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Preparing for Tax Increases

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Helping our clients make important tax decisions is a year round exercise here at Foster & Motley.  With significant changes on the horizon, we think it’s important to summarize the key changes along with important planning considerations.

Our tax discussions with clients start with acknowledging two things – what we know and what we don’t.

What we know is that the tax code, as written today, calls for increasing taxes on ordinary income, capital gains, dividends, payrolls, estates and gifts.  We also know that the Supreme Court ruled the Affordable Care Act, and its embedded tax increases, constitutional.

What we don’t know is how the November elections will wind up and what, if any, changes will be made to the current laws.  Your guess is as good as ours!

Let’s start with Federal tax changes scheduled to begin on January 1, 2013.
  • Ordinary income rates will increase for everyone.  For example, the lowest bracket will increase from 10% to 15% while the top tax bracket increases from 35% to 39.6%.
  • The term “qualified dividends” will be obsolete, and dividends will be taxed as ordinary income.
  • Long-term capital gains tax will increase from a maximum of 15% to 20%.
  • The payroll tax cut will expire, increasing employee payroll taxes by 2%.
As a result of the Affordable Care Act, two new taxes will be targeted at taxpayers with modified adjusted gross income over $250,000 (married filing joint) or $200,000 (single).

  • A 3.8% tax on the lesser of:
    • Net investment income (which includes interest, dividends, royalties, non-qualified annuities, rents, passive business activities and net capital gains)
    • The amount of MAGI in excess of the threshold.   
  • A 0.9% tax on wages and self-employed income above the MAGI thresholds. 

It’s not just income taxes that are set to increase, so are estate taxes.

  • The top estate tax rate will increase from 35% to 55%.
  • The estate tax and lifetime gift exclusion will decrease from $5.12 million to $1 million.
  • The exclusion portability option will cease.

As is always the case with taxes, there’s a lot more to it than these points, but it’s a start.

Of all of the changes, we expect the greatest confusion will surround the 3.8% Medicare tax, so here is an example.  Take Peter and Pam, age 70, with pension income of $120,000 and net investment income of $125,000 for a total modified adjusted gross income (MAGI) of $245,000 - just below the threshold amount.  In 2013 they must start required minimum distributions (RMD) from their IRA’s totaling $50,000, so their MAGI will be $295,000.  The 3.8% Medicare tax will be levied against the lesser of $45,000 (MAGI minus $250,000 threshold) or their net investment income of $125,000.  The Medicare tax will cost Peter and Pam an additional $1,710 in 2013.What if Peter and Pam also plan on selling their house in 2013? Would the 3.8% Medicare tax apply to the gain on their home?  It’s possible, but not to the extent chain e-mails would indicate.  The 3.8% tax would apply only after fully exhausting their $500,000 gain exclusion on the sale of a principal residence (assuming they meet the criteria, which most people do).  If we assume they sell their home in 2013 for $900,000 and they originally paid $350,000, they have a gain of $550,000.  After using their $500,000 gain exclusion, they are left with $50,000 that is subject to the 3.8% tax - resulting in a tax of $1,900.  If they wait to sell their home in a year when their total MAGI is less than $250,000 the tax would not apply.

With tax rates increasing, what strategies should be considered before the end of 2012?

Let’s start with the easy stuff.  A higher tax environment will make tax-deferred savings even more attractive.  Maxing out your 401(k), contributing to a Roth IRA, and contributing to a 529 plan for college expenses will become even more advantageous.  With qualified dividends no longer being a haven for tax-favored investment income, the tax appeal of municipal bonds will increase.  Not only will municipal bond income remain exempt from federal (and in some cases state) tax, but it will not count as part of modified adjusted gross income used to calculate the 3.8% Medicare tax. 

Accelerating income into 2012 with a Roth conversion may also make sense, but there are no one-size-fits-all solutions for Roth conversions.  In the example of Peter and Pam, they should consider a Roth conversion as a way to lower their required minimum distribution and reduce or avoid the 3.8% Medicare tax.  The great thing about Roth conversions is the ability to re-characterize the conversion in 2013 if we see changes to the tax laws.  Basically, that means you can reverse the conversion as if it never happened.  Money goes back into your IRA while the income and subsequent tax is eliminated. 

Selling low basis stock in 2012 is also worthy of consideration.  Generally this is a good idea if you have plans to sell the stock in the next couple of years. 

Just as accelerating income into 2012 can make sense, so can delaying deductions until 2013.  A lot of our clients make charitable gifts each December.  By waiting until January 2013 the deduction would be more valuable since it would offset income subject to higher tax rates.  More advantageous than cash gifts are gifts of low basis, long-term capital gain stocks or mutual funds.  Not only would a deduction offset income subject to higher tax rates, but you also avoid higher taxes on the capital gain.  With taxes on the rise, the dual benefit of this strategy becomes more valuable. 

In closing, tax planning remains difficult with all of the surrounding uncertainty.  We believe it’s important to have a plan,while appreciating that things could change. When in doubt, remember that we are here to help.