With the passage of the American Taxpayer Relief Act (ATRA) on January 1, 2013, Congress avoided the worst of the so-called “fiscal cliff.” While some of the tax measures included in the ATRA are temporary, certain provisions were also made “permanent.” This article describes some of the major changes made to both the individual income tax rules and the gift/estate tax provisions.
Income Tax Highlights
Without this legislation, income tax rates would have reverted to the levels from the late 1990s across the board. Instead, only the top marginal rate has increased from 35% to 39.6%. This higher rate only applies to income that is above the “applicable threshold.” (See the chart for the threshold level for this rate and other income tax rates in effect for 2013 for single and married couples filing jointly.)
Many people will be glad to know that qualified dividends retained their favorable status and will continue to be taxed at long-term capital gains rates. For most people, the long-term capital gains rates will remain at 15%, while taxpayers with income above the “applicable threshold” will see this rate increase to 20%. (Again, see the chart for the taxable income levels where the different rates apply.)
Two other major changes from the individual income tax perspective are the reinstatement of the Personal Exemption Phase-out (PEP) and Pease Limitation. Both of these were temporarily eliminated from the tax code as part of the Bush era tax cuts. The PEP reduces the available personal exemption by 2% for each $2,500 (or portion thereof) by which the taxpayer’s Adjusted Gross Income (AGI) exceeds the “AGI applicable threshold.” (Again, see the chart at the bottom for a breakdown of this threshold.) The Pease Limitation reduces the amount of certain itemized deductions by 3% of the amount by which the taxpayer’s AGI exceeds the “AGI applicable threshold.” The total reduction cannot exceed 80% of the otherwise allowable itemized deductions. For both limitations the phase out does not start until Adjusted Gross Income reaches $150,000 for single taxpayers and $300,000 for married couples filing jointly.
The individual income tax change that will reduce government revenue the most is the permanent fix to the Alternative Minimum Tax (AMT). When originally enacted, the AMT was designed to make sure that wealthier Americans paid a minimum level of tax. However, AMT as originally written was not indexed for inflation, and so each year Congress had to pass an AMT “patch” to avoid subjecting more and more people to the minimum level of tax. The ATRA retroactively “patched” the AMT for 2012 and provided for automatic inflation adjustments for future years.
Gift and Estate Tax Highlights
Other “permanent” changes from the ATRA include an inflation-indexed gift and estate tax exemption amount. Without the ATRA, taxpayers would have seen a return of the federal estate tax on estates over $1 million and at a top estate tax rate of 55%. Instead, the top rate was lowered to 40%, and the exemption amount was raised to an inflation indexed $5 million (in 2011 dollars). The actual estate tax exemption amount for estates of people dying in 2013 will be $5,250,000. In addition, the ATRA retained the concept of “spousal portability.” This allows spouses to make certain elections to preserve their deceased spouse’s unused exemption amount.
The amount of the lifetime gift tax exemption (amount which one can gift during one’s lifetime) was also raised to $5 million and indexed for inflation. The bottom line is that a married couple may now pass over $10 million in assets free of gift and estate taxes.
From a planning perspective, the increased gift and estate tax exemption amounts will allow many people to again focus more on implementing an appropriate estate plan based on family needs instead of estate tax laws. For example, individuals can now focus on more traditional probate avoidance and trust planning issues such as protecting their beneficiaries’ inheritance from creditors and division at divorce.
Anytime there is a change of this magnitude in the estate tax laws, it is a good idea to review the planning you have in place. If you are one of the many who have not updated your estate plan in many years (or perhaps have not gotten around to planning at all), now is also a great time to start the process.