Summary

While most of us were celebrating the new year, members of the U.S. House and Senate were trying to prevent a fall over the dreaded "fiscal cliff," the combination of automatic tax increases and automatic reductions in federal spending. Late on January 1, they finally achieved their goal, and here is a brief summary of what they did.

Income Tax:

  1. The income tax rate reductions that were passed temporarily over the years have now been made permanent, except that joint filers with taxable income over $450,000 (and single individuals with taxable income over $400,000) will now have a maximum tax rate of 39.6%. These higher income brackets will be adjusted annually for inflation in the same manner as the lower income brackets.
  2. The maximum tax rate on long term capital gains and qualified dividends has now been fixed at 20% for those joint filers earning over $450,000 (and single individuals earning over $400,000), and 15% or less for those earning below that level. These rates do not include the additional Medicare tax of 3.8% on investment income under the health care reform law, which will apply to higher income filers ($250,000 joint, $200,000 individual) beginning in 2013.
  3. The temporary "fix" to the alternative minimum tax ("AMT"), which had to be reenacted every year, has now been made permanent in the form of an annual inflation adjustment, relieving Congress from the necessity of adjusting the AMT exemption amount for inflation every year.
  4. The law does not extend the 2 percentage point cut in Social Security payroll taxes that has been in effect for the last two years.
  5. For joint filers earning over $300,000 (and single individuals earning over $250,000), there will be a partial phase out of deductions for itemized deductions and personal exemptions. These provisions were previously in the law, went away and now they are back.
  6. The charitable IRA contribution provision, permitting those over 70½ to make a direct contribution of IRA assets to charity, has been resurrected for 2012 and 2013, but not made permanent. There are some special rules for 2012. First, distributions in January 2013 directly from an IRA to a charity can be treated as being made in 2012. Second, if an IRA distribution was received in December 2012, a gift to charity by the IRA recipient in January 2013 can be treated as though the gift were made in 2012.
  7. The rules on converting balances in 401(k) retirement plans into Roth 401(k) accounts have been relaxed, permitting conversion at any time.

Estate and Gift Tax:

  1. The exemption from federal estate tax has now been permanently fixed at $5,120,000, to be indexed for inflation.
  2. The gift tax exemption has also been permanently set at $5,120,000, indexed for inflation, allowing people to make substantial gifts to family members and others during life.
  3. The rate for estate and gift taxes has risen from 35% to 40%.
  4. Portability of the estate tax exemption has been made permanent. This means that if one spouse does not use the entire exemption at the first death, the surviving spouse can use it. This is a valuable simplification of the planning process, but with somewhat complicated rules.

Now What?

These changes in the law create many planning opportunities:

  • The gift tax exemption permits substantial transfers of assets during life, including business interests, sheltering the amount transferred and the future growth from estate taxation. The higher gift tax exemption also allows for more flexible asset protection planning.
  • For spouses, portability provides the opportunity to avoid creating a trust when the first spouse dies. There are tradeoffs to this approach, however, and it is important to understand these tradeoffs before relying on it.
  • The new law preserves the ability to make transfers of closely held assets, such as business interests, using discounted values. The use of discounts will continue to be under attack, perhaps in future legislation, but for now it's a very useful planning technique.
  • There were no restrictions imposed by the new law in grantor retained annuity trusts (GRATs), which allows the planning flexibility of setting up GRATs for as little as two years.