Special Report of Future Tax Changes - Individuals

This is a continuation of posts to provide information about income taxes for 2012 and beyond. While what will actually happen is uncertain at this time; however, the potential changes are quite significant to your bank account.

SUNSETS FACING INDIVIDUALS

The impact of the looming expiration of the Bush-era tax cuts on individuals has received the most attention because its effect is so great. If the Bush-era tax cuts expire as scheduled, the individual income tax rates will increase across-the-board.

Income Tax Rates for Individuals

Under current law, the reduced individual income tax rates created by EGTRRA, accelerated by JGTRRA, and extended by the 2010 Tax Relief Act are scheduled to sunset after 2012. Unless extended, the individual marginal tax rates, currently at 10, 15, 25, 28, 33, and 35 percent, are scheduled to revert to 15, 28, 31, 36, and 39.6 percent, effective for tax years beginning after December 31, 2012.

IMPACT

Unless Congress acts, all taxpayers – and not just higher income individuals – will effectively experience a tax hike after 2012. The top rate will jump from the current 35 percent to 39.6 percent. The lowest 10 percent rate will be eliminated. Even those taxpayers who may remain in the 15 percent bracket will pay more by not realizing the advantage of having their first dollars of income subject to the 10 percent rate bracket. Additionally, the two percent employee-side payroll tax cut, as enacted under the Middle Class Tax Relief and Job Creation Act of 2012, is scheduled to expire after 2012, affecting all workers in 2013 up to $113,700 of their earned income (the projected Social Security wage base for 2013).

IMPACT

By far, the costliest provisions to extend are the reduced individual tax rates. According to the Congressional Budget Office (CBO), they account for over half of the total revenue loss. And according to the Congressional Research Service (CRS), the extension of the reduced income tax rates in the 2010 Tax Relief Act for two years alone reduced federal revenues by $363.55 billion.

Although the individual tax rates are scheduled to revert to the levels in place prior to EGTRRA, the bracket amounts to which each rate is applied will continue to reflect annual inflation adjustments. However, the entire 10 percent rate bracket will be eliminated and become the lower portion of the 15 percent bracket.

IMPACT

The majority of U.S. businesses are pass-through entities, such as partnerships and S corporations. If the provisions expire, pass-throughs will be hit hard, since profits are passed through to their individual owners. A “C” corporation, with its current corporate level tax of 35 percent (which may drop if recent corporate tax reform proposals are adopted), may become more attractive if individual tax rates rise.

President Obama, in his Blueprint for America and other proposals, has called for making permanent the 10, 15, 25, and 28 percent rates for tax years beginning after December 31, 2012. However, the 33 and 35 percent tax rates would sunset as scheduled after 2012, and would be replaced by 36 and 39.6 percent rates starting at $200,000 for single individuals and $250,000 for joint filers. Additionally, President Obama has proposed to widen the tax bracket for the 28 percent rate. The House GOP has proposed to consolidate the six current individual income tax brackets into two brackets of 10 and 25 percent.

IMPACT

Individuals who anticipate the possibility of being subject to a higher income tax rate after 2012 should explore shifting the timing of income or deductible expenses. Deferring deductions into 2013 may help to offset income that would be subject to a higher rate of tax. Accelerating income into 2012 likewise might lower overall tax liability. Acceleration techniques include billing earlier, selling appreciated property, avoiding installment sales that defer gain, and accelerating bonuses.

Marriage Penalty Relief

Before EGTRRA, some married couples experienced the so-called marriage penalty. EGTRRA gradually increased the basic standard deduction for a married couple filing a joint return to twice the basic standard deduction for an unmarried individual filing a single return. The 2011 Tax Relief Act extended EGTRRA’s marriage penalty relief through 2012.

IMPACT

If marriage penalty relief is not extended, the deduction for married couples will be 167 percent of the deduction for single individuals rather than 200 percent. Based on 2012 amounts, the standard deduction for joint filers is estimated to drop from $11,900 to $9,950 (with rounding).

EGTRRA also gradually increased the size of the 15 percent income tax bracket for a married couple filing a joint return to twice the size of the corresponding rate bracket for an unmarried individual filing a single return. The 2010 Tax Relief Act extended this treatment through 2012.

IMPACT

Under current law, the upper limit of the 15 percent bracket for joint filers is equal to 200 percent of the upper limit for single individuals; after 2012 the upper limit of the 15 percent bracket for joint filers is scheduled to be equal to 167 percent of the upper limit for single individuals. Based on 2012 amounts, the 15 percent bracket for joint filers is estimated to end (and the pre-EGTRRA 28 percent bracket is estimated to begin) at $59,000 rather than at $70,700.

Comment

The fate of marriage penalty relief remains uncertain since it likely will be considered with more politically controversial parts of the sunsetting provisions. As a result, married couples may want to be ready to increase their withholding or make larger estimated tax payments starting in 2013 to avoid any adverse impact from the sunset of the increased 15 percent rate bracket and standard deduction for married couples.

Pease Limitation

The “Pease” limitation on itemized deductions, which was eliminated by EGTRRA and extended by the 2010 Tax Relief Act, is scheduled to be revived after 2012. The Pease limitation, named after the member of Congress who sponsored the original provision, reduces the total amount of a higher-income taxpayer’s otherwise allowable itemized deductions by three percent of the amount by which the taxpayer’s adjusted gross income exceeds an applicable threshold. However, the amount of itemized deductions would not be reduced by more than 80 percent. Certain items, such as medical expenses, investment interest, and casualty, theft or wagering losses, are excluded.

Comment

The applicable threshold for the Pease limitation, if it was in effect in 2012, would have been $173,650.

Personal Exemption Phaseout

Higher income taxpayers may see their deduction for personal exemptions reduced or eliminated under the personal exemption phase-out rules, should the phaseout be revived after 2012. The elimination of the phaseout was first implemented by EGTRRA for certain years and extended by the 2010 Tax Relief Act through 2012. Under the phaseout, the total amount of exemptions that may be claimed by a taxpayer is reduced by two percent for each $2,500, or portion thereof (two percent for each $1,250 for married couples filing separate returns) by which the taxpayer’s adjusted gross income exceeds the applicable threshold. The 2010 Tax Relief Act repealed the phaseout for 2010 and 2011 only.

IMPACT

The applicable thresholds for the personal exemption phase-out, had it remained in effect in 2012, would have been $173,650 for single taxpayers and $260,500 for married couples filing a joint return.