Congratulations, the 2012 tax season is behind us. Time to start planning for 2013.
The dramatic New Year’s Eve peek over – and retreat from – the fiscal cliff did not solve all of the country’s budgetary problems. But it did produce a historic and constructive piece of tax legislation that ended a great deal of uncertainty for taxpayers. Postponing the fight over spending (sequestration, the budget and the debt ceiling), Congress passed and the President signed into law the American Taxpayer Relief Act (ATRA.)
While some of its provisions were retroactive for 2012, the lion’s share of changes affect this year’s taxes and beyond. There is something in the new legislation for everyone. Some of the major highlights include:
As a prudent taxpayer, you don’t have to play a piñata to the tax code, letting the pieces fall where they may. Rather, it’s well worth your while to plan ahead. While many strategies are geared toward higher-income taxpayers who are most subject to the new rules, there are also good ideas for taxpayers in lower brackets as well as for those trying to avoid being subject to higher brackets in the future. Some of these strategies turn traditional planning on its head.
We’ll start with some lower-bracket (10%, 15% and 25%) strategies:
Capital Gains. It is both intuitive and common practice to harvest losses and defer gains. (The first $3,000 of capital loss is deductible against ordinary income. Thereafter losses are netted against gains and then may be carried forward.) But in some circumstances, realizing gains makes sense. Obviously, if you are in the 0% capital gains bracket (15% or below ordinary income bracket) realizing capital gains is a no-brainer. You may want to rebalance your portfolio, reinvest in the same securities and increase your basis or simply spend the money.
Filling Brackets. For retired investors, augmenting other income with Social Security and Required Minimum Distributions (RMDs), which begin at age 70½, may eventually bump you into a higher bracket. (For example from the 15% to 25% bracket at $36,250/$72,500, depending on whether you are single or married.) Realizing capital gains in low bracket years, before entering the higher bracket, might delay the day of reckoning.
Roth Conversions. If you have a substantial IRA, annual partial Roth conversions (or even non-mandatory withdrawals) may be a good strategy. Taking your income up to the top of the 15% bracket earlier will reduce the value of your IRA and result in smaller RMDs in the future.
Asset Location. Traditional asset location strategies continue to make sense. For example, keep dividend-paying stocks in your taxable account and vehicles that generate ordinary income in your IRA.
Now or in the future, you may be in the higher tax brackets (28%, 33%, 35%, and 39.6%) or subject to the 3.8% Medicare surtax. The 20% capital gains rate kicks in at taxable income of $400,000/$450,000. For you, a cottage industry is evolving to develop income tax savings strategies, especially in light of the higher thresholds for the estate tax. Seeking a collaborative planning approach among your CPA, your estate planning attorney and your financial advisor helps ensure your entire team is working in concert, to your benefit.
Potential strategies are too numerous to cover in depth here. But the following are a few of the highlights:
Adjusted Gross Income (AGI). The main fulcrum for dealing with the new tax regime is managing your AGI. The thresholds for both the exemption and itemized deduction phase-outs ($250,000/$300,000) and the Medicare surtax ($200,000/$250,000) are based on AGI. (In contrast, the new 39.6% tax bracket at $400,000/$450,000 is based on taxable income.)
AGI (the last line on page one of your 1040) is a function of: 1) your top line income (wages and salaries, investment income, income from business and capital gains) and 2) adjustments to income – better known as “above the line” deductions. The more typical of these are: contributions to retirement plans; moving expenses; self-employment tax deductions; self-employment health insurance; medical savings account contributions; student loan interest, tuition and fees; and alimony paid.
While we don’t normally have control over the timing of wages and salary income (unless you own your own business) we often can control the timing of income like capital gains or the proceeds from the sale of real estate or a business, to smooth out receipt of AGI.
Medicare Surtax. The 3.8% Medicare surtax applies to the lesser of Net Investment Income (unearned income) or Modified Adjusted Gross Income (MAGI) in excess of the threshold amounts of $200,000 for single taxpayers and $250,000 for married filing jointly. The surtax is in addition to regular income tax and any AMT. These thresholds are NOT indexed to inflation.
Subject to the tax are: taxable interest, dividends, rent, taxable annuities, royalties and net capital gains. Also included is income from passive activities.
