Financial Planning Implications of HR8 – the Taxpayer Relief Act of 2012

Posted by Michael Kitces on Tuesday, January 1st, 5:50 pm, 2013 in Taxes

The last-minute fiscal cliff compromise - H.R. 8, which will also be known as the American Taxpayer Relief Act of 2012 (or "ATRA") - extends the majority of tax cuts that were scheduled to expire at the end of 2012, in addition to retroactively reinstating some rules that had expired in 2011. However, the legislation also introduces a number of changes as well - including a new top tax bracket of 39.6%, and an increase in the top long-term capital gains and qualified dividend rate to 20%. And some old rules that had lapsed and were scheduled to come back have in fact returned, such as the Pease limitation (phaseout of itemized deductions) and the Personal Exemption Phaseout (PEP). In addition, a new rule will allow 401(k) participants to complete intra-plan Roth conversions.

For planning purposes, though, the good news is that not only was the fiscal cliff largely "averted" with last minute legislation, but the changes under ATRA are permanent. On the other hand, making some rules permanent - such as not only the current gift and estate tax exemption, but also the portability of a deceased spouse's unused exemption - will change income and estate tax planning going forward. 

In this article, we take a first look at the details of the H.R. 8 fiscal cliff legislation and some of its financial planning implications. 

(Editor's Note: At the time this article is being initially posted, the House has still not voted on the legislation the House has voted 257-167 in favor of the Senate's full version of the legislation. As a result, it may still be amended or even voted down entirely this should be the final version of the legislation. If any changes to the legislation are made new details come to light, this post will be updated accordingly. You can see a copy of the legislation via Business Insider here the final version of the legislation here.) 

Tax Brackets

The top tax bracket rises to 39.6%, and applies to income in excess of $400,000 for individuals, and $450,000 for married couples. These thresholds are indexed for inflation (in a similar manner to all the other tax bracket thresholds). Notably, the $450,000 threshold for married couples is actually a slight form of marriage penalty release, as in the past the top tax bracket threshold was the same for both individuals and married couples. It's also notable that in practice, this change is effectively the same as just allowing the top tax bracket to lapse back to the old rates, as the top tax bracket was already at $388,350 in 2012 (and would have been just shy of $400,000 with the 2013 inflation adjustment). (Note: bear in mind that tax brackets are based upon taxable income after all deductions, not Adjusted Gross Income.)

The remaining tax brackets are extended at their current levels. Notably, this means the 35% tax bracket is still in effect, although it's now one of the smallest tax brackets, applying for only $388,350 to $400,000 (for individuals; or $388,350 to $450,000 for married couples).

The changes listed here to the tax brackets are permanent - i.e., there is no sunset provision that would cause them to lapse (although Congress could still change the rules in the future, of course!).

Phaseout of Itemized Deductions and Personal Exemptions

The phaseout of itemized deductions and personal exemptions returns for 2013. In point of fact, this change was already scheduled to happen with a lapse of the Bush tax cuts, but ATRA applies new thresholds to the rules.

The phaseout for itemized deductions (also known as the Pease limitation) reduces total itemized deductions by 3% of excess income over a threshold. The threshold amounts are now an Adjusted Gross Income of $300,000 for married couples, and $250,000 for individuals. These amounts are indexed for inflation.

The personal exemptions phaseout (also known as the PEP), reduces personal exemptions by 2% of the total exemptions for each $2,500 of excess income over a threshold) returns for 2013. The threshold for this phaseout will be the same as the threshold for the Pease limtiation (AGI of $300,000 for married couples, and $250,000 for individuals, indexed for inflation). Notably, in the past the PEP had a different phaseout threshold than the Pease limitation, but the new rules under ATRA unify these thresholds.

The net impact of the PEP and Pease limitations is that each rule increases an individual's marginal tax rate by about 1% (with a greater impact on larger families that phaseout more exemptions at once).

