What the tax deal means for you

  @Money March 4, 2013: 9:18 AM ET
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The fiscal-cliff tax deal kept nearly all rates low and threw in some tax breaks. Make sure you take advantage of them.

(Money Magazine)

After much nail biting, the fiscal-cliff deal has finally brought certainty to the federal tax landscape, and for most the news is good.

Almost all the expiring Bush-era income tax cuts were made permanent, though the end of the two-year payroll-tax holiday has meant smaller paychecks.

Even the tax increases that slipped through -- a jump in the top rate from 35% to 39.6% and a hike in the capital gains tax from 15% to 20% -- kick in only on incomes over $400,000 for singles, $450,000 for married couples filing jointly, not the $200,000 and $250,000 cutoffs President Obama had called for.

"The tax bill is a net positive for average Americans," says White Plains, N.Y., CPA Paul Herman.

Related: Fiscal cliff deal raises taxes on 77% of Americans

Look past the headlines, though, and you'll find a mixed bag: new rules that could help you in the years ahead, depending on who you are, but higher taxes for a bigger group than you might expect.

Here are the most important changes you need to know about, and your best moves now.


A lower threshold for tax pain. Just because you're bringing in less than $400,000 a year, you're not out of the woods.

By limiting two important ways to cut your taxable income, the new law subjects singles with adjusted gross incomes as low as $250,000 and married couples with AGIs of $300,000 or more to a potentially higher tax bill.

The first change is a phaseout of personal exemptions, which you can take for yourself, your spouse, and your dependents. For every $2,500 you earn over the AGI thresholds, the total value of your exemptions is reduced by 2%.

Find hidden tax refund money

Likewise, the value of your itemized deductions will be cut by 3% of what you earn over the AGI cutoffs, with a few exceptions (the medical deduction, for example).

These two changes come on top of 2013's new Medicare tax for high earners. If your AGI is above $250,000 for a married couple filing jointly, $200,000 for a single filer, you will owe another 0.9% on wages above that amount and 3.8% on investment income.

What can you do?

Your best defense is to tamp down your income as much as possible, in all the usual ways, says TurboTax vice president Bob Meighan. That means fully funding tax-deferred accounts, including a health savings account if you qualify; keeping investments that throw off a lot of income, such as bonds, in tax-sheltered accounts; favoring tax-efficient index funds in taxable accounts; and avoiding frequent buying and selling.

"Move away from any strategy that would incur short-term gains," says Meighan.

Related: Use your retirement plans to lower your taxes

Also of note: If you've been paying the alternative minimum tax, don't expect relief. By making an inflation adjustment permanent, the tax deal eliminated the annual year-end scramble to "patch" the AMT and keep millions more out of it. That said, if you paid the AMT in the past, you probably still will.


A chance to lock in tax-free income. Under the new law you can convert a traditional 401(k) to a Roth 401(k) at any time, assuming your company offers both choices (nearly half of employers do).

You'll have to pay income taxes on your contributions and earnings when you convert -- that's why the move is best for those in low tax brackets -- but your withdrawals in retirement will be 100% tax-free.

"A Roth is most ideal when you are young or when you know your taxes will rise," says CPA Thomas Astore of Newtown, Mass., "but others can profit as long as there's enough time for the compounding to outweigh the initial tax hit."


A second wind for education perks. The tuition deduction is back for 2013.

The American Opportunity credit, worth as much as $2,500 for higher-education expenses, is around for at least five more years. And you can deduct up to $2,500 in student-loan interest a year indefinitely if you qualify ($75,000 AGI for singles, $150,000 if filing jointly), instead of for five years.

Related: What are the best student loans

Plus, the Coverdell education savings account has become more attractive. The $2,000-a-year max, which had been scheduled to drop to $500, is now permanent. Your contribution isn't deductible, but earnings grow tax-free. And you can withdraw the money tax-free for any education costs, not just college, making Coverdells an option for parents of kids in private schools.

Donations from IRAs. Again in 2013, retirees age 70½ and older can give up to $100,000 from an IRA directly to a charity. This can be a boon if you don't need the income from your account or are looking to reduce the size of your estate.

A break for commuters. If your company offers a transportation reimbursement account, you can now set aside $245 a month pretax for public transit, up from $125 last year and on par with what you can save for the costs of driving to work.

You'll need to change the contribution you set in open enrollment -- when that's possible. Not all employers have made the change yet.

See more: 3 ways to lower your tax bill To top of page

One tax bill you might want to pay now
With many years to go before retirement, converting a 401(k) plan worth $50,000 now to a Roth 401(k) will pay off, even if your tax rate doesn't rise.
After-tax annual income in retirement
Stick with traditional 401(k), tax bracket rises from 25% to 28% $60,570
Stick with traditional 401(k), no change in bracket $62,880
Convert to Roth 401(k) $69,570
NOTES: Assumes converts at age 35, adds $8,000 a year; earns 6% returns; retires at 65 and lives until 95; and 25% tax bracket while working; earns interest on tax savings from not converting in traditional 401(k) scenarios. SOURCE: Paul Herman, Herman & Co.
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