Stern Advice: The cliff deal and your wallet

WASHINGTON Wed Jan 2, 2013 1:49pm EST

WASHINGTON Jan 2 (Reuters) - Carry on, everyone. That's the first takeaway from the fiscal-cliff-averting tax deal struck literally in the eleventh hour on Tuesday.

It wasn't the kind of tax bill that allows for a raft of quick financial planning opportunities, in part because the bill was passed after the books on 2012 have closed, so there is no going back now and fiddling with your year-end deductions.

Nevertheless, there are a few goodies in the bill for many taxpayers, and some new traps that point to long-term strategies. Here's a first look at how to make the most of the new tax rules, with one reminder: When we talk about income levels, we're talking about taxable income. With solid deductions like state taxes and home-loan interest, it can take $300,000 or more in gross income to produce $250,000 in taxable income.

TAKE COMFORT IN CERTAINTY

The best thing about the new tax regime is that it makes permanent many items that had limped from one year-end extension to another. That includes income tax rates, tax rates on capital gains and dividends (including a tasty zero percent tax rate on capital gains and dividends for those below the 25 percent tax bracket), marriage penalty relief, Coverdell education savings accounts and more.

YOUR PAYCHECK IS STILL GOING TO GO DOWN

For most taxpayers, the immediate hit will be the end of the temporary 2 percentage point cut in payroll taxes for Social Security. For the average family earning $50,500 a year, that means you'll see roughly $84 less a month now. It may take your employer a paycheck or two to catch up with that, so if you fail to see a decrease in your first paycheck, don't celebrate yet.

FAVORABLE TAXES ON INVESTMENTS

Taxes on long-term capital gains and most dividends will now permanently be lower than income tax rates. That means buying dividend-earning stocks and growth stocks outside of your tax-deferred retirement plan. (Putting those investments within your retirement fund will instead subject earnings to presumably higher income tax rates when you ultimately withdraw the money in retirement)

The less you earn, the more true that is; folks below the 25 percent tax bracket (in 2012 that was under $35,350 for singles and $70,700 for couples) will have a zero percent tax rate on most investment income. That means giving your low-earning relatives appreciated stock will be a good idea.

Folks earning too much to get the zero rate but less than $400,000 ($450,000 for couples) will have a 15 percent rate on long-term gains and dividends. Those earning more will have a 20 percent rate.

CONSIDER THE COVERDELL

The Coverdell education savings account allows more individual control (and often lower fees) than the 529 plan, but it was never very popular because it was on temporary status and had relatively low contribution limits.

Now, it permanently allows people to contribute as much as $2,000 a year per child. The earnings are not taxed when used for accounts that can be used for elementary, secondary or post-secondary education; 529 plans can only be used for post-secondary expenses. Find these accounts at your favorite mutual fund or brokerage company, and note that this is one provision you can use retroactively - you have until April 15, 2013, to open and fund a Coverdell for 2012.

NEW ROTH OPPORTUNITY, BUT TREAD CAREFULLY

In what they deemed a revenue raising measure, the package-writers included a new provision allowing workers to move money from their existing 401(k) plans into Roth 401(k) plans. That would mean paying income tax on the amount you move over, but then allowing the funds to build in the Roth forever without paying taxes on the earnings. That will only apply to people who work for employers who offer both traditional and Roth 401(k) plans.

Should you do that? The simple answer: convert to the Roth if you expect your retirement tax rates to be higher than your current tax rates. That may be the case if you are a young low-earner, or if you already have so much money saved in your tax-deferred accounts that you will get hit with high-bracket distributions when you're 70-1/2 and have to start taking withdrawals and the tax hits that go with them.

ASK YOUR BOSS FOR BENEFITS

The new plan makes permanent a tax exclusion for up to $5,250 for employer-provided education assistance for college and graduate school education. It also extends through 2013 the monthly exclusion from taxable income for employer-provided mass transit benefits to $240 from $125. And it makes permanent a tax exemption for adoption expenses paid by an employer, up to $10,000. (It also makes permanent a $10,000 tax credit for families that pay their own adoption expenses).

WEIGH YOUR EDUCATION OPTIONS

Folks currently in the throes of paying for college have many different tax-break options available to them now, but they have to be strategic about which break they take. The $2,500 American Opportunity Tax Credit, now extended through 2017, is probably the most rewarding, but you can only take it for four years per student, and it phases out at higher income levels. There is still a less generous lifetime learning credit on the books and an alternative deduction for tuition and fees that has been extended through 2013. Before filing your taxes, ask your tax preparer which of these many options would work best for you.

Finally, you will be able to deduct your student loan interest forever, as long as you earn less than $55,000 for singles and $110,000 for couples. Above that, the deduction phases out.

PLAN FOR FUTURE DEDUCTIONS

The new rules phase out itemized deductions and the personal exemption for individuals with more than $250,000 in taxable income ($300,000 for couples filing jointly.) The calculations are complex, but they shave more and more off of those write-offs as a taxpayer's income rises. That's worth keeping in mind if you're a high earner, but the tax planning opportunities it conveys are limited, unless you're the kind of family that has a very variable income and you have control over it. Then you could arrange bonuses, contracts and the like to go over those levels in alternative years, and take more deductions in the years when you don't go over those levels.

GETTING MARRIED?

The new bill makes permanent the fix for the marriage penalty that affected couples who otherwise would have to pay higher taxes than if they stayed single. But for high earners, that fix doesn't cover the fact that top level tax brackets kick in at $400,000 of taxable income for one person but $450,000 for married couples filing jointly.

On the other hand, uber-wealthy marrieds would eventually benefit from the now-permanent portability rules that allow one spouse to inherit and later pass on the full estate tax limit from their spouse. That's a level adjusted for inflation, but at 2012 levels, means the second spouse to die could pass on as much as $10.25 million before federal estate taxes kicked in. In addition to encouraging marriage, that provision may discourage some trusts from being necessary.

MISCELLANEOUS BENEFITS

The good news for many people are all the little tax benefit extenders that aren't so little for everyone. Teachers will still be able to write off $250 for money they spend out of pocket for supplies; even if they do not itemize deductions. Folks in no-income-tax states will still be able to deduct their state sales taxes instead. Retirees who don't itemize deductions but are already taking required minimum distributions from their tax-deferred retirement accounts can use those distributions to donate to charity and avoid being taxed on them. That's better than a stick in the eye, even if Congress waited so long to deliver it that you had to have acted on faith before the end of 2012 to take advantage of it for last year.