Estate Taxes

The new rules of ATRA make the current estate tax laws permanent, including the $5,120,000 (in 2012) gift and estate tax exemption (which will rise further to approximately $5.25M with an inflation adjustment for 2013); the Federal gift and estate tax exemptions remain unified. This outcome is not entirely surprising; as I wrote earlier this year, the estate tax exemption has not actually been allowed to decline since the Great Depression. However, the top estate tax (and gift, and GST) rate is increased from the prior 35% to a new maximum rate of 40%. 

Notably, the portability rules for a deceased spouse's unused estate tax exemption amount are made permanent, which may significantly impact (i.e., reduce) the use of bypass trusts for all but the wealthiest of families.

Capital Gains and Dividends

ATRA makes permanent the 0% and 15% long-term capital gains tax rates, but increases the tax rate to 20% for any long-term capital gains that fall in the top tax bracket (the new 39.6% bracket with the $400,000 / $450,000 thresholds noted earlier).

Qualified dividend treatment is also made permanent (as the provision was would have caused it to sunset has been eliminated), although notably because qualified dividends are tied to the long-term capital gains rate, the top tax rate for qualified dividends has now risen to 20%.

Notably, individuals who are subject to the new 20% top long-term capital gains and qualified dividends tax rate will actually find their capital gains and dividends taxes at 23.8%, due to the onset of the new 3.8% Medicare tax on net investment income that would also apply at this income levels. 

Miscellaneous Extension Provisions

The American Opportunity Tax Credit (the $2,500 tax credit for college expenses that replaced the prior Hope Scholarship Credit in 2009) is extended 5 years - it was scheduled to lapse at the end of 2012, and will now run until 2017. The Child Tax Credit and the Earned Income Tax Credit were also extended over the same 5-year time period.

A series of "extender" rules are retroactively patched for 2012 and extended one year through 2013, including:

- Deduction for up to $250 expenses for elementary and secondary school teachers

- Exclusion from income of discharged mortgage debt (necessary to prevent a short sale from triggering income tax consequences for the amount of debt that was discharged)

- Deduction of mortgage insurance premiums as qualified residence interest

- Deduction for state and local sales taxes paid (in lieu of state and local income taxes paid, useful in states that have little or no income taxes)

- Above-the-line deduction for up to $4,000 of higher-education-related expenses (although in practice, this provision is rarely used due to the availability of the American Opportunity Tax Credit, which was also extended)

- Exclusion from income for Qualified Charitable Distributions from an IRA to a charity (still with the age 70 1/2 requirement and the $100,000-per-taxpayer-per-year limitation). Notably, a special rule allows qualified charitable distributions made by February 1, 2013 to be counted retroactively for the 2012 tax year, for those who want to take advantage of the rule for 2012 and 2013.

- Business provisions, including the Work Opportunity Tax Credit, the increased Section 179 expense deductions for small businesses, and 50% bonus depreciation for larger businesses.

Notably, the 2% payroll tax cut that has been in place for the past 2 years was not extended, and has lapsed. Payroll withholding will need to be adjusted for employees in 2013 (and per the recent Treasury regulations, high income individuals will also need to adjust withholding later in 2013 for the new 0.9% Medicare tax on earned income).

Separately, the favorable treatment of Coverdell Education Savings Accounts (so-called "education IRAs") created under EGTRRA, including both the higher contribution limits ($2,000/year), and the ability to use qualified distributions for eligible K-12 expenses, has been extended and made permanent under the new law.

AMT Relief

The ongoing series of AMT exemption patches over the past decade are made permanent, and fixed retroactively (since the last patch expired in 2011). The new AMT exemption amount will be $78,750 for married couples and $50,600 for singles in 2012 (these are essentially the 2011 amounts adjusted for inflation). The AMT exemption amounts will be indexed for inflation in the future. In addition, several key AMT thresholds are now also indexed for inflation, including the $175,000 threshold for the 28% AMT tax bracket, and the $112,500 and $150,000 (for individuals and married couples, respectively) thresholds for the phaseout of the AMT exemption.

