Several tax breaks for individuals and small businesses are set to expire on December 31, 2012. New tax laws will hit the middle class in general. As such, tax planning will be critical during the end of 2012. While immediate action may not be necessary, a thorough review of your income tax situation for 2012 and 2013 is necessary in order to plan for correct decision making before the end of the year. Here are some of the changes taxpayers may expect as they head into 2013.

Taxation of Capital Gains and Qualified Dividends

Beginning 2013, the maximum rate for long term capital gains will increase to 20% (10% for low income investors) from 15% (0% for low income investors) in the prior years. In addition, qualified dividends will be taxed at ordinary income rates which can be as high as 39.6% as opposed to receiving capital gain treatment in previous years at a lower rate of 15%.

Phase out of Itemized Deductions

Beginning 2013, itemized deductions will be phased out at certain income levels whereas in 2011 there was no such phase out. Phasing out the $3,800 personal exemption for higher income taxpayers is coming again in 2013. Certain itemized deductions will have a limitation equal to the lesser of 3% of adjusted gross income (AGI) over the applicable amount or 80% of the amount of the itemized deduction otherwise allowable for the taxable year.

Estate and Gift Tax Rates

The gift tax exemption limit was set at $5,120,000 per person for 2012 but will drop to $1,000,000 per person, as it was in 2010, unless Congress takes any action to the contrary by December 31, 2012. In 2012 the top gift tax and estate tax rates were 35%; in 2013 these rates may increase to 55%.

Payroll Tax

The FICA withholding rate is currently 4.2% for each employee earning up to $110,100 in 2012. This figure will increase to 6.2% in 2013 up to $112,500 annual wages per employee. On the other hand, the Medicare withholding rate is currently at 1.45%, and this will increase to 2.35% for 2013 for wages over certain limits ($200,000 for Single, $250,000 for Married Filing Jointly (MFJ), $125,000 for Married Filing Separately (MFS)). Previously there was no income limit in place for Medicare taxes.

Child Tax Provisions

The child tax credit, child and dependent care expense credit and the adoption expense credit will be scaled back in 2013 to the limits previously established prior to 2010. Qualified child and dependent care expense for the purpose of tax credit will be decrease from $3,000 to $2,400 in 2013. The child tax credit will decrease from $1,000 to $500 per child. Furthermore, the child tax credit will not be permitted for calculation with the alternative minimum tax, and there will be a phase out on earned income tax credits based on the number of qualifying children.

Student Loans

Adjustments to the student loan interest deduction will go into effect in 2013. The amount of the student loan interest deduction will be limited for those who earn $50,000 filing Single or MFS and $75,000 for MFJ.

Medicare Surtax on Unearned Income

A 3.8% Medicare contribution tax will be imposed on unearned income (i.e., interest, dividends, capital gains, passive income, including from partnerships and S corporations in which taxpayer does not materially participate) including long-term capital gains, and the profit on home sales for taxpayers with modified AGI over a certain limit ($200,000 for Single, $250,000 for MFJ, and $125,000 for MFS). This means that profits realized on the sale of a personal residence in 2013 in excess of $250,000 will be subject to this Medicare surcharge. Furthermore, the maximum federal rate on long-term capital gains for 2013 and beyond will be 23.8% and the rate on dividends will be 43.3%, versus the current rate of 15% for both.

Medical Expense Deduction

In 2013, only those who are age 65 and older will enjoy the 7.5 percent AGI limit for medical expense deductions. Those under age 65 will only be allowed to deduct medical and dental expenses that exceed 10 percent of their AGI which will make it even harder to deduct medical and dental expenses.

Flexible Spending Accounts (FSA)

There will be a limit of $2,500 contribution per year to employer provided health FSAs. Previously there was no limit.Usually in prior years it was more beneficial to have more deductions at the year end and defer income to the following year; however this year considering the advent of the imposition of additional tax rates on unearned income (capital gains, interest, dividends, etc.), it is advisable to defer expenses to the following year and accelerate unearned income in the current year.  All these changes including the requirements of filing FBAR and meeting FATCA requirements will present more complications for taxpayers. Therefore, careful tax planning and analysis is crucial in order to plan for the changes that are about to occur.

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