It could have been much worse for top earners.
The budget deal passed by Congress Jan. 1 and signed into law by President Barack Obama the following day raises taxes on the income and investments of fewer high earners than Democrats proposed. The accord makes permanent the estate-and-gift tax exemptions that wealthy Americans raced to take advantage of when their fate was uncertain.
Also, Congress didn't go as far as the president proposed in restricting top earners' use of tax breaks such as mortgage interest and charitable deductions.
“The increases in taxes and limits to deductions are more favorable than expected,” said Christopher Zander, partner and head of wealth planning at Evercore Partners Inc. (EVR)'s wealth management unit. “They could have been worse for high net-worth taxpayers.”
Still, families earning $250,000 to $450,000 a year, who are now breathing a sigh of relief, might have more of a tax pinch in 2013 than they anticipate. And those earning more than $450,000 a year may be better off than they expect.
The deal struck by Congress Jan. 1 averts most of the $600 billion in tax increases and spending cuts that were set to take effect this month. It includes a new top income tax bracket with a 39.6 percent rate, which applies to annual taxable income above $400,000 for individuals and $450,000 for married couples. Obama had campaigned since 2007 to set the levels at $200,000 and $250,000, instead.
Democrats had proposed the lower thresholds as a marker for higher rates on capital gains and dividends. Instead, the law raises the rate to 20 percent from 15 percent, also for taxable income above $400,000 for individuals and $450,000 for couples. That means four tax brackets effectively exist for long-term capital gains and dividends this year: the existing zero and 15 percent, 18.8 percent and a top 23.8 percent.
Investors will face two new taxes in 2013 including a 3.8 percent investment surtax that started Jan. 1 for individuals with adjusted gross income of more than $200,000, or $250,000 for married couples, to help finance the 2010 law that expands health-care coverage.
“There were hopes that there would be more simplicity to the tax code,” Zander of Evercore Wealth Management said. “It has now become even more complex.”
Wealthy people should note that the $400,000 and $450,000 income thresholds for top rates on wages and gains apply to taxable income, not adjusted gross income, Zander said. Some top earners above those levels will have some benefit from deductions such as those for mortgage interest paid or charitable contributions that will drop their taxable income below the cutoffs, he said.
A married couple with two children earning $700,000 in wages with $10,000 in qualified dividends and $20,000 in long- term capital gains would save $7,000 in federal taxes owed rather than what they would have paid if the higher rates started at $250,000, according to an analysis by Tony Nitti, a partner at WithumSmith & Brown in Aspen, Colorado, who provides tax consulting for high net-worth people.
The calculation assumes the family had itemized deductions of $55,000 including charitable contributions, mortgage interest, real estate and state taxes paid.
“It's a victory for high-income taxpayers but not as much of a victory for as many high-income taxpayers as people may think,” Nitti said.
That's because taxpayers in the “sweet spot” of $250,000 to $450,000 in annual income may not see tax savings even with the higher income thresholds for rate increases, Nitti said. If they live with children in high-tax states such as New York or California, they probably are subject to the alternative minimum tax, or AMT, which means their tax liability under that system largely won't change.
One example is a married taxpayer with two children living in California with annual income of $450,000 from wages, $20,000 in capital gains, $10,000 in dividends and $55,000 in deductions. The family would have owed about $123,000 in federal taxes if the tax cuts had expired for couples earning more than $250,000, Nitti said. Still, the family's tax bill is the same with the threshold set at $450,000 because of AMT liability, Nitti said.
The AMT is a parallel tax system that requires people to calculate their taxes twice -- once under the regular system and once under the AMT, which takes back some tax breaks. Taxpayers must pay whichever is higher, meaning that reductions in ordinary tax rates often don't benefit AMT payers.
The budget deal also didn't extend a two-percentage point cut in the payroll tax for workers of all income levels that expired Dec. 31. Also, it brings back limits on personal exemptions and itemized deductions for top earners that had been phased out and sets those thresholds at $250,000 for individuals and $300,000 for married couples.
“It's a stealth tax,” said Jere Doyle, senior wealth strategist at Bank of New York Mellon Corp. “Where people will get hit is those who have substantial itemized deductions. They're going to take a haircut once you go over a certain amount.”
That can bump a person's marginal tax rate up by 1 percent to 2 percent, Doyle said.
Millionaires also saw relief with taxes paid on gifts and on estates at death compared with Obama's past proposals. The law makes permanent a $5.12 million exemption, or $10.24 million for married couples, on lifetime gifts and estates. It also indexes those levels for inflation so they will increase over time.
$1 Million Threshold
The thresholds were set to drop to $1 million if Congress hadn't acted, while the president wanted to set the estate tax exemption at $3.5 million.
“I'm thrilled about the fact that this act makes permanent all the provisions” related to estates and gifts, said Carol Harrington, an estate-planning attorney and head of the private client practice group at McDermott, Will & Emery. “I'm skipping around the office throwing confetti in the air over this issue.”
Still, the new law increases the top tax rates on estates or gifts in excess of the $5.12 million or $10.24 million exemption limits to 40 percent from 35 percent. Obama had proposed a 45 percent rate and it was set to rise to 55 percent if Congress hadn't acted.
“It's a significant rate increase,” Harrington said. “Obviously 40 is a heck of a lot better than 55.”
A married couple with a $100 million estate that had used up its exemption with gifts during their lifetime would owe about $40 million in estate taxes this year if the second spouse dies in 2013, or $5 million more than if the death had occurred on Dec. 31, 2012, Harrington said.
Among the tax provisions affecting 2012 returns that Congress extended was the ability of people age 70 1/2 and up to transfer up to $100,000 from an individual retirement account directly to a charity.
“That's been a popular one,” said Tim Steffen, director of financial planning at Robert W. Baird & Co. in Milwaukee. The new law lets people who withdrew money from an IRA in December donate it to a charity this month and apply it to their 2012 taxes. The overall benefit was extended through 2013, not permanently as were many of the other items.
“You may not like all the provisions,” Steffen said of the budget deal. “At least now you know what you're dealing with. We got the certainty we've all been looking for.”