In a separate but related provision, the rules that allow nonrefundable tax credits to be used for both regular and AMT purposes (subject to some restrictions) is also retroactively patched for 2012 and made permanent going forward.

New Roth Conversion Flexibility

In one entirely new rule under the legislation, ATRA will now allow individuals to convert their existing 401(k) plan to a Roth 401(k) plan, if the employer offers designated Roth accounts under the plan, regardless of whether the individual is allowed to take a distribution out of the plan. The transaction will be taxed in a similar manner to any other Roth conversion. Given the way the rule was written, it's unclear whether such a conversion could be recharacterized as IRA-based Roth conversions can, although such a "technical correction" could always be added later (and there's a lot of time to do so, since the deadline for any 2013 conversions of 401(k) plans would be October 2014).

The reason this provision is notable is that, under current law, you can only convert a 401(k) plan if you are eligible to take a distribution from the plan (whether it's going to a Roth 401(k) or Roth IRA), which generally means you have to be 59 1/2, dead, disabled, or separated from service, unless the plan allows in-service withdrawals. The new ATRA provision will allow an intra-plan Roth conversion, regardless of whether you're eligible for a distribution out of the plan (the way you would have to be to get to a Roth IRA). Notably, the rules appear to allow the new intra-plan Roth conversions for 401(k), 403(b), and 457 plans.

Basically, the new rule simply means you can now do intra-plan 401(k) (or 403(b) or 457 plan) conversions from traditional to Roth in the same manner you can do so for IRAs. But you still can't go FROM a 401(k) (or other employer retirement plan) TO the IRA unless you're otherwise eligible for a distribution from the retirement plan. In theory, the increased flexibility for Roth conversions means more (current workers) will convert their existing 401(k) and other employer retirement plans, which provides a short-term revenue increase for the Federal government (thus, this new rule was actually scored as a "revenue raiser" in measuring the fiscal impact of the provision). Of course, as I've written in the past, whether completing a Roth conversion (inside a 401(k) or with an IRA) is a good deal or not depends on several individual-specific factors.

(This article was featured in the "Carnival of Wealth Notre Dame Sucks Edition" on Control Your Cash, the Carnival of MoneyPros on Master the Art of Saving, the Carnival of Retirement on Simple Budget Blog, the Carnival of Money Pros on Consumer Boomer, the Carnival of Passive Investing #26 on My Personal Finance Journey, and also Nerdy Finance #21: Trillion-Dollar Coin Edition on NerdWallet.)

  • Bill Winterberg

    Hooray for tax simplification! ;-)

    • Michael Kitces

      Well, getting past the era of short-term sunsets is SOME simplification, at least.

      Permanence on the estate tax provisions, including portability, will have a profound impact on estate planning for most clients going forward.

      • Brad Barrows

        DSUEA is highly beneficial for individuals with large IRAs like medical professionals and by owners of highly appreciated assets which may go down in value. The limitations like loss of DSUEA on remarriage by the surviving spouse and concerns about lack of control over future distributions by the surviving spouse will still make use of a credit shelter trust coupled with a QTIP trust qualifying for the marital deduction preferable to many. When you look at the effect of inflation and additional earnings on tax plans relying on DSUEA I urge caution, particularly if their are capital assets which will probably stay in the family for generations. Use of DSUEA may best be used as a part of post death planning.

  • Harry Sit

    In-plan Roth rollover is already allowed at present. It has the same qualification rules as rolling out to a Roth IRA (over 59-1/2, terminated, only employer money, etc.). It can’t be recharacterized.

    In its current form, in-plan Roth rollover is practically useless because if you qualify for an in-plan rollover, you also qualify for rolling out to a Roth IRA. Then you might as well roll it to your own Roth IRA. This new provision expands the eligibility for an in-plan rollover, but as you pointed out, it may not be a good idea after all.

    • Michael Kitces

      Thanks for your comment on this. I agree with you, the key issue is the ability to do an in-plan rollover regardless of whether you’re eligible for a distribution out of the plan.

