As 2012 drew to a close, Congress passed the American Taxpayer Relief Act of 2012 that was signed into law by President Obama on January 2nd of this year.  Just in time to address the tax side of our country’s financial issues, the Act, in general, provides support to middle class tax payers.

By addressing the expiration of the Bush era tax cuts, the Act reduces a number of tax increases that would have gone into effect.  However, it also creates other tax increases mostly for the wealthiest Americans.  Because this legislation has broad implications regarding personal tax situations, we thought it might be helpful to provide a brief overview of the bill’s key parts and their potential impact.

The Act kept the Bush era tax rates in place for all but the highest income earners making these income tax rates permanent.  Basically, tax brackets look very similar to last year, except for an inflation adjustment and a new bracket for the highest income earners.  Those individuals with income over $400,000 (married filed jointly over $450,000) are now subject to a maximum rate of 39.6%.

These same high income earners are now subject to a 20% tax rate on capital gains and dividends.  All other taxpayers will continue to pay a maximum of 15%. Had new legislation not been passed, most taxpayers would have been subject to a 20% tax on capital gains and have had dividends taxed as ordinary income.

An additional tax for higher income earners beginning this year is the Medicare surtax which applies to those with income over $250,000 married filing jointly ($200,000 for individuals).  Those taxpayers are now subject to two surtaxes, a 0.9% surtax on wages over the income limit and a 3.8% surtax on the lesser of net investment income or the amount of modified adjusted gross income that exceeds the aforementioned income limits.

Another feature of the 2012 Relief Act is the permanent “patch” for the Alternative Minimum Tax for 2012 and subsequent years.  This effectively precludes many middle income earners from being subject to AMT going forward by increasing the exemption amounts each year by an inflation adjusted amount.  The 2012 exemption amounts are $50,600 for individuals ($78,750 married filing jointly).

Probably the most anticipated potential tax law changes for 2013, were to the federal estate tax laws. With the new Act, changes were less significant than many expected leaving the exemption amounts at relatively high levels.  The Act permanently provides for maximum federal estate tax rates of 40%, up from 35%, with an annually inflation adjusted $5 million exclusion.  For 2013, this means the exemption is $5.25 million for each person.  Portability between spouses was made permanent which allows for a decedent’s unused exemption to be used by the surviving spouse for his/her own transfers during life or at death.

Although many of these tax law changes are said to be permanent, we are all too aware that the entire tax rate structure could be reconsidered in the future as part of overall tax reform.  In the meantime, qualified charitable distributions from IRA’s are allowed once again in 2013, itemized deductions are more limited than in recent years for higher income earners, the annual gift tax exclusion rises to $14,000 per person per donee, and IRA and 401(k) contribution amounts have increased.  Also there are many new, adjusted for inflation income limits and exemptions in place for 2013 and beyond.

As always, we encourage you to have a conversation with your tax advisor to better understand your individual tax situation and we welcome the opportunity to talk with you further about general wealth planning issues.

(Reprinted with permission from E.T. Kelly & Associates, LLC – www.etkelly.com )

With the election over, national political attention has turned to the so-called “fiscal cliff” that encompasses the combination of mandatory deficit reduction measures and expiring tax cuts that will occur on January 1, 2013 if Congress doesn’t act. The uncertainty surrounding future tax rates and structure – not to mention provisions not yet decided for 2012 – makes year-end tax planning more challenging than at any time in recent memory. Our best advice is to set up a plan under various scenarios and remain flexible for as long as possible. It is highly likely that an agreement on taxes and deficit reduction measures will not be in place until the final days of the year.

While nothing is certain, various commentators have expressed a general similarity in opinions regarding tax law scenarios. We have assimilated and summarized those opinions below.

First, high-income taxpayers are squarely in the crosshairs as a source of additional revenue. Throughout his campaign, President Obama advocated a tax increase on single taxpayers with income over $200,000 and married taxpayers with joint income over $250,000. Re-election gives the Administration’s plan momentum, though it is possible that the income levels at which tax increases apply will be used as a bargaining chip to get a deal passed. If so, the $200,000/$250,000 thresholds may increase.

