Executive Summary The last-minute fiscal cliff compromise – H.R. 8, which will also be known as the American Taxpayer Relief Act of 2012 (or “ATRA”) – extends the majority of tax cuts that were scheduled to expire at the end of 2012, in addition to retroactively reinstating some rules that had expired in 2011. However, the legislation also introduces a number of changes as well – including a new top tax bracket of 39.6%, and an increase in the top long-term capital gains and qualified dividend rate to 20%. And some old rules that had lapsed and were scheduled to come back have in fact returned, such as the Pease limitation (phaseout of itemized deductions) and the Personal Exemption Phaseout (PEP). In addition, a new rule will allow 401(k) participants to complete intra-plan Roth conversions. For planning purposes, though, the good news is that not only was the fiscal cliff largely “averted” with last minute legislation, but the changes under ATRA are permanent. On the other hand, making some rules permanent – such as not only the current gift and estate tax exemption, but also the portability of a deceased spouse’s unused exemption – will change income and estate tax planning going forward. In this article, we take a first look at the details of the H.R. 8 fiscal cliff legislation and some of its financial planning implications.

(Editor’s Note: At the time this article is being initially posted, the House has still not voted on the legislation the House has voted 257-167 in favor of the Senate’s full version of the legislation. As a result, it may still be amended or even voted down entirely this should be the final version of the legislation. If any changes to the legislation are made new details come to light, this post will be updated accordingly. You can see a copy of the legislation via Business Insider here the final version of the American Taxpayer Relief Act of 2012 legislation here.)

H.R. 8 – The American Taxpayer Relief Act of 2012 (ATRA)

Tax Brackets

The top tax bracket rises to 39.6%, and applies to income in excess of $400,000 for individuals, and $450,000 for married couples. These thresholds are indexed for inflation (in a similar manner to all the other tax bracket thresholds). Notably, the $450,000 threshold for married couples is actually a slight form of marriage penalty release, as in the past the top tax bracket threshold was the same for both individuals and married couples. It’s also notable that in practice, this change is effectively the same as just allowing the top tax bracket to lapse back to the old rates, as the top tax bracket was already at $388,350 in 2012 (and would have been just shy of $400,000 with the 2013 inflation adjustment). (Note: bear in mind that tax brackets are based upon taxable income after all deductions, not Adjusted Gross Income.)

The remaining tax brackets are extended at their current levels. Notably, this means the 35% tax bracket is still in effect, although it’s now one of the smallest tax brackets, applying for only $388,350 to $400,000 (for individuals; or $388,350 to $450,000 for married couples).

The changes listed here to the tax brackets are permanent – i.e., there is no sunset provision that would cause them to lapse (although Congress could still change the rules in the future, of course!).

Phaseout of Itemized Deductions and Personal Exemptions

The phaseout of itemized deductions and personal exemptions returns for 2013. In point of fact, this change was already scheduled to happen with a lapse of the Bush tax cuts, but ATRA applies new thresholds to the rules.

The phaseout for itemized deductions (also known as the Pease limitation) reduces total itemized deductions by 3% of excess income over a threshold. The threshold amounts are now an Adjusted Gross Income of $300,000 for married couples, and $250,000 for individuals. These amounts are indexed for inflation.

The personal exemptions phaseout (also known as the PEP), reduces personal exemptions by 2% of the total exemptions for each $2,500 of excess income over a threshold) returns for 2013. The threshold for this phaseout will be the same as the threshold for the Pease limtiation (AGI of $300,000 for married couples, and $250,000 for individuals, indexed for inflation). Notably, in the past the PEP had a different phaseout threshold than the Pease limitation, but the new rules under ATRA unify these thresholds.

The net impact of the PEP and Pease limitations is that each rule increases an individual’s marginal tax rate by about 1% (with a greater impact on larger families that phaseout more exemptions at once).

Estate Taxes

The new rules of ATRA make the current estate tax laws permanent, including the $5,120,000 (in 2012) gift and estate tax exemption (which will rise further to approximately $5.25M with an inflation adjustment for 2013); the Federal gift and estate tax exemptions remain unified. This outcome is not entirely surprising; as I wrote earlier this year, the estate tax exemption has not actually been allowed to decline since the Great Depression. However, the top estate tax (and gift, and GST) rate is increased from the prior 35% to a new maximum rate of 40%.

Notably, the portability rules for a deceased spouse’s unused estate tax exemption amount are made permanent, which may significantly impact (i.e., reduce) the use of bypass trusts for all but the wealthiest of families.

Capital Gains and Dividends

ATRA makes permanent the 0% and 15% long-term capital gains tax rates, but increases the tax rate to 20% for any long-term capital gains that fall in the top tax bracket (the new 39.6% bracket with the $400,000 / $450,000 thresholds noted earlier).

Qualified dividend treatment is also made permanent (as the provision was would have caused it to sunset has been eliminated), although notably because qualified dividends are tied to the long-term capital gains rate, the top tax rate for qualified dividends has now risen to 20%.

Notably, individuals who are subject to the new 20% top long-term capital gains and qualified dividends tax rate will actually find their capital gains and dividends taxes at 23.8%, due to the onset of the new 3.8% Medicare tax on net investment income that would also apply at this income levels.

