Late last night, the United States House of Representatives passed is designed to avoid the fiscal cliff, the bill already approved by the Senate that avoids the fiscal cliff, the automatic tax rate reversion and spending cuts agreed to last year by Congress. With recurring drama every few months, the government seems to be taking cues from the reality television playbook, where those with the power to do so overtake the news cycle with a manufactured conflict. Others do it for the ratings and advertising revenue, but the reasons behind the Congress’s use of drama to attract attention to itself baffle me.
As much as I’ve tried to avoid talking about the so-called fiscal cliff, its provisions are important to money management, and thus I can’t ignore it completely. The other melodramatic political deadlines, the debate over raising the debt ceiling and the passing of the annual budget that allows Congress to continue operating, which are generally nothing more than pure theatrics, there was a bigger question as to whether a sharply divided Congress would be able to come together to avoid the fiscal cliff.
H.R. 8, the American Taxpayer Relief Act of 2012, passed the House with a vote of 257 to 167, after earlier passing the Senate 89 to 8. The President is expected to sign the bill into law today. Michael Kitces has already prepared an excellent article about the financial implications of the Act.
Marginal tax rates
The bill is good news for the middle class. The law makes the lower tax rates enacted during President George W. Bush’s tenure permanent. Recently, Congress has had to fight every year to extend the tax cuts, but this will no longer be necessary. Of course, “permanent” is a misnomer. A new bill at any time could change the tax rates, but without an expiration date, no action is necessary to keep them in force. The above applies to all but the top tax bracket. The top rate is reverting back to the higher rate, as it was before the Bush-era tax cuts.
The top marginal tax rate has been 35% in recent years, and in 2013, it would have affected taxpayers earning $398,350 and up, whether filing single or married. (Keep in mind that’s a modified adjusted gross income, your income after all deductions have been accounted for.) That bracket has been bumped up by the Act to $400,000 for single taxpayers, keeping a sliver of taxpayers in the 33% tax bracket. The highest tax rate is back to 39.6%, so that effects only the income above the $400,000 threshold. For couples, that threshold is $450,000, not $400,000. For heads of household, the threshold is $425,000.
Keep in mind how marginal tax brackets work. If you “fall in the top tax bracket,” you don’t owe 39.6% on all of your income. You owe that rate only on the income above $400,000 (or $450,000 or $425,000), and lower tax rates on the income that falls within the lower tax brackets. Here are the 2013 marginal federal income tax rates.
Taxes on investment income
The American Taxpayer Relief Act makes permanent a lower tax rate on capital gains and dividends, but wealthy investors might not be happy with the change of the lower rate from 15% to 20%. Most investors will still pay 15% on long-term capital gains and qualified dividends, but for income falling in the top tax bracket, the rate will increase to 20%. This will have an effect on those who earn most of their money from investing rather than working as an employee or a contractor.
The investment tax increase also affects professional money managers, whose income is considered “carried interest,” and who are basically employees of a mutual fund but receive regular income in a favorable tax situation.
Social Security and Medicare
As I’ve already mentioned, the payroll tax, which has been temporarily reduced by two percentage points over the past few years, has been reinstated. The American Taxpayer Relief Act did not extend this tax cut. That will result in an effective reduction in take-home pay for employees, consultants, and the self-employed, all other things being equal.
At the same time, some investors might find an additional tax on their net income. To help fund Medicare, everyone earning over $200,000 (or $250,000 if filing jointly) will be required to pay an additional 3.8% tax on the lesser of their modified adjusted gross income or net investment income. This is in addition to the 15% or 20% tax on long-term capital gains and qualified dividends and any other income tax. The tax is phased in, so the exact amount you’ll pay depends on your income. (This is an example of why the applications that handle the calculations automatically, like TurboTax, are so valuable, as are qualified tax professionals.)
The Act increases the top estate tax rate from 35% to 40%. Most estates will continue to be exempt from estate taxes as the tax doesn’t kick in until beyond the first $5 million in inheritance.
Other provisions of the American Taxpayer Relief Act
There are a number of other provisions included in the American Taxpayer Relief Act which have a smaller affect on the average taxpayer. Some deductions and credits have been extended or made permanent. For example, he American Opportunity Tax Credit, which is a $2,500 credit for college expenses, and the Child Tax Credit and the Earned Income Tax Credit, have all been extended through 2017.
Read the full text of the Act
You can read the full text of H.R. 8 here.
The drama isn’t over
Now that Congress has experienced its biggest takeover of the public consciousness, expect to see more partisan drama over upcoming debates like the debt ceiling, which is always a fierce debate but is always resolved with a resolution to raise the debt ceiling in order to allow the government to continue to operate. Congress’s own operating budget is another annual threat to politicians’ ability to do their jobs, yet it is always pushed forward for another year.
Nevertheless, with artificial or arbitrary deadlines, it seems the government is more likely to work together and put aside their differences in order to get things accomplished. It also helps raise awareness of issues and encourages the public to talk and debate about proposed laws. I see this as a byproduct of our culture that feeds off drama as a form of entertainment.
The American Taxpayer Relief Act will actually reduce future drama by eliminating the need to renew tax rates every year, but I am confident Congress will find a way to create more needless conflict, encourage the public to become even more partisan and unlikely to listen to other people’s perspectives, and enforce the idea that something is only good if it benefits oneself.
Updated June 23, 2016 and originally published January 2, 2013.