Tax rules change annually due to legislation, court decisions, and cost-of-living adjustments (COLAs) to key tax limits and other items. There are over three dozen COLAs made annually, based on the Consumer Price Index (CPI) in August. Here is a roundup of some COLAs affecting tax rules for 2012 and some planning strategies that can be used to optimize these changes.
Families
Personal exemptions. The personal and dependency exemption increases to $3,800 in 2012 (up from $3,700 in 2011) (Code Sec. 151). This means a family of four claims a total deduction of $15,200 ($3,800 x 4). There is no phase-out of the deduction for high-income taxpayers in either 2011 or 2012.
Tax brackets. All of the tax brackets have been adjusted for inflation. This means that a taxpayer can have more taxable income without being pushed into a higher tax bracket (Code Sec. 1). Where appropriate and possible, it can be helpful to defer income to 2012 if such income would fall into a lower tax bracket and there is no risk of loss with respect to the income.
Earned income credit. Low-income earners can claim a refundable tax credit; the credit limits and phase-out ranges have been increased for 2012 (Code Sec. 32). The amount of investment income that can be received without disqualifying the recipient for the credit is $3,200 (up from $3,150 in 2011).
Adoption credit. The credit amount decreases in 2012 because of the expiration of a law; it declines from $13,360 in 2011 to $12,650 in 2012 and the credit is not refundable (Code Sec. 23). However, the modified adjusted gross income (MAGI) limits on eligibility to claim the credit have increased. Where possible, families should try to complete adoptions this year to take advantage of the higher credit limit and refundability.
Employee benefits
Where employers offer fringe benefits, employees should take advantage of them to the extent possible or desirable. These fringe benefits are tax free and not subject to Social Security and Medicare (FICA) taxes.
Adoption assistance. Employers can provide tax-free payments for adoption expenses in 2012 to the same limit as the adoption credit (Code Sec. 137). The same MAGI phase-outs for the credit apply to the exclusion for adoption assistance.
Transportation fringe benefits. Employers can pay for monthly parking that is tax free up to $240 in 2012 (up from $230 in 2011) (Code Sec. 132(f)(2)(B)). The limit on monthly transit passes and vanpooling is $125 (down from $230 in 2011 when these benefits were in parity with free parking) (Code Sec. 132(f)(2)(A)). The limit on bicycling assistance remains at $20 per month; it is not adjusted annually for inflation.
Alternatively, employers can arrange for employees to pay for their transit passes on a pre-tax basis through cafeteria plans, an option that eligible employees should consider taking advantage of.
Investments
The top capital gains tax rate remains at 15% (zero for taxpayers in the 10% or 15% tax bracket. The rate remains at 25% for unrecaptured depreciation and 28% for collectibles gains. However, the exclusion for qualified small business stock drops back to 50% for stock acquired in 2012; down from 100% in 2011 (Code Sec. 1202). This means that businesses should try to close on deals before the end of this year to give investors the benefit of the full exclusion. Qualified small business stock can also be given to employees in exchange for services and may be suitable for year-end bonuses in some situations.
From a planning perspective, a family can save overall taxes by shifting appreciated property to relatives in these low tax brackets. For example, giving appreciated stock held long term to a parent in the 15% tax bracket and having the parent sell the stock means the family has no tax on the sale. However, there will be no substantial tax savings if children are subject to the kiddie tax; here the gain would likely be taxed at the same rate as the parents would have paid if they had taken the gain.
These transfers can be made gift-tax free in using the annual gift tax exclusion. The exclusion in 2012 is $13,000 per beneficiary per year; there is no change in the exclusion amount in 2011).
Paying for higher education
The tax law provides some key breaks for paying for college; with COLAs, so there should be increased tax savings eligible taxpayers. In 2012, these breaks have improved as follows:
Savings bond exclusion. Interest on U.S. savings bonds used to pay higher education costs is not taxable. This interest exclusion applies only if a taxpayer’s MAGI does not exceed a set limit (Code Sec. 135). In 2012, the MAGI limit for the full interest exclusion is $72,850 for singles and $109,250 on a joint return (up from $71,100 and $106,650 respectively in 2011).
Student loan interest deduction. Interest on a student loan is deductible up to $2,500 annually if a taxpayer’s MAGI does not exceed a set limit (Code Sec. 221). While the dollar limit on this deduction remains unchanged, the starting point of the MAGI phase-out range has been increased for joint filers to $125,000 (up from $120,000 in 2011). The starting point of the phase-out range for singles remains at $60,000.