Miscellaneous Extension Provisions

The American Opportunity Tax Credit (the $2,500 tax credit for college expenses that replaced the prior Hope Scholarship Credit in 2009) is extended 5 years – it was scheduled to lapse at the end of 2012, and will now run until 2017. The Child Tax Credit and the Earned Income Tax Credit were also extended over the same 5-year time period.

A series of “extender” rules are retroactively patched for 2012 and extended one year through 2013, including:

– Deduction for up to $250 expenses for elementary and secondary school teachers – Exclusion from income of discharged mortgage debt (necessary to prevent a short sale from triggering income tax consequences for the amount of debt that was discharged) – Deduction of mortgage insurance premiums as qualified residence interest – Deduction for state and local sales taxes paid (in lieu of state and local income taxes paid, useful in states that have little or no income taxes) – Above-the-line deduction for up to $4,000 of higher-education-related expenses (although in practice, this provision is rarely used due to the availability of the American Opportunity Tax Credit, which was also extended) – Exclusion from income for Qualified Charitable Distributions from an IRA to a charity (still with the age 70 1/2 requirement and the $100,000-per-taxpayer-per-year limitation). Notably, a special rule allows qualified charitable distributions made by February 1, 2013 to be counted retroactively for the 2012 tax year, for those who want to take advantage of the rule for 2012 and 2013. – Business provisions, including the Work Opportunity Tax Credit, the increased Section 179 expense deductions for small businesses, and 50% bonus depreciation for larger businesses.

Notably, the 2% payroll tax cut that has been in place for the past 2 years was not extended, and has lapsed. Payroll withholding will need to be adjusted for employees in 2013 (and per the recent Treasury regulations, high income individuals will also need to adjust withholding later in 2013 for the new 0.9% Medicare tax on earned income).

Separately, the favorable treatment of Coverdell Education Savings Accounts (so-called “education IRAs”) created under EGTRRA, including both the higher contribution limits ($2,000/year), and the ability to use qualified distributions for eligible K-12 expenses, has been extended and made permanent under the new law.

AMT Relief

The ongoing series of AMT exemption patches over the past decade are made permanent, and fixed retroactively (since the last patch expired in 2011). The new AMT exemption amount will be $78,750 for married couples and $50,600 for singles in 2012 (these are essentially the 2011 amounts adjusted for inflation). The AMT exemption amounts will be indexed for inflation in the future. In addition, several key AMT thresholds are now also indexed for inflation, including the $175,000 threshold for the 28% AMT tax bracket, and the $112,500 and $150,000 (for individuals and married couples, respectively) thresholds for the phaseout of the AMT exemption.

In a separate but related provision, the rules that allow nonrefundable tax credits to be used for both regular and AMT purposes (subject to some restrictions) is also retroactively patched for 2012 and made permanent going forward.

New Roth Conversion Flexibility

In one entirely new rule under the legislation, ATRA will now allow individuals to convert their existing 401(k) plan to a Roth 401(k) plan, if the employer offers designated Roth accounts under the plan, regardless of whether the individual is allowed to take a distribution out of the plan. The transaction will be taxed in a similar manner to any other Roth conversion. Given the way the rule was written, it’s unclear whether such a conversion could be recharacterized as IRA-based Roth conversions can, although such a “technical correction” could always be added later (and there’s a lot of time to do so, since the deadline for any 2013 conversions of 401(k) plans would be October 2014).

The reason this provision is notable is that, under current law, you can only convert a 401(k) plan if you are eligible to take a distribution from the plan (whether it’s going to a Roth 401(k) or Roth IRA), which generally means you have to be 59 1/2, dead, disabled, or separated from service, unless the plan allows in-service withdrawals. The new ATRA provision will allow an intra-plan Roth conversion, regardless of whether you’re eligible for a distribution out of the plan (the way you would have to be to get to a Roth IRA). Notably, the rules appear to allow the new intra-plan Roth conversions for 401(k), 403(b), and 457 plans.

Basically, the new rule simply means you can now do intra-plan 401(k) (or 403(b) or 457 plan) conversions from traditional to Roth in the same manner you can do so for IRAs. But you still can’t go FROM a 401(k) (or other employer retirement plan) TO the IRA unless you’re otherwise eligible for a distribution from the retirement plan. In theory, the increased flexibility for Roth conversions means more (current workers) will convert their existing 401(k) and other employer retirement plans, which provides a short-term revenue increase for the Federal government (thus, this new rule was actually scored as a “revenue raiser” in measuring the fiscal impact of the provision). Of course, as I’ve written in the past, whether completing a Roth conversion (inside a 401(k) or with an IRA) is a good deal or not depends on several individual-specific factors.

(This article was featured in the “Carnival of Wealth Notre Dame Sucks Edition” on Control Your Cash, the Carnival of MoneyPros on Master the Art of Saving, the Carnival of Retirement on Simple Budget Blog, the Carnival of Money Pros on Consumer Boomer, the Carnival of Passive Investing #26 on My Personal Finance Journey, and also Nerdy Finance #21: Trillion-Dollar Coin Edition on NerdWallet.)