Last minute maneuvers in Washington DC lead to the passage of new tax legislation, the American Taxpayer Relief Act of 2012, late on January 1, 2013.  The tax legislation came one day after the United States “went over the fiscal cliff.”  However, Congress passed on Tuesday and the President ordered signed into law late on Wednesday legislation that is retroactive to the beginning of the new year.  Under the new legislation, tax rates will increase for all US taxpayers, but the majority of the tax cuts that took place in 2001 and 2003 will remain in place.

Ordinary Income Rates

The American Taxpayer Relief Act of 2012 makes permanent the 2012 tax rates for US taxpayers earning up to $400,000 ($450,000 for married persons filing jointly) per year.  The top tax rate will progress from 35% to 39.6% for US taxpayers earning more than $400,000 ($450,000 for married persons filing jointly) per year effective January 1, 2013.

Capital Gains and Dividend Rates

Capital gains and dividend tax rates also will increase to 20% for US taxpayers earning more than $400,000 ($450,000 for married persons filing jointly) per year effective January 1, 2013.  Most US taxpayers earning up to $400,000 ($450,000 for married persons filing jointly) per year will continue to pay capital gains and dividend tax at a rate of 15%.

Supplemental Withholding Rate

There is no guidance yet from the IRS on how the supplemental withholding rate will be impacted by the tax rate increase for US taxpayers earning more than $400,000 ($450,000 for married persons filing jointly) per year.  In the meantime, employers should continue to use the optional supplemental withholding rate on supplemental wages up to $1,000,000 of 25% (which remains the third lowest rate) until further guidance is issued.  Baker & McKenzie will keep you updated as to any guidance from the IRS on changes to the mandatory supplemental wage rate for supplemental wages exceeding $1,000,000.  In the interim, since this mandatory supplemental rate tracks the highest applicable rate, employers should use the new highest rate of 39.6%.

Expiration of the Social Security Tax Holiday

Also effective January 1, 2013, the Social Security Tax holiday that was in effect in 2011 and 2012 has expired.  As a result, the employee-side social security tax withholding rate for 2013 is 6.2%.  The Social Security wage base for 2013 is $113,700.

401(k) Plan In-Plan Roth Conversions Expanded

The American Taxpayer Relief Act of 2012 also included a provision aimed at raising revenue by allowing participants in 401(k) plans with a Roth feature to transfer their pre-tax 401(k) accounts to Roth accounts within the plan even if the account is not otherwise available for a distribution from the 401(k) plan.  Such transfers could occur even if the plan participant is still an active employee of the plan sponsor and prior to age 59 1/2.  Transfer of a pre-tax deferral account to a Roth account is a taxable event.

Education Assistance

The exclusion from gross income for employer-provided education assistance (which had been previously expanded to include both graduate and undergraduate expenses) in an aggregate amount of up to $5,250 per year has been extended permanently under the American Taxpayer Relief Act of 2012. 

Adoption Employer-Assistance Programs

The American Taxpayer Relief Act of 2012 extended permanently the exclusion from gross income for employer-assistance programs (and the adoption tax credit) for qualified adoption expenses of amounts of up to $10,000.

Mass Transit Benefits

The increased exclusion (from $125 to $240 per month) for employer-provided mass transit benefits is extended through 2013 by the American Taxpayer Relief Act of 2012.

Other US Tax Changes Effective January 1, 2013

Notwithstanding the American Taxpayer Relief Act of 2012, certain other tax changes will take effect January 1, 2013.  Effective January 1, 2013, the Medicare tax rate applicable to wages in excess of $200,000 ($250,000 for married individuals filing jointly; $125,000 for married individuals filing separately) will increase to 2.35%.  Employers are required to withhold and report Medicare tax at the 2.35% rate on all wages over $200,000 with respect to their employees.  The Medicare tax on wages of $200,000 or less will remain at the 1.45% rate. 

Also effective January 1, 2013, an additional 3.8% Medicare tax (in addition to the capital gain rates already in effect, see above) will be applied to investment income for taxpayers with annual income of more than $200,000 or $250,000 for joint filers.  This additional tax will apply to the sale of company stock received by employees, directors and consultants under equity incentive plans and dividends payable on such stock.