      I’ve tweaked the language a bit to clarify that further.

      Thanks again,
      – Michael

  • Rob O’Dell

    Thanks for the ATRA summary Michael!

    So thankful I had my charitably inclined over the age of 70.5 wait until Jan of 2013 to take their RMD for 2012!

  • Connie Hancock

    So, if I have a client make a charitable contribution from their IRA before February 1st, can I exclude that amount from their end-of-year IRA value used to calculate their RMD for 2013?

    Anybody have any thoughts on this?

  • Kathy

    Michael – thank you for a timely and well-written article. May I share it with my clients by forwarding them to this website?

    • Michael Kitces

      Absolutely, please feel free to share a link to this website article with any of your clients and colleagues!

      – Michael

  • Rob Topping


    Thanks for indepth coverage of new tax law. Other articles I’ve read did not have clarity on the phase out of itemized deductions. As I understand it and assuming $600k of AGI, a couple would lose $9k (3% x 300k)of their itemized deductions. If they have more than $9k of itemized deductions, additional deductions would not be affected (i.e. the limitation is a flat amount not a proportional amount). Hopefully this limitation won’t be a deterrant for folks making charitable gift decisions. Besides rules on charitable giving from IRAs (for those over 70 1/2) are there any other new limitations or rules that would impact charitable giving under this new law?

    Rob Topping
    Covenant Wealth Advisors
    Williamsburg, VA

    • http://GreenwayFamilyOffice Joan

      Does a 20% minimum itemized deduction provision exist (ie it’s impossible to lose more than 80% of your itemized deductions under the 3% phase out rule?)

      • Michael Kitces

        Yes, the rules still stipulate that the 3% phaseout of itemized deduction is capped at 80% of the total itemized deductions (as the ATRA provisions simply adopted the existing itemized deduction phaseout rules, with a new starting income threshold).

        On the other hand, it’s worth noting that in practice, it can be difficult for most clients to ever reach this cap, as high income tends itself to lead to higher deductions (e.g., for state income taxes). Nonetheless, it is possible to reach the cap (particularly in states with little or no state income taxes), so yes – the cap is still there.
        – Michael

    • Michael Kitces

      You are correct that the phaseout of itemized deductions is a phaseout based on a percentage of INCOME, not a percentage of DEDUCTIONS. Consequently, it is actually NOT a disincentive to actions that create deductions (e.g., charitable giving). In the scenario you give, you’re correct that $9k of deductions would be phased out – and it’s the exact same $9k, whether you donate $15k or $50k or $100k of income. And the old maximum phaseout threshold still applies here (you can’t phase out more than 80% of your total itemized deductions).

      So the bottom line is that this new rule shouldn’t be a deterrant for charitable giving. It’s simply an indirect way of making high income individuals have a marginal tax rate about 1% higher than their tax bracket alone indicates.
      – Michael

  • Jason

    Michael, do you know if the Coverdell limits were addressed in the bill? I searched through the bill but didn’t see anything. I’m assuming they are now $500 instead of $2000.

    • Michael Kitces

      The elimination of the EGTRRA sunset means the Coverdell provisions that previously existed were made permanent.

      So we’re still at a $2,000 limit, and funds can still be used to fund private secondary school expenses.
      – Michael

      • Bryan


        To be clear…can the Coverdell still be used to fund K-12 education expenses? Your reference is to private “secondary” school which is not “primary” school (K-12) expenses that were part of EGTRRA as you know. So did they remove the K-12 allowance? Thanks for a well researched summary.

        • Michael Kitces

          Let me put it this way – everything that applied to Coverdells on December 31, 2012 still applies today, and is permanent. :)

          Literally, all the new legislation says is “the sunset on EGTRRA no longer applies” – which means everything that was in EGTRRA still applies, but without a sunset, it remains active and permanent.

          Sorry for any confusion. Been reading tax law way too much for the past 36 hours. :)
          – Michael

  • Linda Lubitz Boone

    Michael, thanks as always for this well written piece. Hopefully you will get some sleep tonight as you apparently didn’t last night! Happy New Year to you and your family.

