Ben Franklin declared “nothing can be said to be certain except death and taxes.” More recently we can add to this that the only thing certain about taxes is that they themselves will change.
We know that our tax system is not static — in the last 10 years, there have been over 4,000 changes to the Internal Revenue Code, including nearly 600 changes in 2010 alone. Without congressional action, at the end of 2012 the so-called “Bush-Era tax cuts” will expire, impacting nearly all taxpayers. Bush-Era tax cuts is the term generally used for the 2001 and 2003 Tax Reconciliation Acts. These changes were to last only 10 years, but a 2010 Tax Act extended the cuts until the end of 2012.
Currently, there are many proposals for dealing with these expiring tax provisions, and this will be the subject of much debate, but what will be the impact if Congress does nothing? It is estimated that extending all of the Bush-era tax cuts would cost $2.84 trillion over the next 10 years. It would take a stack of dollar bills nearly 200,000 miles high to equal this amount. Since Congress is required to deal with mandatory budget reductions, it is unlikely that they will just extend all of these cuts indefinitely. So what happens next?
First a few examples: Let’s take a look at the following couple. They are doing well, having combined wages of $125,000. They have 2 young children, $2,000 of capital gains, and $500 of dividend income. Under current rules, they would have a federal income tax of $15,810. However, if the tax cuts expire, their 2013 tax would rise to $20,736, an increase of $4,566. And of course, their payroll tax would also go up 2 percent for another $2,500, resulting in over $7,000 of additional taxes.
If the same couple had wages of $300,000, with $20,000 of capital gains and $4,000 of dividends, they could have a net tax increase of nearly $15,000. And you don’t need to earn a lot to be impacted. A couple with no children earning about $30,000 each would see the total of their income and payroll taxes tax go up by $2,400.
Tax rates: In 2013, individual tax rates will effectively increase for all taxpayers, not just the rich. The top tax rate of 35 percent will increase to 39.6 percent, but the bottom 10 percent rate will disappear, replaced by a larger 15 percent tax bracket. While not part of the Bush-era tax cuts, the current 2 percent payroll tax cut is scheduled to expire at the end of this year, thereby raising taxes on all wage earners.
Capital gains and dividends: Currently, long term capital gains and dividends are subject to tax at a 15 percent rate. If you are in the 10 percent or 15 percent tax brackets, this rate is reduced to zero. This eliminates the tax on long term capital gains and dividends for married couples with income less than $70,700 (and half that if single).
Next year, capital gains rate reverts back to 20 percent (or 10 percent if you are in the 15 percent tax bracket). The news is even worse for those with dividends, as dividends will be taxed the same as other income, up to the maximum rate of 39.6 percent.
Alternative Minimum Tax: As the number of taxpayers subject to the AMT has continued to rise, Congress has continually enacted temporary fixes to moderate the impact by expanding the AMT exemption amounts. So far, this has not been fixed for 2012 and beyond. For 2011, the AMT exemption amount was $74,450 for married filing jointly taxpayers, and $48,450 for a single taxpayer. These will drop significantly to $45,000 and $33,750 respectively. This may cost taxpayers over $80 billion per year.
The marriage penalty: Under our tax structure, the tax on a two individuals, each with their own income is generally more if they are married than if they remain single. The current law attempted to minimize this difference by expanding married filing joint tax brackets and standard deductions, but beginning next year, a portion of this difference is eliminated.
Child tax & dependent care tax credits: Through 2012, there was a $1,000 tax credit for each dependent child under age 17. Beginning in 2013, the credit is cut in half to $500 per child. This credit is phased out as income goes over $110,000 ($55,000 if single).
In order to help people pay child care expenses so that they can work, the tax laws provide for a credit of up to 35 percent of the first $3,000 for a qualifying child or dependent, or twice that for two or more children. Beginning next year, the amounts are reduced to $2,400/4,800, and the top credit rate drops to 30 percent. For example, a lower income taxpayer with two qualifying children would get a 2012 credit of $2,100, but only $1,440 in 2013.
Education provisions: For 2013, you should plan on reductions, or outright elimination of many popular education-related deductions and credits.
Itemized deductions and personal exemption limitations: For higher income taxpayers, the 3 percent of excess adjusted gross income (over $173,650) reduction of itemized deduction would return beginning in 2013, as would the phase out of their personal exemptions.
Gift and estate tax changes: Potentially of even greater impact than the income tax changes is the return to pre-2001 estate and gift tax rules. The rates applicable to taxable gifts and estates will increase from the current 35 percent to 55 percent, while the exclusion from tax will decrease from just over $5 million to $1 million per person.
New taxes as part of health care reform: If you earn more than $200,000 (or $250,000 if married), there will be an additional 0.9 percent Medicare tax withheld from your wages. This tax also applies if you are self-employed.
In addition, there is a new Medicare tax of 3.8 percent on unearned income of high income taxpayers, effectively raising the maximum tax rate on investment income to 43.4 percent. The tax applies to net investment income from interest, dividends, rents, royalties and capital gains, and it kicks in at the same levels of the 0.9 percent tax above.
Business provisions expiring at the end of this year: It is not just individuals that will be impacted by the sun setting on various benefits. The generous bonus depreciation and expanded section 179 expensing rules will disappear. Also gone or going are the incentives for increasing research activities and investing in most energy savings initiatives.
While this covered many of the tax cuts we have enjoyed in recent years, the above list is not exclusive, and there are many other tax cuts that may be disappearing unless action is taken through new legislation. As we have frequently seen, Congress has often waited until the last minute to implement essential changes.
Burton S. Speer is a partner in the tax department at Mengel, Metzger, Barr & Co. LLP, and can be reached at Bspeer@mmb-co.com or (585) 423-1860.