For 2013, January 1st is much more than the start of a new year.  The champagne and streamers are accompanied by many changes in tax provisions and the potential for automatic across-the-board spending cuts.

For months we have been inundated with news about the ominous fiscal cliff.  We cannot turn on the television, open a newspaper, or browse the internet without being told that our economy will spiral into another recession if Congress and the President do not reach a compromise to avoid the fiscal cliff before December 31st.  Most of us have heard that the cliff consists of two main elements: the expiration of the Bush tax cuts and $1.2 trillion in mandatory across-the-board budget cuts, known as the sequester which will take effect January 1, 2013.

In addition to the Bush tax cuts, we have new taxes effective January 1, 2013 which are not related to the fiscal cliff.  They consist of the Medicare portion of the payroll tax set to increase by 0.9% for high wage earners and the new Medicare contribution tax imposed on net investment income of high-income individuals.  These will be discussed in detail a little later.

First, let’s address the fiscal cliff…

The Origin of the Fiscal Cliff

You may be wondering how our lawmakers ended up in such a predicament requiring them to work together in order to avert the so-called cliff in such a short period of time.  The answer may surprise you.  The very same lawmakers are responsible for creating this fiscal cliff and the deadline.  Both parties in Congress and President Obama approved the sequester during 2011.  The automatic spending cuts are called for under the Budget Control Act which was signed into law in August 2011. This is how our lawmakers chose to resolve their bitter fight over raising the country’s debt ceiling. The original idea was to pass something so distasteful it would require lawmakers to finally negotiate a deal to reduce deficits by at least $1.2 trillion over a 10-year period.  The Budget Control Act of 2011 created a Joint Select Committee on Deficit Reduction (“Supercommittee”) whose main objective was to develop a deficit reduction plan over a 10-year period.  The Supercommittee failed to reach a bipartisan agreement before the deadline which resulted in the automatic sequester effective January 1, 2013.

The two components making up the unique combination which results in the fiscal cliff are explained below.

Expiring Tax Provisions

After being extended for an additional 2 years, the “Bush tax cuts” are scheduled to sunset at the end of 2012; therefore, without Congressional action, all taxpayers will face higher tax rates on income and capital gains.  We remember the uncertainty we faced during 2010 as these very same tax cuts were scheduled to sunset on January 1, 2011.  We find ourselves in the same environment of uncertainty 2 years later.

The table below compares the individual income tax rates if the Bush tax cuts expire for all taxpayers to the current individual income tax rates.  We will discuss current proposals from each party designed to avoid the fiscal cliff in more detail; however, it is relatively clear that no legislators want to raise taxes on all taxpayers.  Therefore, the last column shows the tax rates if the Bush tax cuts are extended for taxpayers earning less than $250,000 a year.

The table below includes tax rates for married individuals filing joint returns.

Individual Tax Income Rates

Other than the threat of increased income tax rates for all taxpayers, the Bush tax cuts also included several tax provisions which are set to sunset as of January 1, 2013.  The expiration of these tax provisions will also increase taxes.  Qualified dividends will be taxed at ordinary income tax rates rather than the reduced 15% and the long term capital gains tax will return to 20% from 15%.  The marriage penalty will also return and other tax provisions which affect the deductibility of itemized deductions are set to expire on January 1, 2013.  The table below outlines the significant tax provisions expiring.

Individual Tax Income Rates

The current estate and gift tax provisions are another important component of the Bush tax cuts set to sunset as of January 1, 2013.  During the 2010 negotiations, we were hopeful that our legislators would extend the 2009 exemption of $3,500,000 and rate of 45% rather than return to the $1,000,000 exemption and 55% tax rate.  However, Congress surprised us by increasing the exemption amount to $5,000,000 and lowering the rate to 35% through 2012.  They also included portability, allowing the surviving spouse to utilize any unused exemption from the deceased spouse.  The table below compares the provisions of the current law to the law on January 1, 2013 if no compromise is reached before year end.

There is a possibility that Congress could pass legislation that will “clawback” any exemption in excess of the current amount allowable.  Meaning if you used $5,000,000 of exemption in 2012 and the current allowable amount is $1,000,000 then $4,000,000 could be disallowed in the future.  The consensus is that this is unlikely.

Individual Tax Income Rates

Failure to adjust the alternative minimum tax (AMT) exemption levels by the end of the year would result in an estimated 28 million taxpayers being subject to AMT compared to 4 million taxpayers currently subject to AMT.  Lawmakers in both parties support indexing the exemption amounts to keep the number of taxpayers affected by the AMT at the 4 million mark.  However, rather than permanently indexing the AMT exemption, Congress “patches” the exemption amount each year. The last AMT patch expired at the end of 2011, meaning Congress would have to retroactively adjust the levels of 2012 and then further adjust them for 2013.

