In the wake of the elections, we are now face-to-face with the fast approaching so-called “fiscal cliff.” As of year end there will be major changes in the tax laws which affect everybody, unless Congress and the President can reach an agreement over the next six weeks. The chances of a lame duck Congress, that has been plagued by gridlock, taking major legislative action before year end seems dubious at best, but the prospect of 88% of Americans seeing some level of tax increase next year may be enough of a wakeup call to jolt Congress and the President to reach a compromise.
The increase in taxes will automatically occur as of January 1, 2013 as a result of a number of tax cuts that are going to expire as of year end, including most importantly, the Bush era tax cuts. According to the Tax Policy Center, taxes will increase an average of $3,700 for a typical household, however, for many taxpayers the tax increase will be far, far in excess of that amount. Total additional taxes would amount to over $535 billion, with top level taxpayers each paying an average of more than $100,000 in additional taxes next year. The impending changes in the tax law, if not corrected by year end, will have a major impact on investment planning and estate planning, in addition to business planning. The Congressional Budget Office has indicated that if the economy does go over the fiscal cliff, the country would slide into a significant recession as a result of the tax increases and spending cuts.
Hopefully Congress will act to avert the fiscal cliff or at least to provide a temporary continuedbridge by way of short-term extensions until the new Congress can act with a more permanent fix in 2013. But given the recent history of Congressional paralysis, you should be aware of what the changes in the tax law will be as of January 1, 2013 in the absence of Congressional action, and plan accordingly. Following are some of the most significant changes that will come into effect when that ball comes down in Times Square on New Year’s Eve.
HIGHER TAX RATES
The table below shows the increase in tax rates which will go into effect for 2013 based on the taxable income for married couples filing jointly:
Click here to see Table.
President Obama’s latest budget proposal and official presidential campaign policy would permit the extension of the 2012 rates for middle class Americans. However, he has been adamant that he would not approve an extension of the Bush era tax rates for higher income earners with annual income in excess of $250,000.
CAPITAL GAINS TAXES
The current favorable long-term capital gains tax rate of 15% will increase to 20% in 2013.
Although there has been no official statement addressing the issue of installment sales payments that straddle the change in the tax law, it is likely that installment sales entered into before year end will be taxed at current rates on the payments received this year, while payments received following year end will be taxed at the rates then in effect.
DIVIDEND TAX RATE
The current qualified dividend rate of 15% would terminate as of year end. Dividends received following year end would be taxable as ordinary income, at the ordinary income tax rates indicated above.
HEALTH CARE REFORM TAX
A new surtax of 3.8% will be added to the capital gains tax for high income earners (income in excess of $250,000 for married people filing jointly, or in excess of $200,000 for single) starting in 2013, on top of the increase in the long-term capital gains tax rate. This will effectively bring the top capital gains rate to 23.8% next year. The new investment tax was enacted as part of President Obama’s Health Care Reform Act. This includes an additional 0.9% added to the 2.9% Medicare tax for high income earners and a new 2.9% surtax on investment income, including interest income.
The temporary 2% cut in payroll taxes for 2011 and 2012 will also expire at year end. Payroll withholding for Social Security will therefore increase from 4.2% to 6.2% in 2013.
ESTATE AND GIFT TAXES
The current $5 million per person estate tax exemption amount will decrease to $1 million at year end. The estate tax rate will increase from 35% to 55%, with a surtax of 5% increasing the effective rate to 60% for larger estates. The gift tax exemption will also decrease to $1 million with the top tax brackets increasing to 55% as well.
These changes, among others, in the gift and estate tax laws will undo the last decade of changes in the tax rules which formed the basis for many estate plans.
WHAT COULD HAPPEN?
Immediately following the elections, there has been some conciliatory talk from Congressional leaders and the President indicating a willingness to try to work together to address this situation. One proposal that has been floated would call for closing loopholes and a 30% tax on investment income for those earning over $1 million, otherwise known as the Buffett Rule proposal.
Temporary solutions involving an extension of the Bush era tax cuts for 6 months would give time for Congress to act on a more permanent solution, including a possible major overhaul of the Tax Code. The call for significant tax reform has been embraced by both parties, although it would take quite some time to develop and adopt such a plan, and therefore an interim solution to buy time is a very real possibility.
It is not impossible that a compromise could be reached involving an extension of the lower tax rates for some taxpayers, while the Bush era tax rates would expire for the highest brackets. But of course, it is also equally possible that Congress and the Obama administration will fail to reach a compromise before year end, in which case all of the Bush era tax rates will expire. In that case, Congress and the administration could still act early next year to reinstate the current tax rates retroactively, although this would result in a state of total uncertainty in the meantime.
WHAT TO DO?
It is very important to carefully monitor news coming out of D.C. for any indication of prospects for a compromise on legislation before year end. But for now, plans must be made for the possibility that the tax changes currently slated to go into effect as of January 1, 2013, will indeed occur.
Tax planning must always be considered in the context of overall business and investment planning, but certainly many taxpayers may want to take advantage of the current low capital gains tax rates by selling appreciated investments before year end. Taxpayers engaged in installment sales this year may also want to consider opting out of the installment method of reporting the gain, and recognize the full gain this year at the lower tax rate. However, careful analysis is required prior to making any decisions, including tax projections discounted back to present value for accelerating the payment of taxes.
For estate planning purposes, it is advisable to review your current estate plan to determine the impact of the changes in the gift and estate tax laws. For many people, wills and trusts may need updating or revision to reflect new exemption amounts. Consideration should also be given to year end gifts to take advantage of the current historically high exemption amount which is set to expire as of year end.
But it is important to also consider the potential adverse tax consequences of making hasty decisions now without thoroughly analyzing the results under the potential alternative scenarios for the changing tax laws. At the present time nobody can be sure of the outcome of the negotiations in the Capital, but prudence calls for a review of your tax and estate planning under these uncertain circumstances.