  • Pam

    Michael et al, Thanks,

    1. All I can say is now I really really hope I passed the November CFP exam and don’t have to memorize all these tax law changes!
    2. Also, as a widow, I say good riddance to the by-pass trust. Expensive very quickly due to trust tax rates, has to file its own return, often has a paid trustee and often is (in my case WAS ) managed by C- managers who did not comprehend tax efficiency because they were too busy seeking revenue sharing. Yes, I realize the loss of the by-pass trust means the embedded compounding is lost but, speaking as an end-user,I say simplification trumps that esp with portability
    3. Michael, did they deal with carried interest explicitly? It sounds like they did not.


    • Michael Kitces

      Nothing on carried interest in this legislation, although it’s certainly possible it will reappear in new legislation in the next two months. Bear in mind, we still have <60 days to deal with both the “Sequestration Cliff” and the “Debt Ceiling Cliff” and House Republicans are likely to be much more aggressive on spending cuts this time around, as many seem to feel they “caved” too much on this legislation. In turn, the Democrats and White House may counter with new tax revenue increases, and I’d be surprised if carried interest didn’t come back on the table in those negotiations.
      – Michael

  • Paula Hogan

    For a moment of comic relief, try a Google search of “ATRA”-results include American Therapeutic Recreation Association, Airedale Terrier Rescue and Adoption, Arkansas Teenage Rodeo Association…and more!

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  • Anthony

    Am I misreading this, or did the 18% capital gains rate just go away? Taxpayer Relief Act of 1997 instituted the 18% rate. Section 1(h)(2). JGTRRA of 2003 strikes 1(h)(2) as a conforming amendment when 15% becomes the top rate. JGTRRA Section 303 is the sunset provision. The American Taxpayer Relief Act of 2012 strikes Section 303 of the JGTRRA. So the 18% rate stays gone. But ATRA of 2012 institutes a 20% capital gains rate.

    Uh oh. I think Congress might have just (accidentally?) instituted a capital gains rate on qualified five-year gains which is higher than it would have been had we gone over the cliff.

    Hopefully I’m wrong. If so, someone please point out what I’m missing.

    • Michael Kitces

      To the extent that JGTRRA overwrote the ultra-long-term 5-year capital gains rules, I would expect that permanence of JGTRRA (by removing the sunset) results in a permanent elimination of the 2% rate discount for the 5-year capital gains.

      I’ll have to parse back through the code to double-check that this is really the outcome, though. I haven’t specifically dug into this provision yet.
      – Michael

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  • Neil

    Michael, thank you, as always, for your insight! Re: In-Plan Roth Conversions, do you know if plan documents will need to be amended in order to allow this? I haven’t looked into it yet, but my guess is that it may be at the employer’s discretion as to whether they allow this in their plan…at the administrative expense of amending the plan, etc.

    • Michael Kitces

      The rule is written in the legislation as “the plan may allow” so this would ostensibly require the plan document to be amended to permit the intra-plan Roth conversions (and of course, the plan also has to be amended to allow for Roth accounts in the first place, if it doesn’t already).

      However, the final arbiter of whether or how the plan document needs to be amended (beyond allowing for designated Roth accounts in the first place) will be up to IRS and Treasury. I would expect they’ll try to issue guidelines soon, although obviously they’ve got a bit of other stuff on their plate right now. :)
      – Michael

  • Chris Rivers

    Michael – thanks, this is great. One thing I’m still not clear on, is the 3.8% tax on Net Investment Income, from the Patient Protection Act.

    It seems, because that was not a part of this ATRA bill, that that threshold remains at $250,000 (for MFJ). So in effect, there are 3 cap gains rates – 15% for those earning less than $250k, 18.8% for those earning $250k-$450k, and then 23.8% for those earning more than $450k.

    Am I interpreting that right? CCH was the only source I could find that addressed this.


