Tax Changes for Individuals in the “Fiscal Cliff” Law

The American Taxpayer Relief Act of 2012, also known as the “fiscal cliff legislation,” was signed into law by President Barack Obama on January 2, 2013. Despite the name of the law, all workers will pay higher federal taxes this year due to the demise of the so-called “payroll tax holiday.”

The good news: The new law cancels income tax increases that would have resulted in added misery. It also makes several provisions permanent, which will result in less uncertainty.

The bad news: Higher-income folks will face higher tax rates, starting this year. And there are a couple other new taxes kicking in this year (not part of the new law), which may take you by surprise.

This article summarizes the most important changes for individual taxpayers, including favorable new estate and gift tax provisions.

The Payroll Tax Holiday is Over

For 2011 and 2012, the Social Security tax withholding rate on an employee’s salary was temporarily reduced from the normal 6.2 to 4.2 percent. If you’re self-employed, the Social Security tax component of the self-employment tax was reduced from the normal 12.4 to 10.4 percent. Last year, this payroll tax holiday could have saved one person up to $2,202 (up to $4,404 for a married couple with two incomes). Unfortunately with working folks, the new law does not extend the payroll tax cut through 2013.

Key Point: For this year, the Social Security tax can hit up to $113,700 of salary at a 6.2 percent rate and up to $113,700 of self-employment income at a 12.4 percent rate.

Tax Increases for Higher-Income Individuals

Rates on Ordinary Income: For most individuals, the federal income tax rates for 2013 will be the same as they were for 2012: 10, 15, 25, 28, 33, and 35 percent. However, the maximum rate for higher-income folks increases to 39.6 percent (up from 35 percent). This change only affects:

Filing Status Taxable Income
Single $400,000
Married joint filer $450,000
Head of household $425,000
Married filing separately $225,000

 

Rates on Long-Term Gains and Dividends: The tax rates on long-term capital gains and dividends will also remain the same as last year for most individuals. However, the maximum rate for higher-income folks increases to 20 percent (up from 15 percent). This change only affects singles without taxable income above $400,000, married joint-filing couples with income above $450,000, heads of households with income above $425,000, and married individuals who file separate returns with income above $225,000. These changes are permanent (until further notice).

Important: These higher-income folks can also get whacked by the new 3.8 percent Medicare surtax on investment income, which can result in a maximum 23.8 percent federal tax rate on 2013 long-term gains and dividends.

The 3.8 percent Medicare surtax on net investment income and a new 0.9 percent Medicare tax on wages and self-employment income both affect higher income taxpayers and became effective on January 1, 2013. They were not part of the new fiscal cliff law.

Phase-Out Rules Are Back

Before 2010, higher-income taxpayers had their itemized deductions and personal exemption write-offs “phased out.” This means that they didn’t get the full benefit of the most popular tax breaks.

The phase-out rules were deactivated for 2010 through 2012. Regrettably, the new law brings them back on a permanent basis.

Personal and Dependent Exemption Deductions: Your personal and dependent exemption write-offs can be reduced or even eliminated.

Itemized Deductions: You can potentially lose up to 80 percent of your write-offs for mortgage interest, state and local income and property taxes, and charitable contributions if your adjusted gross income (AGI) exceeds the applicable threshold.

Specifically, the total amount of your affected itemized deductions is reduced by 3 percent of the amount by which your AGI exceeds the threshold. However, the reduction cannot exceed 80 percent of the total affected deductions you started off with.

For both personal/dependent exemptions and itemized deductions, the AGI thresholds are $250,000 for singles, $300,000 for married joint-filing couples, $275,000 for heads of households, and $150,000 for married individuals filing separately.

Earned Income Tax Credit

Legislation enacted in previous years increased the earned income credit for families with three or more qualifying children and allowed married joint-filing couples to earn more without having their credits reduced. These changes, which help lower-income families, were extended through 2017.

American Opportunity Higher Education Credit

The American Opportunity credit, which can be worth up to $2,500 and can be claimed for up to four years of undergraduate education, was extended through 2017. The full credit is available to single individuals whose modified adjusted gross income (MAGI) is $80,000 or less ($160,000 for married couples filing jointly). Single taxpayers cannot claim the credit if MAGI is more than $90,000 ($180,000 for married filing jointly).

