Effects of 2013 Fiscal Cliff Act & Tax Planning

Effects of 2013 Fiscal Cliff Act & Tax Planning

May Ho, CPA 

As I have mentioned previously, Congress proposed tax increases and spending cuts set to go into effect on the New Year were like two wild horses posed to drag the U.S. economy to the edge of a fiscal cliff. Although Congress did not pull back those “horses” before 2013, they avoided implementing drastic tax hike on New Year’s Day when they passed the American Taxpayer Relief Act (ATRA) to preserve most of the George W. Bush tax cuts and extend other expired tax provisions.

The other wild horse, across-the-board spending cuts on discretionary programs known as Sequestration will be held until March. The results are once again dependent on the negotiation within Congress, and we will update you as the situation develops.

According to President Obama’s speech, only the rich will shoulder a tax increase this year, but the political definition of the rich for tax purposes has recently changed dramatically. Within two years, the threshold went up from $200,000 for Medicare Surtax to $250,000 during President Obama’s campaign. It has increased again to $400,000 for top tax rate purposes in new ATRA. The estate exemption amount rose up from $1 million to $5 million (10 million for a couple) in ten years. Is this because of the deflation of U.S. dollars or speedy growth of U.S. people’s wealth?  

It is becoming more confusing to determine the thresholds for the rich. Some are based on earned income, some are based on adjusted gross income, and some are based on taxable income.

Social security taxes are based on earned income. All wage earners and self-employed are subject to 2% FICA tax increase on earned income up to $113,700.  

Medicare Surtax’ threshold is the most complicated. It can be based on earned income (salary or self-employed income), or AGI, or investment income, depending on the nature of the income you get. Earned income over $200,000 ($250,000 for a couple) is subject to 0.9% Medicare tax increase from 2.9%. Investment income for individual’s AGI over $200,000 ($250,000 for a couple) is subject to 3.8% new Medicare Surtax. For estate and trust income, the threshold is at the highest tax bracket. The Medicare Surtax levels up Medicare tax on earned income and investment income to 3.8% on the rich.  

The comeback phase-outs of itemized deductions and exemptions are based on AGI. If a taxpayern AGI.nis over $250,000 ($300,000 for a couple), his (their) itemized deductions and exemptions are phased out.     

The increase of the Income tax rate is based on taxable income. A new 39.6% tax bracket was added for taxpayer’s taxable income over $400,000 ($450,000 for a couple). It rose by 4.6% in 2013.

ATRA 2013 tax changes for each kind and level of income are summarized below. For a summary of tax provisions, please click the link below for an article by the AICPA: http://www.journalofaccountancy.com/News/20137097.htm 

ATRA Tax Increase for Each Level of Income

Single	Married Filing Jointly	FICA		Medicare Surtax		Phase out of itemized deductions and personal exemptions	Top Tax Rate:	Capital Gains & Dividends
		Earned Income: Changed From 4.2% to 6.2%	Passive Income	Earned Income	Passive Income		Changed From 35% to 39.6%	Top Rate Changed From 15% to 20%
				2.9%+ 0.9%	New: 3.8%
<$200k		↑2%	0
$200k	$250k	↑2%	0	↑0.9%	↑3.8%
$250k	$300k	↑2%	0	↑0.9%	↑3.8%	↑1%
$400k	$450k	↑2%	0	↑0.9%	↑3.8%	↑1%
>$400k	>$450k	↑2%	0	↑0.9%	↑3.8%	↑1%	↑4.6%	↑5%

The tax benefit is even greater for rental or business properties. Rental or business properties can be depreciated yearly to offset income, but the adjusted bases of the properties have to be reduced. Upon the sale of the properties, the accumulated depreciation will be recaptured. However, when a taxpayer dies, all the depreciation recaptures are gone due to the stepped-up basis. These tax savings, automatic deferral, and potential tax free features make real estate investment as good as, or sometimes better than, tax free Roth IRA or Roth 401(K) investments.  

If you would like to figure out how much your tax increase will be in 2013, please go to the Tax Policy Center website (http://calculator2.taxpolicycenter.org/index.cfm) and fill out your income information. You can also go the following link to see the detailed information about the tax differences of 2012 tax year, 2013 fiscal cliff, and ATRA:

http://taxpolicycenter.org/taxtopics/Tax_Calculator_Law_Descriptions_11-12.cfm#ATRA.

How to make a good planning for this year’s tax return? Since 2012 has been passed, it is a little too late to make major tax changes for 2012. However, there are still few swords that you can use to cut the tax bills, such as IRA contribution, depreciation, and charitable contributions among them.  

For depreciation, the act extended through 2013 and retroactively to 2012 the $500,000 dollar limitation and phase-out threshold of $2 million in the cost of Sec. 179 property placed in service during the tax year.

IRA contribution can be made before April 15 deadline for 2012 taxes this year. SEP IRA contribution can be made before the business tax return deadlines, including extensions. For corporations and partnerships, the extension deadline is September 15. For individuals, the extension deadline is October15. Please make sure that you file the extensions.  

According to AICPA, “one individual provision extension offering a current opportunity to adjust tax liability for 2012 is tax-free charitable distributions from individual retirement plans, which had expired at the end of 2011. …A special rule (Section 208(b) (2) of the act) allows taxpayers to make such a distribution after Dec. 31, 2012, and before Feb. 1, 2013, which will be deemed to have been made on Dec. 31, 2012. A portion of a distribution from an IRA to the taxpayer made after Nov. 30, 2012, and before Jan. 1, 2013, may be transferred to the charity before Feb. 1 and recharacterized as a qualified charitable distribution.”

For long term tax planning, you should review your living trusts with your estate attorneys or accountants to see if they need to be amended. Do you need to make additional contributions into retirement funds? Should those contributions be pretax IRA or 401(K), or after-tax Roth IRA or Roth 401(K)? Or, should you choose to simply invest in properties such as real estate with tax deferral and potential tax-free features? These are all questions you should be aware for your tax planning.

Here are two articles for your reference: http://www.journalofaccountancy.com/News/20137097.htm

http://www.journalofaccountancy.com/News/20137142.htm.