8
During the last few months of 2012, one of the hottest topics of discussion was the “fiscal cliff”—the potential doom created by a number of national financial issues all coming to a boil at the same time. You know the old saying – “If it wasn’t for the last minute, nothing would ever get done!” Well, Congress passed the American Taxpayer Relief Act of 2012 (ATRA or “the Act”) in the nick of time on New Year’s Day, and President Obama signed it into law on January 2, 2013. Many taxpayers breathed a sigh of relief, since the Act helped avoid massive tax increases for nearly all earners that were slated to take effect January 1, 2013.
This special report reviews some of the major tax law changes included in ATRA along with a wide range of tax reduction strategies. All examples mentioned in this report are hypothetical and meant for illustrative purposes only.
As you read this report, please make a note of each tax strategy that you think could benefit you. Not all ideas are appropriate for all taxpayers. Consider how one tax strategy may affect another, and calculate the income tax consequences (both state and federal). Remember, tax strategies and ideas that have worked in the recent past might not even be available using the current tax laws we have today. Understand all the details before making any decisions—it is always easier to avoid a problem than it is to solve one! Also remember that you have the option to do nothing. As always, please discuss any of your ideas with your tax preparer before taking any action.
Please note—your state income tax laws could be different from the federal income tax laws. Visit www.sisterstates.com to view a wide range of tax information and access links to tax forms for all 50 states.
Tax Law Changes
ATRA leaves income tax rates where they were for 99% of households while raising them sharply on the top 1%. Unfortunately, these new tax laws are the biggest income tax increases in over 20 years for higher wage earners.
ATRA does have some redeeming features. Besides avoiding tax increases worth more than $200 billion a year, it restores stability to the tax code, though perhaps not for as long as we would like to see. The lower tax rates first enacted by George Bush in 2001 and 2003, which expired on December 31, 2012, are reinstated and made permanent for everyone except individuals earning more than $400,000 and couples earning more than $450,000. (Source: WSJ, January 15, 2013)
While the top 1% will bear the biggest burden, many other families, both affluent and poor, will pay more taxes as well. Millions of workers have already been affected by an immediate increase in their taxes, as Congress allowed the temporary 2-percentage-point cut for the employee portion of their Social Security tax to expire. After two years of this payroll tax holiday, many taxpayers will feel the expiration of this benefit more than any other provision in the Act. For example, an employee making $50,000 in 2013 owes an additional $1,000 in payroll taxes, lowering his or her paycheck by about $19 a week. Individuals making under $100,000 wind up bearing more than 60% of the burden of this year’s reversion to the higher payroll tax. (Source: Kiplinger, January 18, 2013)
Stealth Tax Increases
At first glance, ATRA appears simple. In terms of income tax, for example, only the highest tax rate in 2012—the 35% tax bracket—increased in 2013, to 39.6%, and that applies only to taxable income starting at $400,000 for singles and $450,000 for married.
However, don’t get comfortable too soon. Your 2013 marginal tax rate may be much higher than you expect. The rates on upper-incomers can be far greater than the ones listed in the new income tax brackets. The same goes for tax-favored dividends and long-term capital gains.
Phase-outs of tax benefits are one cause. They actually are stealth rate increases, pushing your marginal tax rate above the 39.6% bracket in the new law.
The first change is a phase-out of itemized deductions. For each $2,500 of Adjusted Gross Income (AGI) over the threshold ($250,000 for singles or $300,000 for couples), the value of your itemized deductions will be reduced by 3%, with a few exceptions, such as medical deductions. In no case will taxpayers lose more than 80% of their itemized deductions. Unfortunately, this cutback can add up to 1.19% to your marginal tax rate.
The next change is the loss of personal exemptions, which adds on as much as 1.05% per exemption to your true tax rate. ATRA trims personal exemptions by 2% for each $2,500 of AGI over the $250,000/$300,000 thresholds noted above. Your exemptions disappear once your AGI exceeds $372,500 for singles and $422,500 for joint filers. So a family of four in the phase-out zone can have a 4.2% hike in their marginal tax rate.
New Medicare Surtax
Two other brand-new taxes for 2013 can also increase your marginal rate. The first is the additional 0.9% Medicare surtax on earned income over $200,000 for singles or $250,000 for couples. This applies to both wages and self-employment income.
The next new tax is the additional Medicare surtax of 3.8% on taxable interest, dividends (both qualified and nonqualified), rents, royalties, capital gains and any income coming from passive activities. This levy starts to affect single filers with AGI over $200,000 and married couples over $250,000. Traditional IRA distributions, as well as Roth conversions and distributions from company retirement plans, Social Security benefits, life insurance proceeds and municipal bond interest are not considered investment income subject to the 3.8% Medicare surtax. However, taxable income from these sources can push taxpayers over the income threshold and cause investment income to be subject to the 3.8% surtax. Please refer to the chart on the right that identifies the various sources of income subject to the Medicare tax.
Trusts are hit especially hard. Once the trust’s taxable income exceeds a mere $11,950, the 39.6% tax bracket kicks in AND the 3.8% Medicare surtax also applies. Many trusts and estates pay their net earnings to beneficiaries, which is a tax deduction against the taxable income, which can reduce or eliminate both the income tax and the surtax because the income beneficiary most likely will have a marginal tax bracket significantly less than the 39.6% level. Note: this deduction can still be taken by the trust for the current year, as long as the distribution is paid within the first 65 days of the following year. Be sure to see a tax professional for details.
