INDIVIDUALS             (Business - Estate PLan)

Out with one tax season, in with another. Now that most taxpayers have filed their 2012 returns, it’s time to look ahead to next year—what’s changing, what’s not, and what it means for your ability to retain more of your earnings.

The American Taxpayer Relief Act of 2012 (ATRA)—the compromise legislation passed a few months ago—does, as its name implies, provide substantial tax relief to many taxpayers. Yet while many will enjoy some benefits, others will see tax increases. Let’s take a closer look at the legislation as well as other tax laws impacting individuals starting in 2013, along with some tax planning strategies.

 

The ATRA retains 2012 ordinary income tax rates for most taxpayers. But, beginning in 2013, individuals with taxable income that exceeds $400,000 (for single filers) or $450,000 (for married couples filing jointly) will be subject to a top rate of 39.6 percent. Because the tax rates aren’t scheduled to expire, for 2013 you can employ the traditional timing strategies of accelerating deductible expenses into the current year and deferring income to the next year, where possible, to defer tax.

 

The ATRA retains the 15 percent long-term capital gains tax rate. However, it brings back the 20 percent rate for higher-income taxpayers. The 20 percent rate kicks in when taxable income exceeds $400,000 (for single filers) or $450,000 (for married couples filing jointly). The 0 percent rate for taxpayers in the bottom two brackets was also retained.

If you have children or other loved ones in the lower brackets, consider transferring appreciated assets to them. They can sell the assets and pay less tax (or no tax) on the capital gain. You may find this strategy particularly powerful if you’d pay tax at the 20 percent rate. But before gifting any assets, if the recipients are under age 24, make sure they won’t be subject to the “kiddie tax,” which was created to prevent excessive income shifting and taxes a child’s income at the parent’s marginal rate.

Regardless of your children’s ages, consider the gift tax consequences—and don’t neglect installment sales, which can be useful for reducing and deferring capital gains tax.

Also, consider making a charitable contribution consisting of appreciated securities instead of cash. You’ll not only receive a charitable deduction for the fair market value but also avoid paying the capital gains tax and the new net investment income tax discussed below.

 

The ATRA retains the long-term capital gains treatment of qualified dividends, so most taxpayers will continue to enjoy a 15 percent rate (0 percent for those in the bottom two brackets). However, higher-income taxpayers in the top tax bracket will face a rate increase (to 20 percent) on qualified dividends.

If you hold dividend-producing investments and will face the 20 percent rate, consider whether you should make adjustments to your portfolio in light of their potentially higher tax cost. Keep in mind, however, that qualified dividends will remain more attractive from a tax perspective than other income-producing investments. For example, interest from CDs, money market accounts, and taxable bonds will continue to be taxed at ordinary income rates.

 

The ATRA allows both the overall limit on itemized deductions and personal exemption phaseout to return in 2013 when income exceeds thresholds of $250,000 (for single filers) and $300,000 (for married couples filing jointly). Taxpayers will want to consider the timing of deductions and possibly defer or accelerate deductions to increase the benefit.

 

Before the ATRA, unlike the regular tax system, the AMT system wasn’t automatically adjusted for inflation. Instead Congress regularly passed a “patch” to increase the AMT exemption. The last patch had expired on December 31, 2011, so millions more taxpayers could have been subject to the AMT on their 2012 tax returns.

The ATRA makes the patch permanent by increasing the exemptions for 2012 and indexing them for inflation for future years. It also retains the ability to offset your AMT liability with certain nonrefundable personal credits.

You may be able to time income and deductions to avoid the AMT or reduce its impact. Now that AMT relief is permanent, AMT planning will be a little easier.

 

For the past several years, taxpayers have been allowed to take an itemized deduction for state and local sales taxes in lieu of state and local income taxes. The ATRA extends this break for 2012 and 2013. Consider making a contemplated purchase in 2013 to ensure the sales tax deduction is available.

 

Many child- and education-related breaks that had expired (generally on December 31, 2012) have been retained by the ATRA, while others have been temporarily extended. These include:

• The $1,000 child credit and expanded refundability of the credit
• The increased adoption credit and income exclusion for employer-provided adoption assistance
• The increased dependent care credit
• The American Opportunity education credit (through 2017)
• The above-the-line tuition and fees deduction (through 2013)
• Enhancements to the student loan interest deduction
• The $2,000 Coverdell Education Savings Account (ESA) annual contribution limit and other ESA enhancements

Be aware that the benefit of many of these breaks is phased out if a taxpayer’s income exceeds certain limits.

 

The ATRA included a number of other provisions that were either extended or retained that will benefit individuals.

• Eased restrictions for “in plan” Roth 401(k) rollovers
• Itemized deduction for qualified mortgage insurance premiums (through 2013)
• Exclusion of up to $2 million of debt discharge income from home debt forgiveness (through 2013)
• Nonbusiness energy property credit of 10 percent of the cost with a $500 lifetime credit limit (through 2013)
• Qualified charitable distribution (QCD) from IRAs and qualified plans
• Marriage penalty relief for the standard deduction

The extension of QCDs is particularly beneficial for taxpayers over age 70 1/2 with required minimum distributions from an IRA that’s also set up to make charitable contributions. When you use the QCD, the income resulting from the IRA distribution isn’t included in adjusted gross income (AGI), which means various phaseouts that are based on AGI won’t be as high, potentially resulting in lower tax.

 

Beginning January 1, 2013, an additional 0.9 percent Medicare tax on earned income and a new 3.8 percent net investment income tax (NIIT) go into effect when income exceeds certain thresholds. Taxpayers hit with higher income tax rates under the ATRA will generally also face the expanded Medicare taxes.

The additional 0.9 percent Medicare tax applies to FICA wages and self-employment income exceeding $200,000 (for single filers and heads of households) or $250,000 (for married couples filing jointly). The new 3.8 percent NIIT applies to net investment income to the extent that modified adjusted gross income exceeds those same thresholds.

Net investment income includes interest, dividends, annuities, royalties, capital gains, gains from the disposal of nonbusiness property, net rental income, and other passive income. It does not include wages and self-employment income (which may, however, be subject to the additional 0.9 percent Medicare tax), distributions from IRAs or qualified plans, gains on the sale of an active interest in a pass-through entity, nonpassive income from an active pass-through entity, excluded gains on the sale of a residence, tax-exempt interest (municipal bonds), and Roth IRA distributions.

To illustrate, consider a single taxpayer with $100,000 in net investment income, $300,000 in wages, and $400,000 of modified adjusted gross income (MAGI). The total additional Medicare tax is calculated as follows:

$300,000 IN WAGES – $200,000 THRESHOLD = $100,000 x 0.9% = $900

The total NIIT is calculated as follows:

$400,000 IN MAGI – $200,000 THRESHOLD = $200,000 or $100,000 NII

$100,000 NII x 3.8% = $3,800

TOTAL ADDITIONAL MEDICARE AND NET INVESTMENT INCOME TAX = $4,700

Higher-income taxpayers will want to consider strategies to reduce net investment income. This could include increasing participation or combining (grouping) activities to meet participation thresholds to be considered an active participant in pass-through business activities, restructuring investment portfolios to increase tax-free municipal bond income, or, where and if appropriate, modifying rental agreements.

 

The changes under the ATRA affect many areas of planning, plus there are the Medicare tax increases to consider. Complicating matters further is the fact that higher rates and various limits on tax breaks go into effect at different income levels, depending on the type of tax or break.

For more information on the ATRA, its effect on individuals, and help determining exactly how you’ll be affected and what strategies you can implement to reduce, or at least defer, taxes, contact your Moss Adams LLP tax professional.