The last-minute agreement affects every taxpayers bottom line
By Ian Salisbury and Jen Wieczner
Last Update: 4:44 PM ET Jan 2, 2013
After weeks of wrangling and brinkmanship, Congress has finally passed a deal to avoid the dreaded fiscal cliff, striking compromises on a slew of outstanding tax questions, from what rates the wealthy will pay on income to who will face the dreaded alternative minimum tax.
While big questions including how to address spending cuts and the debt ceilingremain unresolved, Wall Street cheered. The Dow was up more than 300 points for the day.
So what does the deal mean for you? Heres a cheat sheet on the tax provisions that would change the most.
Income tax brackets
Single taxpayers earning less than $400,000, married couples making less than $450,000, and heads-of-households filers making less than $425,000 will pay the same income tax as they did last year. But taxpayers earning more than those amounts in each filing category will face an income tax rate of 39.6% in 2013, up from last years rate of 35%.
Alternative Minimum Tax
The fiscal cliff deal raises the exemption for the AMT and pegs it to inflation, eliminating a long-standing headache for taxpayers.
The AMT is a kind of parallel or shadow tax code that was set up decades ago to prevent a small number of wealthy earners from using tax deductions to shield a disproportionately high amount of their income from taxes. Basically, earners whose income exceeds a certain threshold have to separately calculate what taxes they would owe under AMT rules, which limit or disallow many popular deductions like those for state and local tax payments. Taxpayers who owe more under the AMTs rules have to pay the higher amount. The problem: the income thresholds for the AMT were never automatically indexed to inflation meaning over time more and more people have fallen into the dreaded AMT territory. And while Congress has frequently passed one-off votes to raise the thresholds, there has never been any guarantee they would continue to do so, adding to the frustration and uncertainty surrounding the AMT.
Under the fiscal cliff scenario, individuals making as little as $33,750 could have theoretically owed the AMT. Under the new deal, 2012 income of up to $50,600 will be exempt from the AMT, a threshold that will be tagged to inflation going forward. The nonpartisan Tax Policy Center calculates that about 4 million tax payers owed extra money under the AMT in 2011 when the threshold was about $48,000. The number would have ballooned to more than 31 million for 2012 if Congress had failed to act. Read the Tax Policy Centers analysis
Capital gains and dividends
Taxes on capital gains and dividends for most investors will remain the same in the aftermath of the fiscal cliff deal. For individuals earning more than $400,000, rates on both dividends and capital gains jump to 20% from 15%. (In addition, as part of the deal to pay for the Affordable Care Act, those making more than $250,000 will also pay an additional 3.8% on investment income, including both dividends and capital gains.) The upshot is that for the highest earners both dividends and gains will be taxed at 23.8%.
While thats a significant hike, experts say many investors dodged a bullet. If Congress had failed to reach a deal, dividends were slated to be taxed at ordinary income tax rates. Including the health surcharge, that would have meant a top rate of more than 43%.
Roth IRA conversions
A provision in the bill makes it easier for investors to roll a 401(k) or 403(b) into a Roth IRA. Like the other plans, a Roth is a tax-advantaged retirement accounts. The big difference: 401(k) investors contribute pretax dollars, but pay taxes when they withdraw money in retirement. Roth IRA investors pay tax on that income up front, but can withdraw money later tax-free.
Why does it matter when you pay? Savers that expect to pay higher rates in retirement because they expect overall taxes to rise or expect to be wealthier may want to get the tax payment out of the way sooner rather than later. Since most employers offer 401(k) plans, workers typically dont have a choice about which type of plan works best for the bulk of their savings. Previously, they could convert their 401(k) to a Roth IRA, but only if they left their job or were old enough to start making retirement withdrawals. The new rules will allow other savers to make conversions, if their plan is set up to accommodate them.
While the move may be applauded by investors who will get extra say in how they save for retirement, its also a quick-fix revenue generator for the government. Account holders who convert traditional retirement accounts into Roth IRAs have to pay taxes on their balances when they convert taxes they would otherwise be deferring. A new wave of conversions could spell a revenue windfall for Uncle Sam, although of course it would lower tax receipts in the future.
The payroll tax holiday ended with the new year. As a result, employees will contribute a larger share of their paycheck to Social Security in 2013. The temporary lower rate, which most tax experts did not anticipate would be extended in the fiscal-cliff deal, will rise from 4.2% to 6.2%, the level it stood at before the holiday was enacted. The Social Security program taxes up to $113,700 of wages, so those earning that amount or more will pay $7,049.40 in 2013, compared to the $4,775.40 they would have paid last year. Under the new rate, employees earning a salary of $100,000 this year will pay $2,000 more in 2013 ($166.67 more per month), while people making $60,000 will pay $1,200 more ($100 more per month).
In 2012, estates of up to $5 million per person were exempt from federal estate tax. Amounts above that threshold were taxed at 35%. The Congressional deal affirms that threshold, while also indexing it to inflation. However, it raises the top tax rate to 40% from 35%.
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