2014 Tax Management Strategies

For better than a decade before the American Taxpayer Relief Act of 2012 (ATRA), year-end tax planning was roiled by pending sunsets and phase-outs. More recently, we endured the fear that our government would tumble over the fiscal cliff. However, in 2013, ATRA eliminated the suspense over tax brackets and capital gains rates, ending seemingly endless what-if-scenarios and enabling us to focus squarely on enhancing your portfolio’s tax efficiency.

Of course, nobody said that would be easy. In fact, 2013 also ushered in a new 3.8% Medicare surtax that applies to high wage earners. Part of the Patient Protection and Affordable Care Act, this surtax applies to “unearned income,” including interest, dividends, rents, royalties, annuities, passive income and taxable capital gains. Individuals with modified adjusted gross income (AGI) of $200,000 or married couples with an AGI of $250,000 are impacted.

Importantly, because ATRA and the 3.8% surtax combine to create multiple capital gains rates, we must carefully manage the timing of many investment decisions.

For example, married couples filing jointly with taxable income less than $73,800 and single taxpayers with less than $36,900 in taxable income pay no capital gains tax.  But married couples with taxable income greater than $73,800 and less than $457,600 and single taxpayers making more than $36,900 and less than $405,100 pay capital gains at a rate of 15%.  But capital gains rates jump to 20% for married couples with income greater than $457,600 and singles with income greater than $405,100.

However, as noted above married couples and individuals are faced with a Medicare surtax of 3.8% when their modified AGI exceeds $250,000 and $200,000, respectively.  In essence, there is no 20% capital gains rate.  Rather, married couples and individuals will face a capital gains rate of 0%, 15%, 18.8% (15% plus 3.8%) or 23.8% (20% plus 3.8%).

For instance, given that the capital gains rate is no longer 15% across most of the board, when we think about harvesting portfolio losses to offset the current year’s gains and possibly earned income, we have to consider the risk that you may be taxed at a higher capital gains rate in the future.

Remember, if you harvest a portfolio loss, you do not escape taxes, you simply defer them. That’s because when you return to your original investment after the 30 days mandated by the IRS’ Wash Sale Rule, your new position likely will have a new, lower cost basis. If that particular investment appreciates over time, you’ll owe taxes on those gains. Especially for longer-term positions, there’s real potential for your capital gains rate to increase.

Therefore, our harvesting decisions balance your risk of having a higher capital gains rate with the immediate tax benefit of harvesting the loss and the value of any potential growth on the re-invested money saved in taxes.

Of course, the potential for you to be in a higher tax bracket in the future coupled with market swings the last few years, may make this a good time to harvest portfolio gains instead of losses. In particular, we might consider selling low basis stock positions you inherited or trimming back any over-exposure to company stock.

In the top tax brackets, the 3.8% Medicare surtax is tough to avoid and caught some by surprise last year. Strategies we consider to avoid the tax include investing in municipal bonds, if appropriate, because some income is exempt from the 3.8% surtax on passive income. We might also look at relocating dividend-paying stocks to tax-deferred accounts where that income is not subject to the surtax.

Of course, an easy way to reduce your taxes is to reduce your income. No, I’m not talking about moving to a four-day week, but contributing more to your 401(k) or IRA where your contributions grow tax-deferred, until you make withdrawals at retirement.

Last month, the IRS released new rules for the 2015 tax year. Here are a few particularly significant changes:

  • You can now contribute $18,000 (up from $17,500) into 401(k).
  • If you turn 50 years old in 2015, instead of being limited by the basic 401(k) contribution, you can make a catch-up contribution of $6,000 annually, increased from $5,500.
  • The phase-out range on deductions for singles and heads of household who are contributing to traditional IRAs and are already covered by workplace retirement plans has increased. The phase-outs affect taxpayers with modified adjusted gross income between $61,000 and $71,000, up from $60,000 to $70,000 last year.
  • For married couples filing jointly, in which the spouse who makes the IRA contribution is covered by a workplace retirement plan, the income phase-out range is $98,000 to $118,000, up from $96,000 to $116,000. For an IRA contributor who is not covered by a workplace retirement plan and is married to someone who is covered, the deduction is phased out if the couple’s income is between $183,000 and $193,000, up from $181,000 and $191,000. For a married individual filing a separate return who is covered by a workplace retirement plan, the phase-out range is not subject to an annual cost-of-living adjustment and remains $0 to $10,000.
  • The AGI phase-out range for taxpayers making contributions to a Roth IRA is $183,000 to $193,000 for married couples filing jointly, up from $181,000 to $191,000 in 2014. For singles and heads of household, the income phase-out range is $116,000 to $131,000, up from $114,000 to $129,000. For a married individual filing a separate return, the phase-out range is not subject to an annual cost-of-living adjustment and remains $0 to $10,000.

Note that even if you don’t qualify for a tax deduction for your IRA contributions, there are other benefits. Again, growth in tax-deferred retirement accounts is not subject to the 3.8% surtax. You also have the option of later converting a traditional IRA to a Roth IRA. Remember, although there are income limits for opening a Roth IRA, there on no income restrictions on who can convert a traditional IRA to a Roth IRA. When deciding whether to convert to a Roth we evaluate how the conversion will impact your taxes this year versus the benefit of having a tax-free account to draw from in retirement. The optimal timing for a conversion depends on numerous factors and will be different for each investor. However there are a few obvious windows of opportunity to consider for a Roth conversion – One is prior to your peak earning years when your tax rate could be lower than just prior to retirement (or even in retirement!) and another is after you retire, but before you begin taking Required Minimum Distributions (RMDs) from your IRAs at age 70 ½.

Finally, in addition to helping those in need, your donations to qualified charities can provide valuable tax deductions. To be tax deductible, your charitable contributions must be made to qualified organizations with 501(c)(3) status. This group includes churches and schools, as well as charitable organizations like Big Brother Big Sister, the Red Cross and the American Cancer Society. If you wonder if the cause you want to support qualifies, the IRS’ database of eligible organizations provides a complete list.

To deduct charitable expenses, you must itemize your deductions instead of claiming the standard deduction. (For 2014, the standard deduction for single taxpayers is $6,200 and $12,400 for married couples filing jointly.) Please keep receipts and records of all your donations and keep in mind that, in general, you cannot deduct more than 50% of your adjusted gross income for donations, but 20% and 30% limitations apply in some cases.

Bigger picture, your tax strategy for 2014 will depend not only on your current tax rate, but on your anticipated tax rates for next year and in retirement. Given that, for the moment at least, our planning isn’t compromised by impending tax policy sunsets, we have a better opportunity than we’ve had in decades to develop comprehensive, long-term, individualized tax management plans.

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