2013 Tax Management Strategies to Consider

After more than a decade of uncertainty with impending tax law sunsets, the American Taxpayer Relief Act of 2012 (ATRA) has restored permanency to the US tax code. In a nutshell, ATRA increased the top ordinary income tax rate to 39.6% for individuals earning $400,000 and married couples earning $450,000 and introduced a new top 20% long-term capital gains tax rate for the same top-bracket taxpayers.  ATRA did not change the existing 0% and 15% long-term capital gains rates for those in the lower tax brackets.

Also, managing capital gains has become complicated in 2013 due to the new 3.8% Medicare surtax that applies to individuals with $200,000 of Adjusted Gross Income (AGI) and married couples with $250,000 of AGI. Part of the Patient Protection and Affordable Care Act, the surtax applies to unearned income, including interest, dividends, rents, royalties, annuities, passive income, and taxable capital gains.

If you are in the top tax bracket, the 5% capital gains rate increase plus the Medicare surtax’s additional 3.8% makes your actual capital gains tax rate increased from 15% to 23.8%, 8.8% more last year. Therefore, there’s a greater need for proactive tax planning that carefully balances the timing of capital gains from your portfolio with changes in your earned income.

One of the easiest ways to lower earned income is to invest all you can in qualified retirement plans. Start with your 401(k) plan where the limit this year, and in 2014, is $17,500. Plus, if you’ve already celebrated your 50th birthday, you can sock away another $5,500. It’s also worthwhile to explore deferred compensation programs. And, if you’re getting a bonus this year, inquire if it can be paid in 2014. If you are self employed, consider the potential benefits of delaying invoices so your income registers next year.

Of course, if you sell your home or another property, you could structure the sale with periodic payments if doing so would keep you out of a higher tax bracket. Finally, if you are already retired, it’simportant to coordinate your required minimum distributions (RMDs) from qualified retirement plans with withdrawals from your other investment accounts.

There’s not as much flexibility when trying to avoid the 3.8% surtax on unearned income. Notably, income from municipal bonds, tax deferred annuities or the growth of cash value in a life insurance policy is exempt from the 3.8% surtax. So, if those investment options make sense for you, we consider them.

Also, the 3.8% surtax makes the non-deductible IRA suddenly more attractive. Although you don’t get a tax deduction for your contributions, the account grows tax-deferred, thereby helping you to avoid taxes on interest, dividends, and capital gains distributions that could occur over time in taxable investment accounts.

In the financial planning department, because the 0% and 15% capital gains rates still exist, gifts to family members in lower tax brackets may make sense. Remember, if you gift appreciated stock to an adult child, when they sell it, any gain will be taxed at their tax rate, not yours, provided they are not subject to the Kiddie Tax.

If you are age 70½ or older, you have an additional charitable opportunity. You can make a direct qualified charitable distribution of up to $100,000 from your IRA to a public charity without reporting the IRA distribution as taxable income on your federal income tax return. ATRA extended this benefit for two years for distributions made after December 31, 2011 and before January 1, 2014. For married individuals filing jointly, the limit is $100,000 per individual IRA owner.

Note that donor advised funds and most private foundations do not qualify as public charities. In his recent “Philanthropy Tax E-Letter” Conrad Teitell, President of Taxwise Giving, makes a number of additional clarifications. First, only distributions from traditional and Roth IRAs can be distributed to a qualified charity tax-free. Distributions from your 401(k), Simple IRAs or simplified employee pensions (SEPs) don’t qualify.

Also, the entire distribution must be paid to the charity with no quid pro quo. That is, if you receive (or are entitled to receive) a ticket to a gala or a dinner from the charity as a thank you for your gift, you cannot take the exclusion for any part of the IRA distribution. So, if you distribute $100,000 from your IRA to a charity and are entitled to a thank you benefit worth $50, the entire $100,000 distribution becomes taxable to you, even if you decline the benefit. In fact, when substantiating your donation, the charity must note that it provided no goods or services in connection with your gift.

Finally, the timing of your IRA distribution is very important. You don’t qualify for the IRA charitable distribution until you reach age 70½. The potential confusion here is that distributions that are made at any time during the year that you turn age 70½ meet your IRA’s minimum distribution requirement.

While this is an interesting opportunity, it’s wrapped in its share of red tape. So please consult with your financial advisor if you are interesting in making a qualified charitable distribution from your IRA.

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