And just like that, America’s long national nightmare is over. At least for a few weeks.
A fiscal cliff deal was reached in the wee hours of New Year’s Day, and while the resulting legislation failed to address our country’s spending, deficit and debt limit problems — meaning we’ll be right back at this fiscal cliff debate in February — it did provide much-needed clarity on the 2013 tax law. Here are the highlights:
• The maximum tax rate is increasing from 35 percent to 39.6 percent, but only on taxable income in excess of $450,000 if filing married filing jointly, or $400,000 if single. For all taxable income below the applicable threshold, your tax rates remain unchanged from 2012.
• Similarly, if your taxable income exceeds the aforementioned thresholds, your maximum tax rate on long-term capital gains and qualified dividends will increase from 15 percent to 20 percent. The maximum rate will remain 15 percent for everyone else. Don’t forget, however, to tack on the new 3.8 percent Obamacare tax on net investment income on the lesser of 1) your net investment income (generally interest, dividends, rents and capital gains), or 2) modified adjusted gross income (this will be the same as your adjusted gross income unless you have foreign earnings) in excess of $250,000 if married filing jointly or $200,000 if single.
• The estate tax exemption will remain at $5.12 million but the tax rate will increase from 35 percent to 40 percent.
• High-income taxpayers will once again lose up to 80 percent of their itemized deductions and potentially all of their personal exemptions. The threshold at which the phase-out begins has increased over previous iterations of these limitations, however, to $300,000 of adjusted gross income for married taxpayers and $250,000 for single taxpayers.
• The $1,000 child tax credit, the enhanced earned income credit, and the expanded education credit have each been extended for five years.
While these changes have gotten the bulk of the press, if we’ve learned nothing else from Nicolas Cage movies — and we haven’t — it’s that prominent congressional documents often hold hidden secrets. What follows are two aspects of the fiscal cliff deal that may not have wound up in any headline, but are just as important as those that did.
Even if you’re not rich, your taxes are going up. Under the fiscal cliff deal, the income tax rates will remain unchanged for 98 percent of all taxpayers. Yet, 77 percent of Americans will pay higher taxes in 2013. How can this be? On Dec. 31, 2012, a temporary 2 percent payroll tax reduction expired, and this provision was not extended as part of the fiscal cliff legislation. As a result, if you earn wages or are self-employed, you can expect your paychecks to be 2 percent lighter in 2013 than they were in 2012 on the first $113,700 of income.
The expiration of the payroll tax cut will add an average of $740 to the tax obligation of the American worker. So while your income tax obligation may not rise in 2013 if you earn less than $450,000/$400,000, your payroll tax obligation will increase, correspondingly decreasing your take-home pay.
If you earn between $250,000 and $450,000, you may not have received the reprieve you think you did. If your taxable income tends to fall between these two thresholds, you have likely spent the past few days basking in the glow of your unexpected death row pardon.
For nearly three years, President Obama promised that he would raise taxes for everyone with taxable income in excess of $250,000. But when the dust settled, the threshold was unexpectedly raised to $450,000, sparing you from the reinstatement of the dreaded 39.6 percent tax rate.
But did you really save any tax? Perhaps not, because at your level of income, you reside squarely within the sweet spot of the alternative minimum tax (AMT).
The AMT is a misguided parallel tax created to ensure that wealthy Americans pay some level of income tax. Basically, you must compute both your “regular” tax liability and your AMT liability and then pay the higher of the two. Unfortunately, what was once designed to ensnare only 155 exceedingly rich, exceedingly crafty families has recently become the scourge of the middle class, and now ensnares nearly 4 million taxpayers annually.
At income levels between $250,000 and $450,000, the exemption to the AMT — which was enacted to prevent the AMT from hitting middle class taxpayers and was permanently increased as part of the fiscal cliff deal — does little to no good, as the exemption amount is decreased as your income increases. Making matters worse, if you live in a high-income state, any state taxes you deduct for regular tax purposes are not permitted in computing your income subject to the AMT. Lastly, because the AMT is subject to a flat tax rates of 26 percent and 28 percent, the extension of the lower marginal rates for regular tax purposes is of no benefit in computing your AMT liability.
As a result, you may find that the raising of the 39.6 percent tax rate threshold from $250,000 to $450,000 proves inconsequential, as you would have been subject to the same AMT liability under either scenario.
To illustrate, assume that had the threshold for higher taxes been set at $250,000, your regular tax liability would have been $113,000. Your AMT liability, however, would have been $122,000. Because you are required to pay the higher of the two, you would fork over $122,000 to the IRS.
Assume further that the increase in the threshold to the start of the 39.6 percent tax bracket will decrease your regular tax liability from $113,000 to $108,000. Great news, right? Not quite, because due to the mechanics of the AMT, your AMT liability will very likely remain $122,000, despite the decrease in your regular tax liability. As a result, your final tax liability will remain unchanged: it will be $122,000 in either case.
In summary, while from a tax perspective the new legislation is a better alternative than going over the cliff, it is not a victory for everyone.
Tony J. Nitti, CPA, MST, can be reached at firstname.lastname@example.org .