Now that the election is behind us, Congress and the president are turning their focus to our most immediate domestic challenge – the "fiscal cliff," which refers to the tax hikes and spending cuts scheduled to go into effect starting on January 1, 2013. The Bush tax cuts, enacted in 2001 and 2003, were originally scheduled to expire for tax years beginning in 2011. However, legislation signed in late 2010 extended the Bush tax cuts through 2012. If Congress fails to extend the Bush tax cuts, many significant rate changes and other substantive changes will take effect in 2013. Here is a brief overview.

Individual Income Tax Rates

Ordinary income tax rates will increase for most individual taxpayers beginning in 2013. The lowest 10% bracket will disappear and the top rate will rise from 35% to 39.6%. Qualified dividend income that is currently taxed at long-term capital gain rates will be taxed at these higher ordinary income rates.

Long-Term Capital Gains Rates

The maximum rate on long-term capital gains is scheduled to increase from 15% to 20% in 2013. Additionally, the 3.8% Medicare contribution tax will increase the effective rate of tax on long-term capital gains for certain higher-income taxpayers to as high as 23.8%.

Dividend Income Rates

The Bush tax cuts created the concept of “qualified dividend income,” which currently allows dividends received from domestic corporations and certain foreign corporations to be taxed at the taxpayer’s long-term capital gain rate of not more than 15%. Prior to the Bush tax cuts, all dividend income was taxed as ordinary income. If Congress fails to extend these provisions, the qualified dividend income provisions will expire, and all dividends will once again be taxed as ordinary income. Most notably, taxpayers in the highest marginal income tax bracket who currently enjoy the 15% rate on qualified dividend income will be taxed at 39.6% for dividends received from the same issuer in 2013. Additionally, the 3.8% Medicare contribution tax will increase the effective rate of tax on dividend income for certain higher-income taxpayers to as high as 43.4%.

New Medicare Contribution Tax

A new 3.8% Medicare contribution tax on certain unearned income of individuals, trusts, and estates is scheduled to take effect in 2013. This provision, which was enacted as part of the Patient Protection and Affordable Care Act (PPACA), is scheduled to take effect regardless of whether Congress extends the Bush tax cuts. For individuals, the 3.8% tax will be imposed on the lesser of the individual’s net investment income or the amount by which the individual’s modified adjusted gross income (AGI) exceeds certain thresholds ($250,000 for married individuals filing jointly or $200,000 for unmarried individuals). For purposes of this tax, investment income includes interest, dividends, income from trades or businesses that are passive activities or that trade in financial instruments and commodities, and net gains from the disposition of property held in a trade or business that is a passive activity or that trades in financial instruments and commodities. Investment income excludes distributions from qualified retirement plans and excludes any items that are taken into account for self-employment tax purposes.

Reduction in Itemized Deductions

Under current law, itemized deductions are not subject to any overall limitation. If the Bush tax cuts expire, an overall limitation on itemized deductions for higher-income taxpayers will once again apply. Most itemized deductions, except deductions for medical and dental expenses, investment interest, and casualty and theft losses, will be reduced by the lesser of 3% of AGI above an inflation-adjusted threshold or 80% of the amount of itemized deductions otherwise allowable. The inflation-adjusted threshold is projected to be approximately $174,450 in 2013 for all taxpayers except those married filing separately.

Other Changes Affecting Individuals

Additional employee portion of payroll tax. The employee portion of the hospital insurance payroll tax will increase by 0.9% to 2.35% on wages over $250,000 for married taxpayers filing jointly and $200,000 for other taxpayers. The employer portion of this tax remains 1.45% for all wages. This provision, which was enacted as part of the PPACA, is scheduled to take effect in 2013 regardless of whether Congress extends the Bush tax cuts.

Phaseout of personal exemptions. A higher-income taxpayer’s personal exemptions (currently $3,800 per exemption) will be phased out when AGI exceeds an inflation-indexed threshold. The inflation-adjusted threshold is projected to be $261,650 for married taxpayers filing jointly and $174,450 for unmarried taxpayers.

Medical and dental expense deduction. As part of the PPACA, the threshold for claiming the itemized medical and dental expense deduction is scheduled to increase from 7.5% to 10% of AGI. The 7.5% threshold will continue to apply through 2016 for taxpayers (or spouses) who are 65 and older.

Decrease in standard deduction for married taxpayers filing jointly. The standard deduction for married taxpayers filing jointly will decrease to 167% (rather than the current 200%) of the standard deduction or unmarried taxpayers (currently $5,950). In 2012 dollars, this would lower the standard deduction for joint filers from $11,900 to $9,900.

In addition, the current gift tax exemption is set to decrease and the estate and gift tax rate is set to increase when both expire on December 31, 2012. See our October 4, 2012 Alert for details.