Navigating Today’s Higher Income Tax RatesMarch 2014
Even if you are earning the same amount as you have in the past, your tax liability may be significantly higher under today’s laws. Two separate tax rate increases became effective in the 2013 tax year that impact top taxpayers. Our Fiduciary Trust Forum provides insight into strategies that may help minimize your tax burden.
Q. What are the key income tax changes individuals should be aware of?
Craig: High-income taxpayers are facing two simultaneous income tax increases as they prepare to file their 2013 tax returns. The first increase comes from the American Taxpayer Relief Act of 2012, which increased the top ordinary income tax rate from 35% to 39.6% for single individuals with taxable income over $400,000 and married couples filing jointly with taxable income over $450,000. The Act also includes a higher 20% maximum tax on long-term capital gains and qualified dividends.
The second increase is the new Medicare Contribution Tax, which affects taxpayers filing as single with modified adjusted gross income (AGI) over $200,000 and married couples filing jointly with modified AGI over $250,000. The Medicare tax imposes an additional 0.9% tax on earned income (such as wages) and a 3.8% tax on net investment income (such as interest, dividends and capital gains) in addition to regular income taxes.
Q. What is the total impact on top taxpayers?
Craig: Together, these increases mean that taxpayers in the highest brackets could pay as much as 43.4% in income taxes on ordinary income going forward, and as much as 23.8% on long-term capital gains and qualified dividends.
The impact of these tax increases can be very significant. For example, on their 2013 Federal income tax return, a married couple with $500,000 in wages, $200,000 in qualified dividends, $600,000 in long-term capital gains and itemized deductions totaling $200,000 would have a tax liability of nearly $68,000 more in 2013 than in 2012—almost a 30% increase.
Scenarios like this will ring true for many individuals, including those with lower income than in this example, and many taxpayers are going to be very surprised when they see how much more they will owe.
Q. What planning steps should taxpayers consider this year?
Craig: Now that higher taxes are here, we recommend using traditional tax planning strategies that postpone income into future tax years and accelerate deductions into the current year to reduce the tax burden in the current year. For instance, where possible, postpone lump sum income such as bonuses or the sale of a business into a future tax year, especially near year-end. Conversely, plan to make charitable gifts and other itemized deductions before the end of the current year rather than the beginning of the next year to maximize current-year tax benefits. Of course, be careful if you are subject to the Alternative Minimum Tax because you may not derive any tax benefit.
Q. With higher rates on investment income, how can investors mitigate the tax bite?
Craig: While we never recommend making portfolio decisions for tax reasons alone, if you are planning on selling a security, selling at a loss at year-end rather than waiting until the next tax year can help offset gains and reduce your taxable income. Also, be sure to use any carryover losses from a prior year to further offset gains in the current year.
If you hold taxable bonds that you purchased at a premium, consider amortizing the premium on that bond beginning in 2014. Rather than taking a capital loss at maturity, you can amortize the premium over the life of the bond and use it to reduce the tax liability on the income you receive from the bond each year. Since interest income can be taxed at a much higher rate than capital gains, the tax benefit could be greater.
For example, if you pay $11,000 for a 10-year bond with a $10,000 face value and a 5% yield, you would have a $1,000 capital loss at maturity. However, if you elect to amortize the $1,000 premium over the 10-year life of the bond (approximately $100 per year), you can use the amortization amount to reduce the taxable income of the bond each year. Instead of owing income tax on all $500 of annual interest income, only $400 would be subject to tax ($500 interest received less $100 amortization). You would not have a capital loss when the bond matures, but since the maximum capital gains tax is just 23.8% compared to ordinary income tax rates as high as 43.4%, that capital loss would not be as valuable.
We recommend speaking with your tax advisor about how to make the appropriate election on your tax return to implement this strategy.
Q. How does the new itemized deduction limitation affect the tax benefits of charitable gifts?
Craig: The limitation is based on the size of your adjusted gross income, not on the dollar amount of your itemized deductions. Your otherwise allowable itemized deductions are reduced by 3% of the amount by which your AGI exceeds a threshold of $250,000 for single individuals or $300,000 for married couples filing jointly.
Despite the potential limitation, however, charitable giving can be an excellent tax planning tool, especially in today’s higher tax rate environment.
Q. How are trusts and estates affected by the new Medicare tax on net investment income?
Craig: The 3.8% Medicare tax is applied to any undistributed net investment income greater than $11,950 for 2013 and over $12,150 for 2014 earned within a trust or estate. Trustees and executors should determine if distributing income to beneficiaries who might be in lower tax brackets can help minimize the overall tax burden.
This communication is intended solely to provide general information. The information and opinions stated are as of December 1 2013, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods. IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
FIDUCIARY TRUST FORUM
Director of Tax Strategies
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