January 16, 2013

Congress enacted the American Taxpayer Relief Act of 2012 in order to avert the fiscal cliff. T. Rowe Price's financial planning team has summarized some tax-related provisions below. As expected, the tax changes affect higher wage earners, but Congress still needs to address spending cuts and the debt ceiling in the near future. Investors may see some market volatility as these issues continue to be addressed.

Tax Brackets* Ordinary Income Long-Term Capital Gains**
Rate Single Filers Married Joint Filers  
10% $0 to $8,925 $0 to $17,850 0%
15% $8,925 to $36,250 $17,850 to $72,500  
25% $36,250 to $87,850 $72,500 to $146,400 15%
28% $87,850 to $183,250 $146,400 to $223,050  
33% $183,250 to $398,350 $223,050 to $398,350  
35% $398,350 to $400,000 $398,350 to $450,000  
39.6% Over $400,000 Over $450,000 20%
*Source: Rev. Proc. 2013-15.

**Short-term capital gains are taxed at ordinary income tax rates.

Qualified dividends will continue to be taxed at capital gains tax rates.

Social Security Payroll Tax

Ends the two-percentage-point payroll tax cut for employees. The Social Security tax for employees, previously 4.2%, will revert to 6.2%. (Self-employed individuals are responsible for both the employee's and the employer's portion.)

Gift and Estate Taxes

Permanently extends the lifetime estate and gift tax exemption to $5.25 million for 2013 (with annual inflation adjustments), with a top marginal rate of 40%.

Coverdell Education Savings Accounts

Extends the changes to Coverdell accounts beginning December 31, 2012. The maximum annual contribution is $2,000, and proceeds can be used for qualified education expenses of elementary and secondary schools in addition to college expenses.

Qualified Charitable Distributions From IRAs

The provision that permits tax-free distributions to charity from an IRA held by someone age 70½ or older (up to $100,000 per taxpayer, per taxable year) is extended up to the end of 2013. This provision contains a transition rule under which an individual can make a distribution to a qualifying charity during January 2013 and have it count as a 2012 distribution. Also, individuals who took a distribution in December 2012 and January 2013 will be able to contribute that amount, or a portion of that amount, to a qualifying charity and count that contribution as a qualified charitable distribution if such contribution to the charity is made in cash before February 1, 2013.

Roth Conversion for Retirement Plans

This provision allows amounts in pre-tax salary deferral accounts to be converted to a Roth designated account in the same employer retirement plan, whether or not the participant has a distributable event. The amount converted would be subject to regular income tax in the year it is converted.

Alternative Minimum Tax (AMT)

The AMT exemption is permanently set at $51,900 (single) and $80,750 (joint filers) for 2013 and will adjust for inflation thereafter.

New Taxes That Will Apply in 2013

There is some new tax legislation unrelated to the fiscal cliff that will take effect in 2013, as outlined in the Patient Protection and Affordable Care Act, and will affect high income earners.

Medicare-Related Taxes
  • An additional Medicare tax of 0.9% will be levied on wages that exceed certain thresholds—namely $250,000 for those who are married filing jointly and $200,000 for single filers. Currently, the Medicare tax rate withholding for employees is 1.45%, regardless of income. (Self-employed individuals are responsible for both the employee's and the employer's portion.)

    For example, for a single filer who earns $250,000 in 2013, 2.35% (1.45% + 0.90%) will be the tax levied on $50,000 of his or her earned income (i.e., $1,175). A lower, 1.45% tax will be levied on the individual's other $200,000 of wages, for a total Medicare tax in 2013 of $4,075 ($1,175 + $2,900).

  • A new tax of 3.8% will be levied on high income earners (i.e., with modified adjusted gross income,# or MAGI, exceeding $200,000 for single filers and $250,000 for married couples filing jointly) who have "net investment income," which includes dividends, capital gains, and bond interest. The tax must be paid on the lesser of total net investment income or the amount of MAGI in excess of the appropriate income threshold.

    For example, let's assume a single filer whose MAGI in 2013 is $270,000 includes $45,000 of net investment income. The investor must pay a 3.8% surtax on the lesser of $70,000 ($270,000 - $200,000) or $45,000—a total of $1,710 (3.8% x $45,000).

#MAGI is generally the adjusted gross income (as reported on Form 1040) plus any foreign earned income exclusion (an exclusion for U.S. expatriates working overseas).