Education credits. The credit amount of $4,000 and phase-out range for the American opportunity credit, which can be claimed for qualified higher education costs for the first four years of college, is unchanged (Code Sec. 25A). Forty percent of the American opportunity credit is refundable.
However, the phase-out range for the lifetime learning credit, which can be claimed for any higher education, has increased. The phase-out for 2012 starts at MAGI of $52,000 for singles and $104,000 for joint filers (up from $51,000 and $102,000, respectively, in 2011).
Saving for retirement in IRAs
The annual limit on contributions to traditional and Roth IRAs remains at $5,000 (plus an additional $1,000 for those age 50 or older by the end of the year), but no more than compensation for the year (Code Secs. 219 and 408A). However, the phase-out ranges for eligibility to make contributions have been adjusted for inflation:
Deductible IRAs by active participants. There is no MAGI limit on contributing to a deductible IRA if the person is not an active participant in a qualified retirement plan. However, for those who are active participants, a fully deductible contribution can be made only if MAGI in 2012 does not exceed $58,000 for singles (up from $56,000 in 2011), or $92,000 for joint filers (up from $90,000 in 2011) (Code Sec. 219). The deduction phases out with a range of MAGI; no deduction can be claimed once MAGI exceeds $58,000 for singles, or $112,000 for joint filers. The deduction for married persons filing separate returns phases out for MAGI between zero and $10,000.
For married persons who are not active participants but their spouses are, the phase-out range for the non-active participant to make a deductible contribution is MAGI in 2012 of $173,000 to $183,000 (it had been $169,000 to $179,000 in 2011).
Roth IRAs. While there is no income limit on eligibility to convert to a Roth IRA, income limits continue to apply in the case of annual, nondeductible contributions. For 2012, the phase-out range is $119,000 to $125,000 for singles, and $173,000 to $183,000 for joint filers. The ranges for 2011 had been $107,000 to $122,000 for singles, and $169,000 to $179,000 for joint filers. As in the case of deductible IRAs, the contribution limit for Roth IRA contributions by married persons filing separate returns phases out for MAGI between zero and $10,000.
Retirement saver’s credit. This tax credit for low-income taxpayers who contribute to an IRA, 401(k), or similar plan will be more widely available in 2012. This is because the MAGI limits on eligibility for the credit have been increased. The credit can be claimed in addition to the tax breaks for making the contribution (e.g., a deduction for an IRA contribution and exclusion from income for a 401(k) contribution).
Tax savings for small-business owners
Equipment purchases. The cost of computers, office furniture, machinery and other equipment can be deducted in full under 100% bonus depreciation (Code Sec. 168). This rate declines to 50% in 2012, unless Congress extends it.
If bonus depreciation does not apply (e.g., the property is used rather than new), then equipment can be deducted using first-year expensing (Code Sec. 179). The dollar limit on this expensing deduction in 2012 declines to $139,000 (down from $500,000 in 2011), unless Congress also extends this tax break.
The dollar limit on expensing phases out when equipment purchases exceed a fixed limit. The phase-out is one dollar for each dollar of purchases over the limit. For 2012, that limit is $560,000, so that no expensing can be claimed when equipment placed in service in 2012 exceeds $821,000 (the phase-out for 2011 started once equipment purchases topped $2 million for the year). Businesses can use expensing to upgrade needed equipment on a tax-deductible basis (even if they finance the purchase in whole or in part).
Employing an owner’s child. In 2012, a child can earn tax-free up to $5,950 (the amount of the standard deduction for a single individual). Thus, a teenager employed in a parent’s business can gain experience and tax-free income. While the age of the kiddie tax is now under 24 for those who are full-time students who do not provide more than half of their own support, the kiddie tax does not apply to earned income.
If the business is sole proprietorship or a limited liability company treated as a disregarded entity (i.e., a one-member LLC that files Schedule C of Form 1040), the parent does not pay Social Security and Medicare taxes (FICA) on wages to his or her child who is under age 18. The wages themselves are deductible by the parent, reducing the parent’s income taxes and self-employment tax. The child can shelter income by contributing earnings to a Roth IRA up to the annual limit; the parent can make the contribution on behalf of the child based on the child’s earnings (Code Sec. 408A).
Conclusion
Now is a good time to schedule an appointment with a tax advisor to discuss the impact that COLAs will have on personal tax planning for 2011 and 2012.
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