But like the tax extenders, fixing the AMT is caught up in the greater issue of how to avert the fiscal cliff.  If there is no AMT patch enacted by December 31, 2012, the IRS warns that the start of tax season could be delayed until March for millions of taxpayers.  This is a result of the programming changes necessary to the IRS’s processing systems before returns could be filed.

Individual Tax Income Rates

Spending Cuts or “Automatic Sequestration”

The failure of the deficit reduction supercommittee to reach an agreement in November 2011 automatically triggered $1.2 trillion in broad-based spending cuts over a 10-year period beginning in 2013.  The automatic cuts will be split evenly between defense spending and nondefense spending.

Defense Spending
An estimated $55 billion will be cut in 2013 from projected levels of discretionary defense spending.

• Military personnel and the Department of Veterans Affairs will be exempt from the sequestration and the Department of Defense will have the ability to shift funds so that critical military readiness would not be impaired.

Nondefense Spending
$55 billion will be cut from projected levels of nondefense spending.  Most discretionary programs, including education, transportation and energy programs, will be subject to the automatic cuts.

• Social Security, Medicaid and Medicare benefits are exempt and cuts to Medicare provider payments cannot exceed 2%.

Status of Negotiations – Only 3 Weeks Remaining

It appears that the initial offers from the White House and House Republicans were geared more toward satisfying their bases than at real negotiating.  Now that both parties have positioned themselves, we can hope that the motivations behind their next offer will be geared toward achieving a viable deal.

Initial White House Offer to Republicans

  • Income Tax Rates: Extend the Bush tax cuts to taxpayers earning less than $250,000 a year.
  • Capital Gains and Dividends: Raise both capital gains and dividend rates to unspecified amount (speculation has been 20%).
  • Estate Tax: Lower exemption to $3,500,000 and raise rate to 45% (return to 2009 levels).
  • AMT Patch: Increase exemption level from $45,000 to $78,750 in 2012.
  • Stimulus: Extend the payroll tax cut to 4.2% for employees.
  • Sequester: Defers $1.2 trillion in mandatory government spending cuts until January 2014.
  • Tax Reform: Calls for comprehensive tax reform during the next two years that is consistent with a $1.6 trillion tax increase.

Republican Counteroffer to White House

  • $800 billion in new revenue through closing loopholes (will not raise tax rates).
  • $600 billion in cuts to federal health care programs (Medicare and Medicaid).
  • $200 billion in savings by adjusting the cost-of-living increases in Social Security and Medicare.
  • $300 billion in discretionary cuts and another $300 billion in mandatory cuts.

The White House’s offer does not include any details on spending cuts and the Republicans’ offer does not include any details on which tax loopholes they would close to raise revenue or how they would cut Medicare.

If our Congressional leaders do not reach a deal by December 31st then their first order of business when they reconvene in 2013 will be to reduce taxes.  Politically, this may be easier for Republicans since agreeing to extend the Bush tax cuts for all taxpayers earning less than $250,000 right now could be interpreted as them agreeing to raise taxes on the “wealthy.”  However, if they agree to the same concept in 2013 it would be interpreted as them reducing taxes for the majority of taxpayers.

What truly happens if we “go over the cliff?”  Congress will most likely reach a compromise during January.  At the end of the day, they will not want taxes reverting back to the Clinton-era rates for all taxpayers.  However, the main concern is the market’s reaction to the uncertainty of approaching 2013 with no sign of compromise.  It is expected that we will see a negative market reaction if there is no deal by year end.  There is no way to predict the severity of this reaction.  Another concern is the level of uncertainty introduced into our business environment.  This makes it difficult for business owners to make hiring decisions.  Many business owners have expressed that they want Congress to reach a compromise.  Some have even expressed that they are prepared for taxes to increase; however, the uncertainty of their future tax rates and overall economic policy makes it difficult to plan.

The chart below measures the economic policy uncertainty levels over the past 12 years.

Individual Tax Income Rates

While it has not received the same level of attention due to the focus on the fiscal cliff, there is another problem looming.  The government is running out of money again.  According to the chart above, the 2011 debt ceiling debate resulted in the highest level of uncertainty over the past 12 years.  Last year’s impasse resulted in the imposition of the automatic cuts now referred to as the fiscal cliff.  It remains to be seen whether a new debt ceiling increase is included as part of a larger agreement encompassing the expiring tax provisions and impending spending cuts or whether it is debated on its own.

