Income and Estate Taxes – A Surprising Bit of Certainty

At a time when it seems that politicians here and abroad are contributing to the uncertainty of the world economy, the US Congress recently delivered a bit of certainty in two very important aspects of our financial lives.  It took two old line Senators – McConnell and (now Vice President) Biden – to hammer out a deal in the waning hours of 2012.  The final deal allowed both sides to claim victory – higher taxes on upper income taxpayers for the Democrats and permanently lower rates in all other brackets for the Republicans. 

Remember the phase-ins and phase-outs and constantly changing brackets of the 2000s?  Gone.  In the end, the lower tax rates initially established under President George W. Bush were made permanent for all but the highest income earners.  In addition, no major deductions or exemptions were modified and that pesky alternative minimum tax fix (that Congress has been doing annually for who knows how long) is now permanently fixed by indexing it to inflation. 

Congress also drastically reduced the applicability of the estate tax by making permanent the estate/gift tax exemption at $5,250,000, also indexed for inflation. Portability (sharing of the exemption between husband and wife) has been made permanent.  The quid pro quo?   A higher estate tax rate of 40%.  

This all seems too good to be true, right?  Well, if you make more than $200,000 (single) or $250,000 (married), your 2013 income tax calculation is about to get a lot more complicated.  We aren’t going to try to explain all of the nuances here but let’s summarize by saying that there are three new ways that your taxes will go up. 

First, the 3.8% Medicare surtax will apply to net investment income to the extent the $200,000/$250,000 threshold income is exceeded.  Second, at incomes above $250,000/$300,000 personal exemptions and itemized deductions begin to phase out.  Finally, at incomes over $400,000/$450,000, a new higher income tax rate of 39.6% applies and the capital gains rate increases from 15% to 20% (in addition to the Medicare surtax).  

Behind each of the these general ways that taxes may rise is a somewhat complicated formula – best left to your tax accountant. 

Stepping back from the details, it seems pretty likely that those with high incomes and estates exceeding $10.5 million will look to shift income-producing assets out of their estates by way of gifts below the gift tax exclusion amount.  The secondary benefit is that the income from those assets could be taxed at substantially lower rates in the hands of a lower tax bracket recipient.  

Our advice – seek the counsel of your tax accountant and estate attorney early in 2013 – as asset and income shifting might be an important part of a smart estate and income tax strategy.  The sooner you look at your options, the more effective they will be in 2013 and future years.