Note: when you add all of these potential stealth and Medicare surtax together, this can easily increase your marginal tax rate to above 40% and, when you add in your state income tax rate, the marginal tax rate for high wage earners can exceed 50%.
Type of Income / Subject to 3.8% Medicare Contribution Surtax?YES / NO
Taxable Interest and Dividends / X
Capital Gains / X
Royalties and net rental income / X
Installment sales proceeds / X
Gain from the sale of personal residence in excess of the IRC 121 exclusion / X
Passive income from S corporations / X
Passive activity income / X
Income from a trade or business that trades in financial instruments or commodities / X
Non-passive income from S corporations / X
Wages / X
Income from qualified pension, profit-sharing plan and stock bonus plans / X
Social security income / X
Tax-exempt interest / X
Life insurance proceeds / X
Source: The Essential Planning Guide To The Income & Estate Tax Increases, pg. 61
Investment Income
The qualified dividend provisions were set to expire at the end of 2012. That would have meant dividends being taxed at the same rate as wages and ordinary income, which created quite a stir within the financial community. The rates for high-income taxpayers on dividend income would have almost tripled by increasing the tax rates from 15% to 43.4% (including the 3.8% Medicare surtax).
Instead, ATRA left unchanged the taxation on stock dividends and long-term capital gains. The 15% tax rate will continue to apply to taxpayers in the 25%, 28%, 33% and 35% income tax brackets. Now let’s review some great news for most taxpayers—people in the 10% and 15% tax brackets (up to $72,500 taxable income for couples and up to $36,250 for singles) will continue to have a 0% tax rate on long-term capital gains and stock dividends.
Unfortunately, the new law permanently raises rates on long-term capital gains and dividends for top-bracket taxpayers. People that have enough income to pay tax at 39.6% rate will pay 20% on the net long-term capital gains and dividends, up from the 15% maximum tax rate in 2012.
One tax strategy is to review your investments that have unrealized long-term capital gains and sell enough of the appreciated investments in order to generate enough long-term capital gains to push you to the top of your 15% tax bracket. This strategy will be helpful because you do not have to pay any taxes on this gain. Then, if you want, you can buy back your investment the same day, increasing your cost basis in those investments. If you sell them in the future, this will help reduce long-term capital gains. You do not have to wait 30 days before you buy back this investment—the 30-day rule only applies to losses, not gains. Note: this non-taxable capital gain for federal income taxes might not apply to your state. Please discuss any of your ideas with your tax preparer before taking any action.
Remember that marginal tax rates on long-term capital gains and dividends can be higher than expected. The 3.8% surtax raises the effective rate on tax-favored gains and dividends to 18.8% for filers below the 39.6% tax bracket and 23.8% for people in the highest tax bracket.
Reduce Your Adjusted Gross Income
As you can see, reducing your AGI will in turn reduce your exposure to any of the surtaxes or stealth tax increases. Therefore, focus on finding as many above-the-line deductions as possible, as these reduce your gross income in order to arrive at your AGI. (While below-the-line deductions reduce your AGI, which in turn reduces your taxable income, they do not usually result in reduction of the surtax.) Let’s review some alternatives:
· Determine which sources of income are flexible and which are not. Pensions, RMDs and other types of fixed income are not flexible and are therefore difficult to reduce. Flexible sources of income include interest income, dividends, capital gains, and IRA distributions in excess of the RMDs—all of which can possibly be altered in order to reduce your AGI.
· Consider investing in certain tax-advantaged investments like municipal bonds and life insurance. Income from these products is not included in investment income when calculating the surtax. Review the pros and cons of each investment before you make any decisions—don’t let the tax tail wag the dog!
· Look at your 2011 income tax return Schedule D page two to see if you have any capital loss carryover for 2012.
· Take capital losses by selling assets with paper losses. These capital losses offset all capital gains dollar for dollar. Up to $3,000 of additional capital losses can be deducted to offset other income. Excess capital losses can be carried forward to future years and used the same way. Carefully review your taxable brokerage accounts for investments that may have become worthless during 2012. You should be able to use the same type of tax reduction strategy as mentioned above.
· Sell real estate or business property that has an unrealized loss. This loss is not subject to the $3,000 limitation noted above. Instead, the disposition of real estate or business investments will usually generate an unlimited loss against other sources of income. For example, if a taxpayer bought a rental property at the height of the real estate market, it is still possible that the value has not fully recovered. If, for example, the taxpayer sold a rental property that generated a $100,000 loss, then 100% of this could be used to offset other ordinary income. It might be wise to generate additional income such as a Roth IRA conversion and then offset this with the rental property loss. Please see a tax specialist for more details.
· Business losses can also reduce AGI. Losses can come from a sole proprietorship, partnership, or other forms; you might even be able to turn a hobby into a business. However, you have to run the activity like a real business, not a hobby, to meet the IRS’s rules for deducting losses.
· Losses from a real estate rental can also reduce AGI when the real estate qualifies as being actively managed under the IRS rules. This by itself is not a good reason to acquire a rental property, but if you are thinking about it anyway, it can be one more factor in its favor.
· Maximize your contributions to a 401(k) or 403(b) plan, IRA or other retirement accounts.
· Compare your actual retirement account distributions to your RMD. If possible, reduce your current distributions to the RMD level. Many people pay unnecessary taxes by taking out more than their RMD. If you face a cash shortfall, it is usually best to take the difference out of non-retirement accounts. The reason is simple—distributions from most retirement accounts are 100% taxable, compared to distributions from non-retirement accounts, where only the gain is taxable and at the lower capital gains tax rate.