Taxpayer Relief Act of 2012

The American Taxpayer Relief Act of 2012:  What Relief?

I have many working clients who are now looking at their paychecks and wondering "Why is my take home pay less?  I thought the fiscal cliff resolution only affected those making over $400,000?"

We waited with bated breath until the very end, January 1, 2013, for Congress to avoid the oncoming "fiscal cliff".  A deal was made, and most Americans breathed a sigh of relief as we were told that income taxes would not increase for those individuals making less than $400,000, or for couples making over $450,000.

Despite this feeling of relief, every working American is now paying more in taxes, and there are hidden tax traps for those earning under $400,000.  What really happened effective January 1, 2013 and what are the opportunities under the "American Taxpayer Relief Act of 2012"?

·    Income Taxes:  While 2013 introduces a new top tax rate of 39.6 % (up from 35%) for individuals whose income exceeds $400,000 ($450,000 for married taxpayers filing a joint return) with the other marginal rates - 10, 15, 25, 28, 33 and 35 percent - remaining the same, there are some hidden tax increases which will affect all your working and/or higher net worth clients.

o  The Social Security portion of the payroll tax, which was reduced to 4.20% for employees for tax years 2011 and 2012, has increased back up to 6.20% in 2013, up to a maximum income of $113,700.  This increases taxes about $1,000 for the typical American worker.

o  The American Taxpayer Relief Act of 2012 added a limitation for itemized deductions claimed on 2013 returns of individuals filing single with an adjusted gross income (AGI) of $250,000 or more ($300,000 for married couples filing jointly).  This limitation "sunset" in 2010, but is back for 2013.

o  An additional .9 % Medicare tax on incomes over $250,000.  This additional tax has no limiting income threshold.

o  There is an additional 3.8 % tax on investment income for taxpayers with AGI's over $200,000 ($250,000 for married couples filing jointly).  Note that this additional tax is on all earned income, including income from interest, dividends, annuities, royalties, and rents which are not derived in the ordinary course of trade or business, excluding active S corporation or partnership income. Gross income does not include items such as interest on tax-exempt bonds and veterans' benefits, which are excluded under the income tax guidelines.

o  The long-term capital gains tax has increased to 20% from 15%, unless individuals have AGI's in excess of $400,000 ($450,000 for married couples filing jointly).

  • However, if your client's MAGI is over the threshold amount for the 3.8% Medicare surtax (see bullet point above), their capital gains will also be subject to that tax, for an effective long-term capital gains rate increase of 8.8% to 23.8%.

o  Starting in 2013, only medical costs that exceed 10% of your adjusted gross income (AGI) can be deducted.  This is increased from 7.5%

·    Estate and Gift Taxes:  The estate tax rates, estate and gift tax exemptions and reunification of the gift and estate tax systems are all part of the "permanent" legislation.  Estates of decedents who die during 2013 have a basic exclusion amount of $5,250,000, up from a total of $5,120,000 for estates of decedents who died in 2012.  This amount will continue to be indexed for inflation.  The gift tax exemption mirrors the estate tax exemption.  However, the tax rate above this amount has increased to 40% from 35%.

·    Other Changes - 401k plans may now be rolled into a Roth IRA while still employed.  Prior to 2013, after leaving a company, a 401k plan could be rolled into a self-directed IRA and then rolled into a Roth IRA.  Taxes are paid on the distribution and after a 5-year wait all monies received (including any gains) are tax-free.  The U.S. Treasury is allowing this, thinking that some individuals will pay the tax now (increasing Treasury revenue) for tax-free benefits in the future

It's clear that American workers, and especially ones earning less than $400,000, will be paying more income taxes.  With Medicare being means-tested (where income does include items such as municipal bond interest and recent home sales), the wealthier will continue to pay more in taxes.  The fiscal cliff hasn't really been averted, just postponed.  The federal deficit will continue to increase, and financial pressure will remain on social programs such as Medicare/Medicaid and Social Security, with no fix in the foreseeable future.

