The IRS’s 2012 Cost-of-Living Adjustments:
More significant changes than in recent years

by Barbara Ashorn, Tax Manager

On Oct. 20, the IRS released most cost-of-living adjustments for 2012. These are automatic adjustments built into the tax law, but they don’t always result in increases. With inflation now a little higher than it has been, some amounts that haven’t risen in recent years are increasing for 2012 and others are increasing by larger sums. Among the items that have increased are the standard deduction, personal exemptions and limits on 401(k) contributions. Still, there are many amounts that will stay the same as they were for 2011. The changes — or lack thereof — could affect your tax planning.

Individual Income Taxes

Tax brackets will widen and personal exemptions will increase for 2012, and by larger margins than they rose for 2011.  Tax-bracket thresholds increase for each filing status but more significantly for the higher brackets. For example, the top of the 10% bracket increases by $200 to $400, depending on filing status, but the top of the 33% bracket increases by $9,200 ($4,600 for married couples filing separately). This should reduce the risk that slightly higher earnings in 2012 could push you into a higher tax bracket.

The personal and dependency exemption increases by only $100, to $3,800 for 2012. Fortunately for high-income taxpayers, the income-based personal exemption phase-out and the itemized deduction phase-out are eliminated through 2012 under the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.

However, it’s important to note that brackets, exemptions and income phase-out ranges for the alternative minimum tax (AMT) aren’t annually adjusted for inflation by the IRS. Rather, Congress must legislate any adjustments. The AMT is a separate tax system that limits some deductions, doesn’t permit others and treats certain income items differently. If your AMT liability is greater than your regular tax liability, you must pay the AMT.

Currently, the AMT exemptions and the tops of the phase-out ranges are scheduled to drop substantially for 2012, which could significantly increase your risk of being subject to the AMT.

Education and Child-Related Breaks

The maximum benefits of various education- and child-related breaks generally remain the same for 2012. But most of these breaks are also limited based on the taxpayer’s modified adjusted gross income (MAGI). Taxpayers whose MAGIs are within the applicable phase-out range are eligible for a partial break; breaks are eliminated for those whose MAGIs exceed the top of the range.

The MAGI phase-out ranges generally remain the same or increase modestly for 2012, depending on the break. For example:

The American Opportunity credit. The MAGI phase-out ranges for this education credit (maximum $2,500 per eligible student) remain the same for 2012: $160,000–$180,000 for married couples filing jointly and $80,000–$90,000 for other filers.

The Lifetime Learning credit. The MAGI phase-out range limits for this education credit (maximum $2,000 per tax return) increase for 2012; they’re $104,000–$124,000 for joint filers and $52,000–$62,000 for other filers — up $2,000 and $1,000, respectively.

The adoption credit. The MAGI phase-out range limit for this credit also increases for 2012 — by $4,500, to $189,710–$229,710 for joint, head-of-household and single filers. The maximum credit, however, decreases by $710, to $12,650 for 2012. This is because a tax law provision that allowed a credit of $13,360 for 2011 doesn’t apply to 2012. So the credit returns to being inflation-adjusted based on a $10,000 limit that previously applied.

(Note: Married couples filing separately generally aren’t eligible for these credits.)

These are only some of the education- and child-related breaks that may benefit you. Keep in mind that, if your MAGI is too high for you to qualify for a break for your child’s education, your child might be eligible. Also be aware that additional education- and child-related tax breaks are scheduled to become less beneficial in 2013.

The following link may help you determina the marginal effects changes in your income may pose to your 2011 income tax:  http://interactive.taxfoundation.org/taxgraph/.

Retirement Plans

For the first time since 2009, deferral limits for 401(k) plans — as well as many other retirement-plan-related limits — have gone up, though catch-up contributions (for those age 50 or older) and certain limits related to IRAs, SIMPLEs and SEPs remain the same:

Unlike most other retirement-plan-related limits, IRA-related MAGI phase-out range limits did see some increases in 2010 and 2011. And the trend continues for 2012:

Traditional IRAs. MAGI phase-out ranges apply to the deductibility of contributions if the taxpayer (or his or her spouse) participates in an employer-sponsored retirement plan:

• For married taxpayers filing jointly, the phase-out range is specific to each spouse based on whether he or she is a participant in an employer-sponsored plan:
  • For the spouse who participates, the 2012 phase-out range limits increase by $2,000, to $92,000–$112,000.
  • For the spouse who doesn’t participate, the 2012 phase-out range limits increase by $4,000, to $173,000–$183,000.
• For single and head-of-household taxpayers participating in an employer-sponsored plan, the 2012 phase-out range limits increase by $2,000, to $58,000–$68,000.

Taxpayers with MAGIs within the applicable range can deduct a partial contribution; those with MAGIs exceeding the applicable range can’t deduct any IRA contribution. But a taxpayer whose deduction is reduced or eliminated can make nondeductible traditional IRA contributions. The $5,000 contribution limit (plus $1,000 catch-up if applicable and reduced by any Roth IRA contributions) still applies. Nondeductible traditional IRA contributions may be beneficial if your MAGI is also too high for you to contribute (or fully contribute) to a Roth IRA.

Roth IRAs. Whether you participate in an employer-sponsored plan doesn’t affect your ability to contribute to a Roth IRA, but MAGI limits may reduce or eliminate your ability to contribute:

• For married taxpayers filing jointly, the 2012 phase-out range limits increase by $4,000, to $173,000–$183,000.
• For single and head-of-household taxpayers, the 2012 phase-out range limits increase by $3,000, to $110,000–$125,000. 

You can make a partial contribution if your MAGI falls within the applicable range, but no contribution if it exceeds the top of the range.

(Note: Married taxpayers filing separately may be subject to much lower phase-out ranges for both traditional and Roth IRAs.)

Gift and Estate taxes

The annual gift tax exclusion will remain at $13,000 for 2012. It hasn’t increased since 2009, when it rose from the 2008 amount of $12,000. Why so long without an increase? Even though statutorily the exclusion is adjusted for inflation every year, it can increase only in $1,000 increments. With low inflation rates over the last few years, it hasn’t yet hit that $1,000 threshold.

The 2010 Tax Relief act called for the gift, estate and generation-skipping transfer (GST) tax exemptions to be adjusted for inflation for 2012, and these amounts have increased by $120,000, to $5.12 million. The gift and estate tax exemptions are on a combined basis, so every dollar of gift tax exemption used during your lifetime reduces the estate tax exemption available at your death by $1.

The GST tax exemption, though separate, usually must also be applied to transfers to “skip” persons — generally grandchildren and others more than one generation below you — if you want the transfers to be completely tax-free.

Keep in mind that all three taxes are scheduled to return to pre-2001-tax-law levels in 2013, with a $1 million exemption (though the GST tax exemption will be adjusted for inflation) and a top rate of 55%. So you may want to maximize your gifts and GSTs in 2012 to lock in the higher exemption amounts.

Maximize Benefits, Minimize Perils

The 2012 cost-of-living adjustments may provide you with some welcome benefits. These might include the ability to make larger retirement contributions and the opportunity to transfer more assets to your loved ones tax-free.

But the adjustments don’t address some key issues, such as the AMT. And certain tax breaks are scheduled to expire at the end of 2011, such as the ability to deduct state and local sales taxes in lieu of state and local income taxes. This — combined with the fact that in 2013 tax rates are scheduled to go up and many more breaks are scheduled to expire — means that 2012 will also present some tax planning perils.

If you’d like to maximize your tax benefits and minimize your tax planning perils for 2012 and beyond, please contact us. MFR tax professionals can help you develop a strategy based on your specific situation and goals as well as tax law developments as they occur.