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Surprise: Fed Tax Cut Package Allows Investors to Keep More in Their Pockets and Pass More on to Their Beneficiaries

Dec. 29, 2010 3:27 PM ET
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When President Obama signed the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 on December 17, it averted a situation in which tax rates would have increased on January 1 for all income brackets and the estate tax would have been reinstated at a rate of 55% on amounts greater than $1 million.

The tax relief act was the result of a compromise brokered between President Obama and Senate Minority Leader Mitch McConnell (R-Kentucky). As a result of some good old-fashioned horse trading, Republicans achieved their priorities of extending current tax rates for all income levels and lowering the estate tax. Meanwhile, Democrats got employment benefits extended for 13 months, as well as the extension of several tax credits that largely target lower- and middle-class taxpayers.
The official technical explanation of the act prepared by Congress’ Joint Committee on Taxation is 177 pages long. Instead of wading through each scintillating page, here is a rundown of the provisions of the act that are most relevant to investors:
· Bush-era tax rates extended for all income levels: Current tax rates for all income brackets are extended through 2012. This means the highest tax bracket, which had been scheduled to increase to 39.6% in 2011, will remain at 35% for the next two years. Long-term capital gains and qualified dividends will continue to be taxed at a maximum of 15%.
· Estate tax reinstated and lowered: For 2011 and 2012, the estate tax will be 35% on amounts greater than $5 million. The estate tax had been eliminated completely for 2010, and in 2009 the tax was 45% with an exemption amount of $3.5 million. As noted in The Kiplinger Tax Letter, dated December 22, 2010, “The new estate laws are particularly confusing. The way Congress did it, the estate tax was actually retroactively revived for 2010, with a $5-million exemption, a 35% rate and the date of death value serving as the tax basis for inherited assets.
“However, estates can elect instead to use the prior estate tax rules for 2010…no estate tax, but heirs get a carryover basis for inherited assets that have appreciated by more than $1.3 million (+$3 million for assets passing to a surviving spouse).” For 2011 the exemption is $5 million with a 35% rate, and inherited assets get a stepped-up basis. The new rate and exemption amount for 2011 and 2012 will also apply to generation-skipping transfers and lifetime gifts.
· Payroll taxes reduced for 2011: The amount that employees pay for payroll taxes in 2011 will be reduced from 6.2% to 4.2%. This tax, also called FICA, is used to fund Social Security and applies only to the first $106,800 of wages. Self-employed people pay both halves of the payroll tax, so their share will be reduced from to 12.4% to 10.4% in 2011.
· Charitable IRA transfers renewed for 2010 and 2011: Individuals older than 70 ½ can make direct IRA transfers of up to $100,000 directly to charities. This provision had expired at the end of 2009, but the tax relief act extends it through 2011.
· Two-year AMT patch protects middle-class taxpayers: Exemption amounts for figuring the alternative minimum tax will remain near their 2009 levels for 2010 and 2011. This two-year patch will prevent an estimated 21 million middle-class Americans from being affected by the dreaded AMT for the first time.
· Sales tax deduction still available: Taxpayers who itemize their deductions can elect to deduct state and local sales taxes in place of state and local income taxes through 2012.

The bottom line is the tax relief act provides some clarity about where tax rates will be…but only for the next two years. If you enjoyed following the drama on Capitol Hill that preceded the law’s passing, I have good news for you: We’ll likely see a replay of the whole process again in 2012.

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