New Taxes for 2013 – Unrelated to Fiscal Cliff   

The new taxes imposed in 2013 are a result of the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Affordability Reconciliation Act (collectively, the 2010 health care reform legislation).

Medicare Payroll Tax

For taxpayers receiving wages, the hospital insurance (HI) portion of the payroll tax (commonly referred to as the Medicare payroll tax) is currently 1.45% of covered wages and is not subject to a wage cap.  Beginning in 2013, the health care reform legislation increases the HI tax on high-wage individuals by 0.9%.  This results in a maximum of 2.35% for the employee’s portion of the Medicare payroll tax.  The employer’s portion remains at 1.45%.

The additional 0.9% tax applies to the extent that wages exceed $200,000 ($250,000 in combined wages if you are married and file a joint return).  In 2013 a single person earning $300,000 in wages will owe a Medicare payroll tax at a rate of 1.45% on the first $200,000 of wages and a Medicare payroll tax at a rate of 2.35% on the remaining $100,000 of wages for the year.

$200,000 x 1.45% = $2,900
$100,000 x 2.35% = $2,350

The total Medicare payroll tax for 2013 is $5,250, compared to $4,350 in 2012.

Employers will withhold the additional 0.9% on any wages exceeding $200,000 regardless of your marital status.  Your employer will not account for any wages earned by your spouse, so if you are married, you may owe more (or less) tax than the amount that is withheld.  If you owe more, you will pay any additional tax due on your federal income tax return.  If you owe less, you will claim a refund on your tax return.

If you are self-employed, the additional 0.9% tax applies to self-employment income that exceeds the dollar amounts (reduced, though, by any wages subject to FICA tax).  You will not be able to deduct any portion of the additional tax.

Medicare Contribution Tax

Beginning in 2013, a new 3.8% Medicare contribution tax will be imposed on the unearned income of high-income individuals (the new tax is also imposed on estates and trusts, although slightly different rates apply).  The tax is equal to 3.8% of the lesser of your:

• Net investment income (generally, net income from interest, dividends, annuities, royalties & rents, capital gains and income from a business that is considered a passive activity)

– OR –

• Modified adjusted gross income (MAGI) that exceeds $200,000 ($250,000 if married filing jointly)

Tax-exempt interest, veterans’ benefits and any excluded gain from the sale of a principal residence are not considered net investment income.  It is also important to note that qualified retirement plans and IRA distributions are not considered investment income.  Retirement distributions can increase your MAGI above the threshold; however, the 3.8% tax will not be imposed on these distributions.

Meaning, if your MAGI is $275,000 (married filing jointly) and $200,000 of that is retirement distributions while the remaining $75,000 is net investment income, the additional 3.8% tax will only apply to the lesser of $75,000 (net investment income) or $25,000 (the amount of MAGI that exceeds $250,000).  Therefore, the 3.8% tax will be applied to $25,000 of income or $950 in tax.

Using the same example above – if the entire $275,000 of MAGI was net investment income, the 3.8% tax would still only apply to $25,000 of income.  That is the lesser of $275,000 (net investment income) or $25,000 (the amount of MAGI that exceeds $250,000).

If you have high wages and investment income, you could be subject to both the 0.9% additional Medicare payroll tax and the 3.8% Medicare contribution tax on your investment income.  This is in addition to your ordinary income tax rates.

Annual Gift Exclusion is Inflation-Adjusted for 2013      

The annual exclusion for gifts will increase to $14,000 per person.

Tax Planning

2012 year-end planning is challenging to say the least.  It is a safe assumption that tax rates will definitely not decrease next year for high income taxpayers.  The amount of any potential increase is, of course, unknown.  If you are able to accelerate income into 2012, we would recommend doing so unless you believe your circumstances would change substantially and you would fall into a lower bracket in 2013.  Normally, we would recommend postponing deductions until next year; however, due to the potential limits on itemized deductions this may not be the best solution.  There is also talk of potentially capping deductions on high income taxpayers; therefore, it may be safest to take your deductions now while we know the tax implications.  As always, please discuss your specific situation with your tax professional.


This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the Funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts.

There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject to risks as well. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments and smaller companies typically exhibit higher volatility. Bonds and bond funds will decrease in value as interest rates rise. High-yield bonds involve greater risks of default or downgrade and are more volatile than investment-grade securities, due to the speculative nature of their investments. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.

Diversification may not protect against market risk. There is no assurance the objectives discussed will be met. Past performance does not guarantee future results Index returns are for illustrative purposes only and do not represent actual portfolio performance. Index returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index.