At midnight on December 31st, the Bush-era tax cuts are due to expire, raising income tax rates across the board to levels last seen in 2001. President Obama's 2% payroll tax holiday will end as well, along with a host of other business and investment tax breaks. All told, 4 out of 5 U.S. households would face an average of $3,701 more in taxes next year.
Higher Tax Rates for All
You may think that only individuals in the top 2 brackets will face higher federal income taxes if the Bush cuts go bye-bye as scheduled on January 1, 2013. Not true. Unless Congress takes action and the president goes along (whoever that is), rates will go up for everyone -- not just "the rich."
Specifically, the existing 10% bracket will go away, and the lowest "new" bracket will be 15%. The existing 25% bracket will be replaced by the 28% bracket; the existing 28% bracket will be replaced by the 31% bracket; the existing 33% bracket will be replaced by the 36% bracket; and the existing 35% bracket will be replaced by the 39.6% bracket.
Bottom line: We'll all see higher taxes.
Higher Capital Gains and Dividends Taxes for All
Right now, the maximum federal rate on long-term capital gains and dividends is only 15%. Starting next year, the maximum rate on long-term gains is scheduled to increase to 20% (or 18% on gains from assets acquired after December 31, 2000 and held for over 5 years), and the maximum rate on dividends will skyrocket to a whopping 39.6%.
Right now, an unbeatable 0% rate applies to long-term gains and dividends collected by folks in lowest 2 rate brackets of 10% and 15%. Starting next year, those in the lowest 2 brackets will pay 10% on long-term gains (or 8% on gains from assets acquired after December 31, 2000 and held for over 5 years) and 15% and 28% on dividends (compared to 0% now).
Bottom line: taxes on long-term gains and dividends will go up for everyone.
Harsher Marriage Penalty
The Bush tax cuts included several provisions to ease the so-called marriage penalty. The penalty can cause a married couple to pay more in taxes than when they were single!
Right now, the bottom 2 tax brackets for married joint-filing couples are exactly twice as wide as for singles. This helps keep the marriage penalty from biting lower and middle-income couples. Starting next year, the joint-filer tax brackets will contract, causing higher tax bills for many folks.
Currently, the standard deduction for married joint-filing couples is double the amount for singles. Starting next year, the joint-filer standard deduction will fall back to about 167% of the amount for singles.
Bottom line: lots of lower and middle-income income couples will face higher tax bills due to a harsher marriage penalty.
Return of Phase-Out Rule for Itemized Deductions
Before the Bush tax cuts, a nasty phase-out rule could eliminate up to 80% of a higher-income individual's itemized deductions for mortgage interest, state and local taxes, and charitable donations. The rule was gradually eased and finally eliminated in 2010. Next year, however, the phase-out will be back in full force unless Congress takes action and the president approves. So if you itemize and have 2013 adjusted gross income above about $175,000 (or about $87,500 if you use married filing separate status), get ready for this phase-out rule to take a bite out of your wallet.
Return of Phase-Out Rule for Personal Exemptions
Before the Bush tax cuts, another nasty phase-out rule could eliminate some or all of a higher-income individual's personal exemption deductions (for 2012, personal exemption deductions are $3,800 each). The rule was gradually cut back and finally eliminated in 2010. But it will be back with a vengeance next year unless Congress takes action and the president approves. So you need to be ready for yet another bite out of your wallet if you are a married joint-filer with 2013 adjusted gross income above about $265,000. If you're single, the magic number will be about $175,000. If you use head of household filing status, watch out if your 2013 adjusted gross income exceeds about $220,000.
Some Bush Tax Cuts Are Likely to Be Continued
Some elements of the Bush tax cuts have gained bipartisan support and will probably be continued beyond this year. Examples include inflation-indexed alternative minimum tax (AMT) exemption amounts, the ability to use nonrefundable personal tax credits to offset your AMT bill, and the deduction for qualified higher education tuition and fees. The current versions of the child tax credit, earned income credit, dependent care credit, and adoption credit are also more likely than not to be continued. The Bush tax cut legislation liberalized these credits and later legislation liberalized them even more.
How does this affect you? See this interactive map - just choose your state. The chart on this page explains what changes.
How do we plan for this in this political climate? It's difficult to predict what will happen, but our advice is: when making decisions regarding gains, it would prudent to take them this year in case Taxmageddon comes to pass.
No one knows what will happen and it's likely we won't see any decisions until December 31st. The wisest thing to do is operate under the assumption that Congress will not act.
Contact us if you'd like to start planning early!
- Maco & Associates