Tax Certainty Improves, but the ‘Fiscal Cliff’ Debate Isn’t Over

Posted on January 16, 2013

President Obama signed into law a Congressional bill called the American Taxpayer Relief Act that will mean increased taxes for many taxpayers but prevented steeper increases while delaying debate on fiscal issues that could rock the economy. The newfound tax certainty under the American Taxpayer Relief Act was a welcome holiday-season gift. But political fights over federal spending cuts and U.S. government debt are likely to erupt during this year’s tax season ahead.

The president and the Congress clarified tax policy but came dangerously close to pushing the nation off the so-called “fiscal cliff,” or allowing simultaneous tax increases and government spending cuts to begin this month, as previously scheduled. Congress soon will return to the “cliff,” however, and the associated economic risks of fiscal austerity.

Features of the act unrelated to taxation include delaying until March a wide range of automatic federal spending reductions, known as the “sequestration,” that had been scheduled to start this month. The broadest immediate impact of the new legislation is an instant increase in the Social Security payroll tax rate to 6.2 percent of income from the temporary 4.2 percent level.

Love it or hate it, the new law is timely, at least. The law’s enactment calmed concern about the pace of tax-return preparation and processing in the current tax season. The enactment of the American Taxpayer Relief Act during the first few days of January should minimize any delays at the Internal Revenue Service in processing 2012 tax returns and disbursing refunds. Protracted political efforts to pass the law could have kept the IRS from revising tax forms and software companies from updating tax programs until the late stages of the tax season.

The wealthiest taxpayers face bigger tax bills on this year’s income, to be sure, as a result of the new law. But taxpayers with annual wages above thresholds as low as $200,000 could pay more taxes, too.

Relief from the threat of the alternative minimum tax is part of the package. The American Taxpayer Relief Act permanently indexes the amount of individual income exempt from the alternative minimum tax to the rate of inflation. It also sets the exemption amounts for 2012 at $78,750 for married taxpayers who file joint tax returns and $50,000 for filers of individual tax returns.

But the new law also limits certain deductions. For example, medical expenses above 10 percent of an individual’s adjusted gross income are now deductible, up from the previous threshold of 7.5 percent. Exceptions apply to taxpayers and their spouses who turn 65 between now and the end of 2016. For them, the threshold will remain 7.5 percent.

Also new this year is a Medicare tax equal to 3.8 percent of the lesser of (1) the individual’s net investment income during the year or (2) the amount the individual’s adjusted gross income above a threshold amount, which tops out at $250,000 for married couples filing joint tax returns. Examples of investment income include annuities, dividends, interest, rents and royalties.

Laws other than the American Taxpayer Relief Act also took effect this month and added to taxpayer liability. For example, the 2010 health care reform legislation this month raised the hospital insurance portion of employees’ Social Security tax, also known as the payroll tax, from 1.45 percent of covered wages in excess of the threshold to 2.35 percent. The threshold is $250,000 for married couples filing joint returns and for surviving spouses, $125,000 on married people filing individual returns, and $200,000 for other types of taxpayers.

Except for an increase in the top rate for the wealthiest taxpayers, the American Taxpayer Relief Act provides a permanent extension the individual income tax cuts during President George W. Bush’s first term in office under two public laws: the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). 

The American Taxpayer Relief Act preserved the six marginal tax rates on individual income under the 2001 and 2003 laws (10 percent, 15 percent, 20 percent, 28 percent, 33 percent and 35 percent) and created a new one: 39.6 percent on taxable income over thresholds of $400,000 for individual taxpayers,  $425,000 for taxpayers who file as heads of households, and $450,000 for married taxpayers who file joint returns (or $225,000 for married spouses filing separate returns).  The tax rate on capital gains and dividends rises to 20 percent for the wealthiest taxpayers and remains 15 percent for taxpayers in the middle tax brackets.

In addition, certain tax provisions under EGTRRA that were temporary have become permanent under the American Taxpayer Relief Act. These include generous rules for calculating tax credits for the care of dependents, based on expenses up to $3,000 for one dependent or as much as $6,000 for more than one. The American Taxpayer Relief Act also extended through this year several temporary provisions for individual taxpayers, among them the ability to make tax-free charitable contributions with funds from individual retirement plans and to exclude from gross income the discharge of home-mortgage debt, through a short sale, for example.

The exclusion of assets from estate tax and gift tax remains $5 million plus an adjustment for inflation. It is $5.12 million for 2012 tax purposes. But the top estate tax rate increased, effective January 1, to 40 percent from 35 percent. The new law also made permanent the so-called “portability” election for widows and widowers. It permits an increase in the tax-exempt portion of a surviving spouse’s estate by the amount of the allowable exemption that the deceased spouse never used. 

Various tax credits related to energy conservation, research and other expenses are part of the new law, too. Tax credits for energy conservation that expired at the end of 2011 got an extension through 2013 under the American Taxpayer Relief. These include credits for purchases of energy-efficient appliances and homes and for development of facilities to generate energy from wind and other renewable resources. The new law also enhanced and extended through 2013 a tax credit for spending on research and development, which had expired Dec. 31, 2011. The enhancement allows partial inclusion of R&D expenses of an acquired business in calculating the credit.