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Deciphering the Taxpayer Relief Act of 2012

March 09. 2013 12:38AM
Daniel Cohen 

"The devil is in the details" rings true when it comes to deciphering much of the legislation enacted at the federal level these days.

It takes more than a newspaper article to explain in detail the myriad bits of tax law changes and additions passed by the American Taxpayer Relief Act of 2012. Some are so complicated that even the savviest investors will need to consult their financial advisers and tax accountants to avoid running afoul of the new requirements.

This article will reveal some of the major new taxation changes resulting from the recent "fiscal cliff" compromise reached by the Obama Administration and the U.S. House of Representatives.

After much debate, the aforementioned American Taxpayer Relief Act of 2012 was enacted on Jan. 2. Numerous pages of new tax code have been created. Some taxpayers will be happy with the changes; other will be disappointed. Many will be more confused than ever.

Most of the increases are levied on those with taxable income greater than $400,000 if single or $450,000 if married. However, for those with adjusted gross incomes greater than $250,000 if single or $300,000 if married, there are limitations on itemized deductions that may result in even higher taxes.

The new tax law makes permanent the tax rates for those with taxable income of $400,000 or less if single or $450,000 or less if married. Those earning greater than those amounts will see their maximum tax rate return to 39.6 percent. The act also permanently repeals the personal exemption phaseout and itemized deduction limitations for those taxpayers with adjusted gross income under $250,000 if single or $300,000 if married.

You may notice that for certain changes in the tax code, the taxable income amounts were used as the benchmark while for other changes adjusted gross income was used. Adjusted gross income is someone's income before the deduction of items such personal exemptions and itemized deductions. Many taxpayers will be relieved that they were not affected by the higher tax rates being levied on singles with taxable income over $400,000 or those married with taxable income over $450,000.

However, the bigger concern may be the personal exemption phaseouts and itemized deduction limitations. These will affect a much larger group of taxpayers because the changes are based on adjusted gross income rather than taxable income, and the levels are set at $250,000 for single and $300,000 for married.

Every investor was relieved that preferential capital gains and dividend rates have been made permanent. For those in the 10 percent or 15 percent tax brackets, which are generally singles with taxable income under $36,250 or married couples with taxable income under $72,500, the capital gains and dividend tax rate will remain zero percent.

Yes, there is no tax on realized gains or dividends earned if you are in the lower tax brackets. If you are in these brackets, consider investing in dividend-paying companies to create a tax-free income stream for yourself at dividend rates much better than the interest rates banks are paying.

Single investors with taxable income below $400,000 and married couples with taxable income below $450,000 will continue to pay capital gains and dividend tax rates at 15 percent while those earning more than those amounts will start to pay 20 percent. Don't forget that in addition to these rates is the 3.8 percent surcharge on investment earnings that was part of the Affordable Care Act passed in 2010, which goes into affect starting this year.

The Taxpayer Relief Act also makes permanent the current estate tax exemption amount of $5,250,000, and this amount will be indexed for inflation going forward. In addition, the act makes permanent a provision in previous legislation that allowed the unused exemption to be transferred to a surviving spouse.

In simple terms, if one's spouse dies, then the surviving spouse will have an estate tax exemption of $10,500,000 assuming none of the exemption was previously used. Also, the gift tax and generation-skipping tax exemption levels are now set at $5,250,000 and will be indexed to inflation. The maximum tax rate on gifts greater than these limits is now 40 percent.

For seniors older than 70½ years, the act extends for two years the provision that permits tax-free distributions to charity from an Individual Retirement Account.

The act also allows for conversion of funds in retirement plans including 401(k), 403(b), or 457(b) to be converted to a Roth account in the same plan. The converted amount is subject to income tax.

The major changes outlined in this article will at least scratch the surface of new taxation impacts imposed by the American Taxpayer Relief Act of 2012. There are, however, many other provisions in the act that affect both individuals and businesses.

Daniel Cohen is vice president of investments and senior portfolio manager at the Manchester office of UBS.

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