Higher Education Tuition Deduction

This tuition write-off, which can be $4,000 or $2,000 depending on income, expired at the end of 2011. The new law retroactively restores it for 2012 and extends it through 2013.

Note: You cannot claim this deduction and the American Opportunity credit for the same student in the same tax year.

Option to Deduct State and Local Sales Tax

In past years, individuals who paid little or no state income taxes were given the option of instead claiming an itemized deduction for state and local sales taxes. The option expired at the end of 2011, but the new law retroactively restores it for 2012 and extends it through 2013.

Charitable Donations form IRAs

In past years, IRA owners who had reached age 70 ½, were allowed to make tax-free charitable donations of up to $100,000 directly out of their IRAs. The donations counted as IRA required minimum distributions. So charitably inclined seniors with more IRA money than they needed could reduce their income taxes by arranging for tax-free IRA donations to take the place of taxable IRA required minimum distributions.

This break expired at the end of 2011, but the new law retroactively restores it for 2012 and extends it through 2013. To take advantage of the retroactive deal, you can treat donations made in January of this year as having been made in 2012. You can also donate IRA distributions taken in December of last year to charities and treat them as 2012 IRA donations. You must transfer such amounts to qualified charities by January 31, 2013.

Parity for Employer-Provided Parking and Transit Benefits

For 2012, employer-provided parking allowances are tax-free up to a monthly limit of $240. For 2013, the monthly limit is $245. Thanks to the new law, you can be given up to these same amounts last year and this year for tax-free transit passes or vanpooling. For example, you could get up to $245 per month this year to pay for the park and ride plus up to another $245 to pay for the train.

Without the new law, there would have been only a $125 monthly limit on employer-provided transit passes and vanpooling for 2012 and 2013.

Key Point: If your company doesn’t pay for these fringes, it might offer a salary reduction arrangement instead. Say you set aside $245 per month for the train plus another $245 for the park and ride. If you’re in the 25 percent federal income tax bracket this year, you could save up to $1,920 in federal income and employment taxes.

Tax-Free Treatment for Forgiven Principal Residence Mortgage Debt

For federal income tax purposes, a forgiven debt generally counts as taxable cancellation debt (COD) income. However a temporary exception applied to COD income from cancelled mortgage debt that was used to acquire a principal residence. Under the temporary rule, up to $2 million of COD income from principal residence acquisition debt that was cancelled in 2007-2012 was treated as a tax-free item. The new law extends this break to cover eligible debt cancellations that occur in 2013.

Deduction for K-12 Educators’ Expenses

The $250 deduction for teachers and other K-12 educators for school-related expenses paid out of their own pockets was retroactively restored for 2012 and extended through 2013.

Energy-Efficient Home Improvement Credit

In past years, taxpayers could claim a tax credit of up to $500 for certain energy-saving improvements to a principal residence. This break expired at the end of 2011, but the new law retroactively restores it for 2012 and extends it through 2013.

Mortgage Insurance Premium Write-Off

Premiums for qualified mortgage insurance on debt to acquire, construct, or improve a first or second residence can potentially be treated as deductible qualified residence interest. Before the new law, this break was only available for premiums paid through 2011. The new law retroactively restores the break for premiums paid in 2012 and extends it to cover premiums paid in premium amounts allocable to periods before 2014 and it is phased out for higher-income taxpayers.

Qualified Conservation Contributors

Liberalized deduction rules for qualified conservation contributions expired at the end of 2011. The new law retroactively restores them for tax years beginning in 2012 and extends them through tax years beginning in 2013. Qualified conservation contributions are charitable donations of real property interests, including remainder interests and easements that restrict the use of real property.

For individuals, the maximum write-off for qualified conservation contributions of long-term capital gain property is increased from the normal 30 percent to 50 percent of adjusted gross income. In addition, qualified conservation contributions are not counted when calculating an individual’s allowable write-offs for other charitable contributions. Qualified conservation contributions in excess of what can be written off in the year of the donation can be carried forward for 15 years (only a five-year carryover period is allowed under the normal rules). For an individual who is a qualified farmer or rancher, the qualified conservation contribution write-off for donated farm or ranch real property can be as much as 100 percent of the donor’s AGI. However, the donation must include a usage restriction stating that the property must remain available for agricultural or livestock production.