So, for example, if you are in the 33% bracket and you are subject to this tax (because of your AGI), your marginal taxable bond interest will be taxed at 36.8% and your capital gains will be taxed at 18.8% (15% + 3.8%). If you are in the 39.6% (highest) bracket, your marginal ordinary investment income is taxed at 43.4% and capital gains are taxed at 23.8%.
Major sources of investment income that are not subject to the surtax are: tax-exempt interest, income that would otherwise be subject to the tax if you are actively in engaged in the trade or business; income from a business you are actively engaged in (think dividends from your own business); and distributions from an IRA or qualified plan (but be careful, this is counted toward MAGI and could subject other investment income to the surtax).
Harvesting. As with lower-bracket taxpayers, if you anticipate being subject to higher taxes in the future, it may very well pay to realize capital gains earlier than you otherwise might, to take them at expected lower rates.
Income Shifting. A good tactic for managing these higher rates is to shift income to your children or grandchildren, who may be taxed at lower rates. If you own your own business, you can put them on the payroll. (Of course they have to actually do some work.)
You can also transfer income-producing assets to children and grandchildren, either through a 529 college savings plan or using Uniform Transfers to Minors Act (UTMA) accounts. The annual gift tax exclusion is now $14,000, and with the lifetime exclusion for couples at $10 million, this strategy increasingly makes sense. But watch out for the “kiddie tax,” which taxes children’s unearned income above $1,900 at the parents’ marginal rate.
Philanthropy Strategies. The direct IRA charitable rollover for taxpayers over 70½ continues for 2013. The main advantage of this strategy is that it does not increase AGI by the amount of the donation. Also consider contributions of appreciated assets (which eliminate taxation of capital gain), either directly or via a charitable trust of one form or another.
Trusts. Trustees of taxable trusts (i.e. non-grantor trusts) must be particularly cognizant of the new rules. Trusts have extremely compressed tax rates. The new top 39.6% income tax rate, the 20% capital gains rate and the 3.8% Medicare surtax all apply to undistributed trust income above $11,950. So trustees need to consider distributing trust income to beneficiaries in lower brackets and taking the trust’s deduction for distributable net income (DNI).
ATRA permanently (as permanently as possible in this volatile political climate) set the unified Gift, Estate and Generation Skipping Tax exemption amount at $5 million (adjusted for inflation). For 2013, the exemption amount is $5.25 million per person (twice that for married couples, with proper planning). The tax rate on non-exempt amounts is a flat 40%.
“Proper planning” used to almost always involve establishing a so-called “by-pass” trust, which passed the exempt amount to the next generation, but allowed the surviving spouse access to income (and sometimes principal) from the trust. On the second death, the surviving spouse could pass an additional exempt amount, thereby effectively doubling the amount passing tax-free. With the permanent inclusion of “portability” in the law, it is no longer necessary to utilize a by-pass trust to achieve the double exemption. On the death of the surviving spouse, the unused exemption for assets that were transferred directly to the surviving spouse can be “picked-up” by the second estate. BUT (and this is a big but) in order to take advantage of this, a timely estate tax return must be filed in connection with the first death, even if no tax is due. “Timely” means within 9 months of death unless an extension is requested.
It is estimated that the estate tax will now affect less than 1% of taxpayers. But don’t let that dull you into complacency around your estate planning. With growth, an estate now clearly under the limit may be subject to estate taxes in the future. And, all of the other non-tax concerns involved with estate planning remain – and some still strongly suggest the use of trusts. Here are just a few:
The foregoing is offered by way of background only, to give you a sense of possibilities worth exploring. I have not drilled all the way down to a level of detail necessary to cover all cases. Your circumstances and needs are unique to you and your family. On top of that, much of this is uncharted territory amidst the new ATRA environment.
In short, before taking any action of your own, it is critical for you to thoroughly explore the ideas offered here with a tax professional who is familiar with your situation. And don’t forget to loop your investment advisor in as well.
Finally, as we do every year, we provide a comprehensive guide in matrix form to a wide range of the new tax numbers in the downloadable “2013 Key Numbers.“
Steve Smith, Principal of Right Path Investments is here to guide you with preparations to take your next step. If you're ready to take that step, schedule some time for a one on one with Steve today.