By DJ Berry
This is part two of a two part article concerning the recent action by the U.S. Supreme Court in upholding the constitutionality of the 2010 health care reform legislation. Part one dealt with the key individual and business aspects of the consequences of this action; this part will discuss the expiring provisions of the Bush-era tax cuts. First, we will look at the relevant tax cuts set to expire for individuals. The second part of this section of the article will deal with certain other sunset provisions.
A significant amount of tax cuts that may expire exist for individuals. First, consider one of the more important expirations, at least as it applies to the country as a whole-tax rates are set to increase for every type of taxpayer. As of now, the tax rates are 10, 15, 25, 28, 33 and 35 percent. These amounts are set to revert back to 15, 28, 31, 36 and 39.6 percent in 2013. This means that all taxpayers will have a tax hike, not just those who are considered to be wealthy.
Individual marginal tax rates are not the only tax rates set to increase. Under current law, reduced tax rates on qualified capital gains and dividends are set to sunset after 2012. Barring a change, this means the capital gain rates will revert back to 20 percent (10 percent for taxpayers in the 15 percent bracket) after 2012. With this knowledge, it might be a sound strategy to sell any capital assets that have a built-in gain, and accelerate the capital gains to 2012 and its lower rates.
Dividends might receive even harsher tax treatment than capital gains. For 2012, qualified dividends are taxed at a maximum rate of 15 percent. If the tax cuts expire for 2013, all dividends will be taxed as ordinary income at the taxpayer’s marginal individual tax rate. As mentioned above, this results in a potential tax as high as 39.6% (this tax does not even include a potential 3.8% Medicare tax, which is discussed in part one of the article).
Next, the so-called marriage penalty is also set to expire. For married couples who filed as married filing jointly since the Bush-era tax cuts were enacted, standard deductions were adjusted so that a “penalty” did not occur by filing as married as opposed to single. Previously, married couples did not receive a standard deduction that was twice that of a taxpayer who filed as single. The Bush-era tax cuts changed that. The act will cause the deductions to revert back.
The Bush-era tax cuts also removed both the limitation and phase outs on itemized deductions and personal exemptions. In general, these only apply to taxpayers who make over a certain amount of money, so it is only anticipated to affect wealthier taxpayers. If possible, it might be wise to push any potential itemized deductions to 2012, as opposed to waiting until 2013. The uncertainty regarding the tax rules make it difficult to wait.
A number of education-related tax incentives are also scheduled to expire or be reduced after 2012. First, any contributions to a Coverdell account (also known as an ESA) will be reduced from $2,000 to $500. Next, thresholds on student loan interest paid will decrease after 2012, making it more difficult for higher income taxpayers to deduct the interest paid. Finally, the American Opportunity Tax Credit, which can currently be used for all four years of post-secondary education by a taxpayer or their dependents, will revert back to the Hope Credit, which can only be used for the first two years and has lower benefits than the American Opportunity Tax Credit.
While a large amount of individual (i.e., Form 1040) tax cuts are set to expire, cuts related to other taxes are also set to expire. The estate, gift and generation-skipping taxes will all change in 2013 if nothing is done by Congress. Tax rates for estate returns would revert from the current 35 percent to 55 percent, and the exemption amount would change from $5,120,000 in 2012 to $1,000,000 for 2013 and beyond. This reversion would certainly cause an inordinate amount of taxpayers to be required to file an estate return, especially compared to the level of taxpayers required to file in 2012.
As for the gift tax, it will sunset from its current tax rate and exclusion amount, which match the estate tax return, and will again match the estate tax return, with an exemption amount of $1,000,000 and a maximum tax of 55 percent. Since the gift tax has been reunited with the estate tax, the levels for both should match in 2012 and beyond. The generation-skipping tax is also linked to the estate tax rates, and will sunset after 2012 and increase by 20 percentage points to 55 percent in 2013.
Because it is an election year, it is improbable that all of the expiring provisions will be extended into 2013 and beyond, which means it would be wise to consider accelerating into 2012 any possible tax benefits that are now available. This could include the sale of capital gains, gifting to avoid the increase of both gift and generation-skipping tax increases, or perhaps even deferring items that would be taxed as ordinary income in 2013 by placing them into retirement plans or other tax sheltered plans. Please note that the health reform is Federal law, so none of the above (or part 1 of the article) is intended to apply to any tax consequences attached to state law. We are willing and able to aid in any strategy that might help defray some of the uncertainty attached to the 2013 tax year.