    • Michael Kitces

      You are correct that the 3.8% Medicare tax on net investment income remains with its own $200,000 (individuals) and $250,000 (for MFJ) thresholds. This actually means there are four long-term capital gains tax brackets, though: 0%, 15%, 18.8%, and 23.8%.

      It’s also worth noting that the thresholds for 0%, 15%, and 20% capital gains tax rates are based on taxable income (after deductions), while the threshold for the 3.8% Medicare tax (and thus the 18.8% capital gains “bracket”) is based on AGI.

      I hope that helps a little!
      – Michael

  • Janet

    Happy New Year Michael and thank you for this excellent analysis!

    Following up on the capital gains tax rate stream — If an individual’s taxable income just exceeds $400K (say it is $425K) so that they are in the new top rate of 39.6% and they have $100K of long-term cap gains – are they all subject to the new 20% rate or just a portion relative to going over the threshold? Thanks :)

    • Michael Kitces

      It appears that the new rules only apply the 20% long-term capital gains tax rate to the portion of capital gains that actually fall above the $400k threshold (just as the 0% capital gains rate only applies to gains that actually fall within the bottom two tax brackets).

      So in the example you give, with $100k of capital gains and $325k of “other income after deductions” the first $75k of capital gains would be taxed at the 15% rate, and the last $25k of capital gains would be subject to the 20% rate. The tax law always assumes the capital gains “stack on top” after all other ordinary income and deductions.
      – Michael

      • Joshua


        With Janet’s question, wouldn’t the total tax rate on the first 75k be 18.8% and the final 25k be at 23.8% due to the medicare tax?

        • Michael Kitces

          In practice, yes if taxable income was high enough to reach the $400k/$450k taxable income (after deductions) thresholds, the 3.8% Medicare surtax (based on AGI before itemized deductions) would apply at that point as well (albeit calculated separately).
          – Michael

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  • Anthony

    As the 3.8% is based on AGI, I guess it’s possible for someone to be in the 0% capital gains bracket and still have to pay 3.8% on capital gains.

    Actually, now that I think about it, it’s not just theoretical. Think big time gambler with $250K of winnings, $250K of losses, $15K of social security, and $5K of capital gains.

    So there are four possible long-term capital gains tax brackets: 0%, 3.8%, 15%, 18.8%, and 23.8%.

    That is, if you want to look at it that way. As the 3.8% is based on AGI and not taxable income, I’m not sure it makes sense to include it in the “capital gains tax brackets”. If you want to calculate the effective marginal tax rate for capital gains, along with the medicare tax there are so many other factors to consider, PEP and Pease, the phaseout of the AMT exemption, in lower brackets the taxability of social security and the phaseout of credits.

  • Kirsten

    If the company’s plan allows for in-service withdrawals for plan members who are still with the company and under 59 1/2, does the entire 401k balance qualify for the Roth IRA conversion (including employee and employer contributions and appreciation)? I understand that prior to the law change, inservice withdrawals were limited to the employer contributions.

  • Dave Demming Jr

    Great work as always Michael. Have you confirmed that the AGI limits for Roth conversions have been waived permanently? Haven’t problems confirming that understanding outside of assuming it was on the books in 2012 so it was extended… Thanks!


    • Michael Kitces

      The AGI limits for Roth conversions were permanently repealed under the Pension Protection Act of 2006. There was no sunset for them. They’re gone for good, and realistically won’t be back, as restricting Roth conversions now would reduce revenue to the Federal government over the next 10 years, which in turn would force Congress to RAISE a new tax to offset the impact.

      And to say the least, if Congress does introduce any new taxes in the coming year, there are a lot of other things they’d like to pay for rather than instituting Roth conversion limits!
      – Michael

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  • Dave Demming Jr

    Thanks Michael.

    Great work on this month’s Kitces Report outlining much more detail on ATRA. That’s a plug for you… :)

    This month’s report is worth the price of admission.


    • Michael Kitces

      Thanks Dave! :)

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