Congress has finally passed legislation averting the so-called “fiscal cliff.”  While few of us who watched the process would consider it Washington’s finest hour, we now have answers to the questions that have made proactive planning so difficult.  Here are the highlights:

•  The Bush tax cuts have been permanently extended for income up to $400,000 ($450,000 for joint filers). Ordinary income above those thresholds is taxed at 39.6%, while qualified corporate dividends and long-term capital gains above those thresholds are taxed at 20%.

•  The 2% payroll tax “holiday” of 2011-2012 has ended. This will mean as much as $1,000 in additional tax on workers earning $50,000 per year.

•  The Alternative Minimum Tax has finally been indexed for inflation. This means Congress will no longer have to “patch” it every year to avoid entangling millions more taxpayers in its web.

•  Finally, the Medicare tax provisions of the Affordable Care Act, or “Obamacare,” have taken effect.  This will mean an additional 0.9% tax on earned income above $250,000 and a 3.8% tax on investment income for taxpayers earning more than $200,000 ($250,000 for joint filers).

Additional Changes

Itemized Deductions Going Down
The “fiscal cliff” bill has re-imposed the phaseout of itemized deductions and personal exemptions that went away in 2010.  If your income tops $250,000 (singles), $275,000 (heads of household), or $300,000 (joint filers), you’ll lose three dollars of deduction for every hundred dollars of income above the threshold.

Tax Strategies for Healthcare Costs
Paying for medical care becomes harder every year.  The recent healthcare reform act improves coverage and extends it to more Americans, but actually makes it harder to deduct unreimbursed expenses.  (Formerly, you could deduct medical expenses exceeding 7.5% of your Adjusted Gross Income.  Under the new law, starting in 2013, that floor has risen to 10%.)  It also limits contributions to employer-sponsored flexible spending plans to $2,500/year.
If you’re free to select your own coverage, consider choosing a “high-deductible health plan” and opening a Health Savings Account (HSA.) These arrangements bring down premium costs and use pre-tax dollars for out-of-pocket costs, bypassing the floor on AGI. If you’re self-employed, consider establishing a Medical Expense Reimbursement Plan, or MERP. These plans let you pay family medical expenses with pre-tax business dollars. They may even help you avoid self-employment tax.

IRS Audit Odds Still Low
IRS audit odds are increasing, from 1 in 200 returns for 2000 to roughly 1 in 100 for 2010. But your chance of getting audited is still minimal. Don’t take low audit rates as an invitation to cheat! But don’t let fear of an audit stop you from taking every deduction you’re entitled to. If you have questions, contact us and we can advise you.

New Tax on Interest Income
The healthcare reform act imposes a new “Unearned Income Medicare Contribution” of 3.8%, beginning on January 1, 2013, on interest income.  This tax may make municipal bonds and money market funds more attractive relative to fully taxable vehicles.  However, the recent economy has jeopardized state and local tax revenues, so there may be credit quality issues to consider.  You might also consider deferred annuities and permanent life insurance for fixed-income portions of your portfolio.

New Tax on Dividend Income
Tax on “qualified corporate dividends” is now capped at 20% for income exceeding $400,000 ($450,000 for joint filers).  Further, beginning in 2013, the healthcare reform act imposes a new “unearned income Medicare contribution” of 3.8% on dividend income for individuals earning over $200,000 ($250,000 for joint filers).  Consider favoring stocks that pay little or no dividend in taxable accounts and holding stocks paying higher dividends in tax-deferred accounts.

Permanent Life Insurance for Tax-Free Income
As mentioned earlier, the healthcare reform act imposes a new “Unearned Income Medicare Contribution” of 3.8%, beginning on January 1, 2013, on “investment income” (broadly defined to include interest, dividends, capital gains, rents, royalties, and annuity distributions) for individuals making over $200,000 ($250,000 for joint filers).  Permanent life insurance offers a variety of investment options for accumulating cash values, along with tax-free withdrawals and loans so long as you keep the policy in force.

New Tax on Real Estate Income
The healthcare reform act imposes an “unearned income Medicare contribution” of 3.8%, effective starting in 2013, on income from real estate investments and taxable gains from the sale of your primary residence, for individuals making over $200,000 ($250,000 for joint filers).  There are several strategies you can use to minimize taxable real estate income, including favoring tax-deductible “repairs” over depreciable “improvements” and cost segregation strategies to maximize depreciation deductions.

Higher Tax on Capital Gains
Tax on long-term capital gains (from sales of property you hold more than 12 months) is now capped at 20% for income exceeding $400,000 ($450,000 for joint filers).  The recent healthcare reform act also imposes a new “unearned income medicare contribution”, beginning in 2013, of 3.8% on capital gains for individuals earning over $200,000 and families earning over $250,000.  When you plan to sell appreciated assets, check with us first, to discuss if you can use tax-free exchanges, installment sales, charitable trusts, or similar strategies to minimize or even eliminate tax on those sales.

Estate Tax Uncertainty Resolved
The estate tax has veered from zero (in 2010) to 35% on estates exceeding a $5 million “unified credit” (2011-2012).  The “fiscal cliff” bill keeps the unified credit at $5 million and indexes it for inflation, and raises the rate to 40% on assets above that threshold. This means that smart estate planning will still be a part of affluent families’ financial plans.

At BASC Expertise, we’ve made a commitment to keep you informed of tax changes and will continue to do so. While smart information is crucial, intelligence alone is useless without the right action.  If the changes we’ve discussed so far have you worried about your financial future, you owe it to yourself to have us take a comprehensive look at your taxes and finances, so that we can determine exactly how to ensure that your tax liability remains as low as possible. Give us a call at 480-355-1398 to set up a consultation.