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Avoiding the Fiscal Cliff – Tax Update

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Continuing past trends, Congress and the House took us all to the very edge of the Fiscal Cliff, but finally passed legislation to avoid the majority of the damage that would have been caused by going over.

The final bill is very similar to the summary we provided just before the holidays. For most of you, the changes will be modest compared with recent years, but tremendous relative to what would have occurred if nothing was done. There are some significant tax increases for high-income earners, but they, too, pale in comparison to what would have occurred if we took the plunge.

The areas that will most significantly impact you as individual taxpayers are as follows:

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  • The 2% payroll tax holiday has come to an end. Earnings subject to the Social Security portion of payroll taxes will see a “tax increase” of 2%, regardless of income levels. This temporary 2% reduction has been in place since 2010.
  • For households with joint income under $300,000 (or individual income under $250,000), your income tax situation will largely remain unchanged. The bill also makes the 0% capital gains rate permanent in the lowest two tax brackets.
  • Taxpayers earning more than $300,000 jointly (or $250,000 individually) will be subject to limitations and phase-outs on personal exemptions and itemized deductions. While this does not explicitly change the taxpayer’s marginal tax rate, it subjects more income to taxation and results in a larger tax liability.
  • Taxpayers earning more than $450,000 jointly (or $400,000 individually) will be subject to an increased tax rate (35% to 39.6%) and an increased capital gains rate (15% to 20%). Accounting for the Obamacare taxes taking effect, the 39.6% bracket is really 40.5% and the capital gains rate is really 23.8%. On the positive side, taxes on qualified dividends will continue to receive favorable treatment rather than reverting to ordinary income rates. These changes are now “permanent” and indexed for inflation, which eliminates the sunsets that have caused so much uncertainty the past few years.
  • The ongoing AMT patches are now permanent and will be indexed by inflation for the 10 years, eliminating the need to introduce a new patch each year.
  • Estate tax exemptions will be set at $5.25 million in 2013 and will be indexed annually for inflation. The highest tax rate will increase from 35% to 40%. “Portability” of an unused exemption between spouses will remain in effect. These changes have been made permanent after more than a decade of estate and gift tax uncertainty.
  • Greater flexibility in Roth conversions. Under the new law, 401(k) balances may be converted to a Roth 401(k) as long as the plan allows designated Roth accounts under the plan. Prior to this, one could only convert a 401(k) balance to a Roth if they were eligible for a distribution from the plan (termination of service, disability, over age 59.5).
  • Extension of several existing tax credits and deductions, including the education deductions and credits, mortgage insurance premiums, the state sales tax deduction, and the ability to complete a direct rollover of IRA assets to a qualified charity.

There are numerous planning opportunities arising from this new tax law, but virtually none of them require immediate or drastic changes at this time.

Deficit hawks will be upset by this bill, as it really does not address the growing deficit, and most certainly does not balance the budget. On the whole, it raises relatively little in the form of additional revenue and merely punts on addressing the spending side of the equation.

Democrats believe we didn’t raise taxes enough and Republicans believe we didn’t cut enough spending. And both are right if the goal was to eliminate the national debt. However, the goal was to avoid another recession and avoid inflicting financial pain on the low and middle classes. This bill should accomplish that.

Have no fear – there is plenty more political drama in the month or two ahead…

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