Second, increasing tax rates is one way to generate revenue; adjusting the calculation of taxable income by limiting deductions is another. One proposal limits the percentage benefit of itemized deductions to 28% even though taxpayers may be in a higher tax bracket. This proposal applies to the same high-income taxpayers as the proposed higher tax rates.

Third, irrespective of a change in income tax rates, new taxes imposed by the Patient Protection and Affordable Care Act become effective on January 1, 2013. These taxes generally apply at the same $200,000 single/$250,000 married income level and are assessed at a rate of .9% of earned income (wages, self-employment income) and 3.8% of net investment income (interest, dividends, capital gains, rents, royalties, annuities). For additional information on how these taxes are calculated, please refer to the summary page attached at the end of this document.

Fourth, high-income taxpayers and increased income tax rates are not the only potential sources of revenue. The payroll taxes for all taxpayers with wages and self-employment income were reduced in 2011 and 2012. This payroll tax holiday may not be extended. The future of tax credits for children and college education are also undecided at this point.

Finally, states base their tax systems on federal taxable income, but often have adjustments that effectively increase tax at the state level. Minnesota, for example, already excludes a portion of itemized deductions for upper-level taxpayers. Minnesota also imposes a lower threshold at which estate tax applies to the assets of a decedent. Whereas the federal estate tax applies to an estate of $5.120 million in 2012 (also subject to change in 2013 and beyond), the Minnesota estate tax kicks in at an asset level of $1 million. While state tax considerations are not as large on a percentage basis as federal, states are also looking for new ways to raise revenue and combat their own deficits. It would not surprise us to see a greater divergence between federal and state taxable income leading to higher effective state tax rates.

What can you do to best minimize your tax bill? Our advice is to take the long view. While it is conceivable that current income tax rates could be extended through 2013, it is likely that rates will never be lower than they are in 2012. For some taxpayers, accelerating income into 2012 may create substantial tax savings. For others, investment and other considerations may dictate no action at this time. As always, every taxpayer’s scenario is different.

The pages that follow show tax provisions that have already expired for 2012 or are set to expire in 2013. If an item on the list or the information in this letter piques your interest as to how various tax scenarios will affect you, we invite you to contact us.

We also encourage you to contact us if you experience or expect a substantial life or financial change. Birth, death, marriage, divorce, a child graduating, job changes, retirement, a home purchase, a new business venture and any number of other life events can significantly affect your tax situation. We will assist you in planning for the tax aspects of life’s changes, challenges and celebrations.

In this season of celebration and giving thanks, we want to express our deepest gratitude to you for your business and your support of our firm. It is our pleasure to serve you.

Sincerely,

E.T. Kelly & Associates, LLC

Expired Tax Provisions

Sometimes referred to as “extenders,” the following set of tax provisions has been extended on an annual basis for several years. These provisions have not been extended to 2012. We expect Congress to decide the fate of these items in the coming weeks.

• Alternative Minimum Tax (AMT) – Congress has patched the AMT annually for the past ten years. If a fix is not passed, the number of taxpayers subject to AMT increases six fold and the tax affects middle-class families.

• Higher education tuition deduction – An above-the-line deduction for higher education.

• Optional state and local sales tax deduction – Taxpayers may deduct sales taxes paid if the sales tax amount is more than state income taxes paid. This provision is beneficial for taxpayers who live in locations without a state income tax.

• Charitable distributions from IRAs – Allows IRA owners over age 70½ to satisfy the required minimum distribution by donating funds directly from the IRA to a charity. The amount is not included in income and there is no additional deduction for a charitable gift.

• Teacher classroom expense deduction – Teachers deduct up to $250 for supplies they purchase personally for use in their classrooms.

Tax Provisions Expiring After 2012

A host of tax incentives are scheduled to expire after 2012. The following items are the most prominent and are at the heart of Congressional negotiations.

• Individual tax rates – The current individual marginal income tax brackets of 10, 15, 25, 28, 33, and 35% expire after 2012. Rates are scheduled to revert to 15, 28, 31, 36, and 39.6 percent. For reference, a married couple enters the 25% tax bracket at taxable income of $70,700 in 2012 and the 35% bracket at taxable income of $388,350. The elimination of the 10% tax bracket affects all taxpayers.

