications of this provision of ATRA 2012 apply to each taxpayer the same but impact each taxpayer in proportion to their exemptions and deductions. The higher your exemptions and deductions, the larger the reduction and thus, the higher the out of pocket tax increase.

What could I consider? In addition to any influence you may have over your adjusted gross income (401(k), deferred compensation, or HSA contributions as examples), you could consider timing or bunching itemized deduction items such as charitable contributions in years where their impact could be greater. It also impacts other itemized deduction items such as state and local tax deductions and mortgage interest deductions, so each item should be weighed in light of this provision.

5. ESTATE, GST AND TAXABLE GIFT RATES:

2012’s spousal exclusion portability provisions remain intact. Exemption allowances remain at the $5MM inflation-adjusted level (estimated to be around $5.2MM± in 2013). The top transfer tax rate, though, expands to 40% from its previous 35% level.

What does it mean? For those who can consider taxable gifts to reduce their taxable estate without undermining retirement, it is still very highly advantageous to do so and to not do so means potentially even higher estate transfer taxes at the highest levels.

What could I consider? “Without undermining retirement” is the tricky part for many people and kept them on the sidelines in prior years where this was available. You should absolutely consider doing a financial plan to project out what your retirement needs might be, factoring a wide range of possibilities, in order to determine if this strategy may be right for you. In addition, as “permanent” as this act is being communicated, Congress retains the power to change any and all of the provisions in the tax code, so considering this option while it is the law of the land remains a wise choice.

6. ALTERNATIVE MINIMUM TAX (AMT):

AMT income levels were raised for 2012 and indexed for inflation moving forward. Retroactive to 2012, a $78,750 inflation-adjusted exemption is provided to joint filers/$50,600 single. In addition, nonrefundable personal credits (such as adoption, child care, energy efficient credits) now are available to offset a taxpayer’s entire regular and AMT liability.

What does it mean? This eliminates the need for Congress to “patch” this each year, thus significantly reducing annual uncertainty.

What could I consider? Moderately high income earners may no longer be so concerned about owning AMT munis either outright or within bond funds. There may also be greater capacity to recoup previously paid AMT taxes via nonrefundable tax credits.

7. QUALIFIED CHARITABLE DISTRIBUTIONS (FROM IRAs):

ATRA 2012 reinstates tax free qualified charitable distributions (QCDs), retroactively for 2012 and in 2013. In addition, certain distributions made before 02/01/13 can be deemed to have taken place on 12/31/2012. Distributions actually taken after 11/30/12 but before 01/01/13 can also be elected for a limited time (January 2013) to be retroactively treated as a QCD. These provisions still only apply to taxpayers age 70½ and older on up to $100,000 of designated IRA funds.

What does it mean? If you are taking minimum distributions, are charitably inclined and do not need the funds for other purposes, you have a short-term window to take advantage of potentially advantageous tax opportunities.

What could I consider? Similar to the estate gifting options, you should start with a determination of whether you will need any distributions for your long-term needs before considering this provision. Whether you do or do not, the window is brief, so do not delay weighing your options.

8. ROTH CONVERSIONS:

Taxable Roth conversions are now permitted by 401(k)/qualified plan participants of any age (previously needed to be over 59½) – but only into companion Roth accounts sponsored by one’s employer. The guidelines and ability to convert personal IRAs into personal Roth IRAs remains in place.

What does it mean? If your employer’s plan has a Roth account option and the plan administrator can accommodate it, you have an additional option to convert retirement accumulations into Roth accounts within that plan without having to leave that employer or rollover the account to an IRA first.

What could I consider? The lower you believe your current tax rate to be in relation to an anticipated higher tax rate when you need the funds, the more this option may appeal to you. Important considerations include whether the conversion will push you into a much higher current bracket and the impact a higher bracket could have on interest and dividend income taxes.

9. OTHER ODDS AND ENDS:

Other provisions contained in the new tax legislation to review include: state and local sales taxes, education expenses, discharge of mortgage debt, conservation easements, depreciation allowances, long-term care (CLASS provisions), medical expense deductions, business and energy-connected tax breaks to name a few.

PARTING THOUGHTS

It remains easy to become distracted by the many provisions of any legislation, by the volume of information and considerations and their impact to you and your long-term plans to the degree that you can quickly feel out of control and indecisive.

So what can you control? It is always prudent to treat any change as an opportunity to begin or revisit your financial plan. It is likewise always prudent to seek the advice of trusted advisors with the proper expertise for wisdom and direction. These two things can greatly increase the positive impact of the decisions you make and your discipline in light of changing circumstances.

Regardless of financial markets, legislation, volatility, or countless other things you have limited influence over, you can also always be mindful of your spending decisions and how much you save. Of the many “levers” that positively influence the viability of your financial plans, your saving rate continues to be at the high end of that list.

Lastly, there seems to be a large public discourse criticizing governmental leaders for waiting until the last minute to make critical financial decisions and discuss them with the proper level of importance. One thing we can all do is to not be personally guilty of the same thing. Do not delay! Contact your advisor today!

This content is general in nature and does not constitute legal, tax, accounting, financial or investment advice. You are encouraged to consult with competent legal, tax, accounting, financial or investment professionals based on your specific circumstances. We do not make any warranties as to accuracy or completeness of this information, do not endorse any third-party companies, products, or services described here, and take no liability for your use of this information.

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