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The American Taxpayer Relief Act of 2012 (ATRA) (written February 2013)

In late 2012 I wrote a summary of potential changes to the tax code in case the U.S. went over the “fiscal cliff.” At the eleventh hour, Congress finally acted on the potential expiration of the Bush tax cuts, and some other changes occurred which taxpayers should be aware of. As a result, this post focuses on issues that affect the majority of tax payers.

On a lighter note, we also cover an effort in financial education for youngsters. For more on this, see the section at the end of this newsletter on how to become a “finance smarty pants!”

  • Overview of ATRA
  • High Earners
    -Highest Earners Were Impacted Most
    -Phase-out of Personal Exemptions and Reduction of Itemized Deductions for a Broader Group
    -New Medicare Tax
    -What Higher Earners Can Do
  • Provisions Applying to More Taxpayers
    -Chance to Convert Traditional 401(k)s to Roths
    -Education Provisions
    -Donations from IRAs
    -Tax Break for Commuters
  • Keep an Ear to the Ground on Tax Talk

By now you know that there was little change for the vast majority of taxpayers after last year’s tax negotiations were complete. Many of the Bush era tax cuts scheduled to expire were made permanent, and the stock market has had a major rally due to the removal of this major fiscal uncertainty, combined with some improving economic news. You may also know that the payroll tax holiday expired, meaning we returned to pre-financial crisis withholding levels, which lowered take-home pay. You may also have noticed a longer wait for a refund, if you filed early, since tax systems had to be reprogrammed at the last minute.

Despite the lack of change for many taxpayers, a complete description of ATRA is rather lengthy, and I will not attempt to cover everything here, especially since there are many excellent summaries online. Google the formal name of ATRA and you will get over 2 million results!

So what, if anything, changed that most of us should pay attention to?

High Earners

1. Highest Earners Were Impacted the Most
The main tax increases were a rise in the top rate from 35% to 39.6% and the capital gains tax from 15% to 20%. However, these only apply to single taxpayers with income over $400,000 and couples married filing jointly with over $450,000. So for the vast majority, life remains mostly unchanged regarding tax brackets and capital gains. But there are some twists you’ll want to pay attention to.

2. Phase-out of Personal Exemptions and Reduction of Itemized Deductions for a Broader Group
The following changes apply to single filers with Adjusted Gross Income (AGI) over $250,000 and joint filers with AGIs over $300,000.

Personal exemptions are reductions in taxable income you take for yourself, your spouse and other dependents. Under the new law, for every $2,500 you make over the AGI thresholds, you lose 2% of the total value of your exemptions.

Similarly, you get to take less of your itemized deductions. They will be cut by 3% of what you earn over the AGI thresholds, with some exceptions (like the medical deduction). The maximum reduction in itemized deductions is 80%, aside from medical expenses, investment interest costs, and casualty and gambling losses.

3. New Medicare Tax
In addition to these phase outs, a new Medicare tax kicks in for high earners to pay for provisions of the Affordable Health Care Act. If your AGI is above $200,000 for single taxpayers or $250,000 for those married filing jointly, you will owe another 0.9% on wages above that income and 3.8% on investment income.

4. What Higher Earners Can Do
If you have to deal with the phase outs and the new Medicare tax, you will need to reduce your AGI as much as possible. One key way to do this is to fully fund your tax deferred accounts: 401(k)s, 403(b)s and health savings accounts. (Important note: this will not help when it comes to the 0.9% Medicare tax on wage income.)

You’ll also want to pay attention to where your investments are housed. If at all possible, you’ll want to keep taxable bond and mutual funds in tax-sheltered accounts, and placing the most tax-efficient investments possible in your taxable accounts. It will also be important to focus on strategies that generate long-term, rather than short-term gains in your taxable portfolio. Of course, all of these strategies are good for all tax payers to the degree you can implement them.

Provisions Applying to More Taxpayers

1. Chance to Convert Traditional 401(k)s to Roths
This provision is especially beneficial for younger taxpayers. Under ATRA, you can convert a traditional 401(k) to a Roth 401(k) at any time, if your employer offers both (about half of employers do, and that proportion has been increasing over recent years). The conversion is a “taxable event,” meaning you’ll pay income taxes on your contributions and earnings, which is why it is good to do this while you are in a lower tax bracket. The benefit of the conversion is that in retirement, when you withdraw the money, it will be 100% tax free. A conversion is more clearly beneficial for those who are young, or those who have reason to believe their taxes will rise. Other taxpayers may still benefit if they have enough years to retirement so that the growth in the account is sufficient to offset the cost of the conversion. You may want to consult a financial advisor or tax specialist to analyze this question if you are unsure. Important note: unlike IRA conversions, 401(k) conversions cannot be recharacterized.

2. Education Provisions

The American Opportunity Credit – this credit, worth as much as $2,500 for higher-education expenses, is back for at least five more years.

Student Loan Interest Deduction – you may deduct up to $2,500 in student loan interest if you qualify ($75,00 AGI for singles, $150,000 if filing jointly). You may do this indefinitely instead of just for five years.

Coverdell Education Savings Accounts – these are now more attractive. The $2,000 a year maximum, which had been scheduled to drop to $500, is now permanent. Your contribution is not deductible, but earnings grow tax-free. Withdrawals are tax-free not only for college, but for any education costs. This makes Coverdells attractive for private schools, like prep or parochial schools.

3. Donations from IRAs
Retirees age 70 ½ can once again give up to $100,000 directly to a charity from an IRA. You do not get a charitable deduction, but neither do you pay tax on the withdrawal. (Just make sure that the payment goes directly to the charity.) This strategy is appealing for those who do not need the income or who are looking to reduce the size of their estate.

4. Tax Break for Commuters
For those whose companies offer a transportation reimbursement account, you can now set aside $245 a month pretax for public transit, an increase from $125 last year. Not all employers have made this change yet, so you may need to change the contribution at open enrollment.

Keep an Ear to the Ground on Tax Talk: Take Tax Breaks while You Can

Although ATRA was a relief to the average tax payer, fiscal challenges lie ahead for our federal government. The sequestration looks increasingly likely as I write to you, and by the time you read this, it may be a reality. Although that will not increase taxes (instead, it makes across the board cuts in certain government expenditures), it appears to be just one more battle in a lengthy war over how to close federal budget deficits. There continue to be rumblings about reducing tax breaks for everything from retirement plan contributions to mortgage deductions. Take advantage of the opportunity to secure your financial future now, as there may well be more change to the tax code in future years.