• Long-term capital gains and qualified dividends – Under current law, long-term gains and qualified dividends are taxed at reduced rates as compared to ordinary tax rates. In 2012, the maximum tax rate on qualified capital gains and dividends is 15% (0% for taxpayers whose taxable income places them in the 10% and 15% ordinary income tax brackets). After 2012, the maximum capital gains tax rate is scheduled to revert to 20% (10% for taxpayers in the 15% ordinary tax bracket) and dividends will be taxed at the ordinary income tax rates (potentially up to 39.6%).

• Limitation on itemized deduction and phaseout of personal exemptions for higher income taxpayers – A move back to prior law disallows a portion of itemized deductions for taxpayers with income over a certain level ($166,800 when this provision was last applicable in 2009). Personal exemptions are also phased out at various income levels.

• Bonus depreciation – Business assets placed in service in 2012 are eligible for 50% bonus depreciation.

• Payroll tax holiday – In 2012, the employee portion of wages and self-employment income is subject to 4.2% social security tax. The percentage reverts to 6.2% in 2013.

• American Opportunity Tax Credit (AOTC) – This education incentive provides a credit of up to $2,500 for undergraduate college students.

• Federal estate and gift tax – Under current law, the maximum federal estate and gift tax rate is 35% with the first $5.120 million excluded from tax altogether. The federal estate tax is scheduled to revert to a maximum tax rate of 55% and $1 million exclusion after 2012; however, a compromise on lower rates and an increased exclusion is a high priority for both political parties.

Summary of the Patient Protection and Affordable Care Act

In June, the Supreme Court affirmed that the Patient Protection and Affordable Care Act (ACA) will remain intact. As part of its ruling, the Court upheld the individual mandate requiring Americans to buy health insurance or pay a penalty. The act has far-reaching implications for individuals and employers as outlined below.

Perhaps the most highly publicized provision of the ACA is the imposition of two new taxes at the individual taxpayer level beginning in 2013. These taxes apply when modified adjusted gross income exceeds $200,000 for a single taxpayer or $250,000 for married taxpayers filing jointly.

Tax on Net Investment Income – If taxpayer income exceeds the applicable $200,000/$250,000 threshold, a 3.8% tax applies to the extent net investment income is above the threshold. Net investment income is defined as income from interest, dividends, capital gains, rents, royalties and annuities. Net investment income does not include tax-exempt income or distributions from a qualified retirement plan such as an IRA or 401(k).

Two examples outline the calculation of this tax:

Example 1 – Married taxpayers have dividend income of $10,000 and other non-investment income of $250,000. Accordingly, income in excess of $250,000 includes the full dividend amount of $10,000. Because dividends are considered investment income, $10,000 is subject to the 3.8% tax.

Example 2 – Married taxpayers have non-investment income of $246,000 and dividend income of $10,000. The 3.8% tax is not charged until total income exceeds $250,000, so only a portion of the divided is subject to the extra tax. The portion subject to the tax is total income of $256,000 less the threshold amount of $250,000. Only $6,000 of the $10,000 investment income is subject to the 3.8% tax.

Tax on Earned Income – Taxpayers with wages or self-employment income above the $200,000/$250,000 threshold are subject to a tax of .9% on their earnings over the threshold amount. This tax is applied separately from the 3.8% tax on net investment income and taxpayers can be subject to both.

For example, if each spouse earns $150,000 from an occupation, the combined wages of $300,000 exceed the $250,000 threshold and $50,000 would be subject to the extra .9% tax. Unfortunately, employers are not required to withhold the .9% tax until an employee’s wages for the year exceed $200,000. In this example, neither spouse’s employer would withhold funds from wages, and the taxpayers would be required to pay the difference when filing their tax return. If married taxpayers know their income will exceed the $250,000 threshold, they should consider completing a revised Form W-4 to request that the employer withhold an additional specific dollar amount from each paycheck.

Taxes Apply Separately – Combining the examples above, assume married taxpayers have total wages of $300,000 and dividend income of $10,000. In this case, $50,000 is subject to the .9% tax on wages exceeding $250,000. The full $10,000 dividend is net investment income above the $250,000 threshold for married taxpayers and is subject to the 3.8% tax.