What are the opportunities?

Income Taxes

·    Maximize 401k and other self-directed contributions (including make-up provisions for those age 50+, if available) to minimize taxable income.

·    Key employees may be offered nonqualified benefits (i.e. cash value life insurance), decreasing their current taxable income.

·    Shift current after-tax income into more tax-deferred contracts, such as annuities and cash value life insurance to grow tax-deferred with possible tax-free distributions.  This is especially important for those who may already easily max out their 401k and other defined contribution limits.  For example, ultimate payouts of tax deferred annuities can be used to pay future long-term care premiums (with no exclusion ratio worries) or life insurance distributions can generally be made tax-free.

o  With the average American facing $240,000 in out-of-pocket health care costs, according to Fidelity, and with Medicare costs being "means-tested" (the more you income you have, the more you pay for the same coverage), utilizing tax-advantaged contracts like life insurance may be the best opportunity to plan today for a certain, and increasing, cost in the future.

o  For those of you who may think that "tax-free" municipal bond interest payments are the savior for retirement distributions, think again.  They are included in Medicare means-testing formulas.  A better alternative may be annuity and/or life insurance purchases that can build cash values for future tax-advantaged leverage.

Estate Taxes

·    While the extension of the estate and gift tax amounts will continue to only affect approximately 4,000 estate tax returns each year, there is no doubt that life insurance, for almost any income level, provides leverage - turning pennies into tax-free dollars.  To equalize an estate among siblings, provide cash flow to prevent a family business from being sold at death, or to lock in current estate values for future generations, life insurance is still a tremendous planning tool.

·    There are many states (including New York and New Jersey) that have no gift tax statutes, but do have significant estate taxes.  By gifting now, your clients can shift assets that would have otherwise been subject to the 10% marginal rate of taxation at time of death in New York and New Jersey.  For example, a $5 million gift today will generate no federal estate tax payable on that amount and because there is no state gift tax, 10% of that amount, or $500,000, will be saved.

·    Charitable deductions become more important for affluent clients faced with higher income tax rates.  Charitable Remainder Trusts (with Wealth Replacement Trusts funded with life insurance), private foundation contributions, and contributions to Charitable Lead Trusts, etc. become significant opportunities.

·    Life insurance trusts can be funded with significant lump sum contributions given the high lifetime exemptions.  This eliminates Crummey Notices, and is a cleaner way to fund irrevocable life insurance trusts.

Long Term Care 

·    There are approximately 1.7 million nursing home beds in the U.S. with 86% occupancy.  With statistics indicating that 70% of Americans will need some sort of nursing home care during their lifetime and with over 10,000 Americans a day turning age 65 (and will for the next 17 years), along with few new facilities being built, how can a person be more assured of "winning" a bed?

o  Those that have assets to provide for long-term care (LTC) using a traditional LTC, linked benefit contract, a LTC rider on a life insurance policy, or a combination of these, will be in a much better position to "win" that bed.

·     Guaranteed Income:

o  A typical rule-of-thumb for retirement has been to spend down 4% of assets as yearly retirement income.  4% of $100,000 would be $4,000 the first year.  But how many clients remember 2001 and 2008 when the financial markets were significantly down?  Many clients have become scared.

  • Talk about shifting 20-40% of retirement assets into a guaranteed income stream by purchasing an annuity.  Yes, annuity rates are lower than the past (but still much higher than "safe money" CDs and money market accounts).  But consider this:
  • Over the long-term, can we really invest more sensibly than insurance carriers? And,
  • Given the fact that 50% of those 85 and older have some sort of dementia², this guaranteed stream could help prevent poor investment decision-making at advanced ages.

While each situation is different and requires a unique analysis, we have a variety of concept and product solutions to help you mitigate (and possibly negate) the income and estate tax increases, while also helping you gain a sense of security and confidence.