Hidden Benefits of the Fiscal Cliff

On New Year’s Day, Congress and the White House drove America off the fiscal cliff. That same evening, they engineered a soft landing by passing the American Taxpayer Relief Act of 2012. Talk about cutting things close. The brinksmanship and last-minute fixes provide a good example of how not to run a country. And naming the new tax law the American taxpayer Relief Act of 2012 when it raises tax payments for 77% of Americans is certainly noteworthy for irony, or maybe chutzpah.  While you’ve been hearing about the fiscal cliff and the law that fixed it for some weeks now, there are some important details that have been omitted from most of the media coverage I’ve seen. For example:

The Good

Will you be paying college tuition for yourself, your children, or your grandchildren? The new law retroactively reinstates the above-the-line tax deduction for qualified tuition and expenses. By “above the line,” I mean that up to $4,000 of these expenses can be deducted before calculating Adjusted Gross Income.  Since many unrelated tax benefits depend on the size of your AGI, above-the-line deductions are good. You can claim this tuition deduction if your AGI is less than $130,000 for a married couple filing a joint return.

The new law also permanently expands the student loan interest deduction. Before this law, taxpayers could only deduct student loan interest during the first five years of repayments. Now that time limit is removed.

Another temporary benefit made permanent by the new law is the expansion of Coverdell Education Savings Accounts. They were originally created with measly $500 annual contribution limits. A 2001 tax law temporarily increased this limit to $2,000. The new law means the bigger contribution limit is staying around. And eligible education expenses include both elementary and secondary schools.

Another item in the new law that may affect your college planning is its impact on Section 529 Plans. While the law doesn’t address these plans directly, the changes it makes to capital gains taxes may make you want to reconsider them. Specifically, the law makes permanent the so-called “Bush Tax Cuts” for all but the highest tax brackets. This means that capital gains and qualified dividends will be taxed at a 0% rate for people in the 10% or 15% income tax brackets. A married couple filing a joint return in 2013 with taxable income of $72,500 or less would pay no taxes on long-term capital gains or qualified dividends. Since the primary advantage of Section 529 Plans is that their gains are tax-free if spent for qualified education expenses, they may hold no advantage for people in lower tax brackets. If this is you, a standard brokerage account would provide you with more flexibility, both in terms of investment choices and in terms of how you ultimately spend the money, while giving up nothing in tax advantages to the 529 Plan.

The Bad

The law helps business owners by extending the Bonus Depreciation rules. that’s good. But the extension is only temporary, lasting for one year. That’s bad.

The temporary decrease in Social Security taxes is officially over, so your FICA tax payments will go back up from 4.2% to 6.2% of the first $113,700 you earn in 2013.

The Ugly

Beware the hidden tax hike. The politicians and the media have been trumpeting the fact that tax rates are only going up for single filers earning $400,000 or more, and joint filers earning more than $450,000. This is true. But if you earn more than $250,000 (single) or $350,000 (joint), your effective tax rates are still going up. That’s because your personal exemption and your itemized deductions (including charitable contributions and mortgage interest) are both phased out at your income. So while your tax bracket won’t rise, the loss of exemptions and deductions increases the amount of taxable income to which the rate applies.  Welcome to the Taxpayer Relief Act of 2013.  It wouldn’t be politics without some bad and some ugly, but at least this is a tax law with some good in it. Talk to me if you want to know more!