Now that the election is over, Congress must make important decisions about the tax rules for this year. A batch of tax breaks that affect millions of taxpayers expired after 2011, and lawmakers need to deal with them before year end.
The most significant issue will be the alternative minimum tax (AMT). The exemptions have fallen to 2001 levels pushing over 20 million filers into the AMT if levels remain. A Senate measure would set the 2012 exemption amounts at $78,750 for marrieds and $50,600 for singles, an increase of $4,300 over last year for joint return filers and $2,150 for singles. It also provides for slightly higher exemptions in 2013.
There are also a number of individual tax breaks that are likely to be renewed:
- The election to deduct state and local sales taxes in lieu of state income taxes.
- The above-the-line tax deduction for up to $250 of teachers’ classroom supplies.
- Allowing people who are age 70½ and older to directly transfer up to $100,000 tax free from their IRAs to charity.
- Plus the write-off for college tuition and related expenses.
A one-year deal that addresses these issues and includes an extension of the Bush tax cuts for upper-incomers in 2013 is less likely. President Obama will assert his opposition to extending the tax rates on upper-incomers, and he is loath to compromise on that again. The fight over rates may spill over to 2013.
The big issue in 2013 will be tax reform. The Joint Committee on Taxation’s study, issued in October provided key insights into what reform might look like. It would ax some big tax breaks, with the savings used to reduce tax rates. All itemized deductions would be scrapped…write-offs for mortgage interest, charitable contributions, medical expenses, state and local income and property taxes.
No preferential tax rates on gains and dividends…taxed as ordinary income.
Interest paid on state and local bonds issued after 2012 would be taxed.
Existing municipal bonds would be grandfathered…interest on them would remain tax free. The AMT would be repealed, along with the cutback in personal exemptions. However, these cutbacks would fund rate cuts of only 1 to 1½ percentage points from tax brackets.
President Obama wouldn’t kill itemizations outright. He favors trimming these write-offs in two ways:
- Reinstate a 3% cutback in itemized deductions that lapsed after 2009, but at higher income levels than before. Deductions other than medical expenses, investment interest paid or casualty losses would be trimmed by 3% of the amount by which adjusted gross income (AGI) exceeds $250,000 for marrieds, $225,000 for household heads, $200,000 for singles and $125,000 for married filers who file separate returns. The reduction could not exceed 80% of itemized deductions.
- Reduce the value of itemized deductions for high-incomers… write-offs that remain after applying the 3% reduction noted above. The tax value of itemizations would be capped at 28% beginning in 2013. When coupled with his proposal to reinstate the 36% and 39.6% brackets, taxpayers in brackets above 28% would be paying an extra tax of up to 11.6% of their write-offs.
President Obama will insist that rates rise for single filers with incomes over $200,000 and couples with incomes above $250,000. But that doesn’t sit well with some moderate Senate Democrats, so if a tax rate hike is approved, it’s likely to hit only taxpayers with taxable income over $1 million.
The President will most likely support a continuation of current law, including retention of portable exemptions for surviving spouses. Moderate Senate Democrats don’t back slashing the exemption or hiking the 35% top rate. So it’s highly unlikely that in a final deal, the exemption will fall to $3.5 million and the rate will rise to 45%. There’s no chance of a permanent $1-million exemption.
Capital Gains & Dividends
Tax rates on capital gains and dividends are most likely only going to increase for millionaires, if at all. Most likely, that means a 20% rate on capital gains and dividends. President Obama has proposed taxing dividends as ordinary income, but Senate Democrats rejected that idea earlier this year. Keep in mind the 3.8% Medicare surtax applies to capital gains of singles with adjusted gross incomes above $200,000 and couples over $250,000. So the top tax rate on capital gains is rising next year for upper-incomers anyway, even if the 15% maximum base rate ends up being extended for everyone in 2013.
The President has proposed taxing the interest paid on state and local bonds issued after 2012. Existing municipal bonds would be grandfathered…interest on them would remain tax free.
The main theme for 2013 will be tax overhaul. The last time we had major tax reform was back in 1986. The maximum tax rate was lowered from 50% to 28%, while capital gains were taxed as ordinary income, the ability to deduct passive losses from real estate activities was restricted, and itemized deductions were pared back, especially interest write-offs. President Obama knows that the only way to end the cycle of temporary tax laws that have to be renewed every year is through tax reform. Both parties know how important this issue is but disagree on the details. Hopefully a compromise will be reached in 2013.
- 2012 tax rates are most likely to be extended for another year while tax reform is addressed in 2013.
- Any final version of tax reform will include the elimination of the AMT.
- The new Medicare tax will raise the tax rate on capital gains and dividends for upper income taxpayers in 2013.