2013 Year-End Tax Planning and Tax Changes for Individuals
By Greg Erickson, J.D. and Cindy Harper
As Congress always seems behind these days, it is not surprising that the American Taxpayer Relief Act of 2012 was signed into law on January 2, 2013. For many taxpayers the new law will look much like the old law, but for many others the new rules promise nothing resembling “relief.” Indeed, the new law means higher taxes - much higher taxes - for high income taxpayers. But as 2013 draws to a close there are still some opportunities to reduce your 2013 tax bill and plan ahead for 2014. We will examine the impact of the 2013 tax changes on individuals, and then discuss various tax planning strategies before year-end and going forward.
How Will the 2013 Tax Law Changes Impact You?
So, here we are, close to the end of 2013 and you have heard all the talk about how much your taxes will be going up this year. But have you really looked at specifics of the increases and what they mean to YOUR tax bill? Here is a summary of the tax increases that apply starting in 2013.
For most taxpayers, the lower tax rates from the 2001 and 2003 tax acts remain. However, taxpayers with the following taxable income are looking at a new marginal tax rate of 39.6% for 2013 -
||Married Filing Jointly/Surviving Spouse|
||Head of Household|
|$225,000||Married Filing Separately|
The long-term capital gains tax rate are now permanent at 0% for those in the 10% to 15% brackets, 15% for those in the 25% to 35% brackets and 20% for those in the 39.6% tax bracket. Also, qualified dividends continue to be taxed at capital gains rates.
Limitations on itemized deductions (known as “PEASE”) and personal exemptions (known as “PEP”) are back for 2013 for taxpayers with Adjusted Gross Income (AGI) exceeding these thresholds -
||Married Filing Jointly/Surviving Spouse|
||Head of Household|
|$150,000||Married Filing Separately|
For PEASE, deductions are reduced by 3% of the amount by which a taxpayer’s AGI exceeds the threshold. The reduction is limited to 80% of allowable deductions, so taxpayers will receive at least 20% of their itemized deductions. Expenses that are excluded from this limitation are medical expenses, investment interest expense and casualty or theft losses. The PEASE limitation does not apply to estates or trusts.
The personal exemption for 2013 is $3,900 per person. The PEP reduces the exemption by 2% for each $2,500 (or portion thereof) of AGI in excess of the threshold. In simpler terms, a married couple with two children who earn $425,000 in 2013 forfeit all four of the $3,900 personal exemptions.
The new 3.8% Medicare surtax on unearned income applies to the lower of (1) net investment income or (2) excess of modified AGI over $200,000 for Single taxpayers and $250,000 for Married Filing Joint taxpayers. The definition of net investment income includes interest, dividends, annuity distributions, rents, royalties, income derived from a passive activity, net capital gain derived from the disposition of property. Net investment income does not include salary, wages or bonuses, distributions from IRAs or qualified plans, any income taken into account for self-employment tax purposes, gain on the sale of an active interest in a partnership or S corporation, items that are otherwise excluded or exempt from income tax (i.e. tax exempt bond interest, excluded gain on the sale of principal residence). The 3.8% Medicare surtax applies to trust and estates with income in excess of about $12,000. That is, interest or rental income in a trust in excess of that is now taxed at 43.8%; capital gains and qualified dividends in excess of that amount are taxed at 23.8%.
There is an additional 0.9% Health Insurance Tax on wages and self-employment income in excess of $200,000 for Single taxpayers and $250,000 Married Filing Jointly taxpayers. Withholding is required on wages above $200,000 and any true-up for this tax is computed on your income tax return.
In case you haven’t been counting, this means if you were in the top tax bracket of 35% for 2012, your interest income is probably now subject to a 43.8% tax and your capital gains are now subject to a 23.8% tax. That is a 25% tax increase on the interest and 58.67% tax increase on your capital gains! And the increase is actually higher as this doesn’t take into account the effect of the PEASE and PEP limitations or Alternative Minimum Tax.
To illustrate the increase, let’s assume a Single taxpayer with the following facts:
- $360,000 Wages
- $100,000 Long-Term Capital gain
- $460,000 Adjusted gross income
- $20,000 Mortgage interest
- $30,000 State taxes
- $7,000 contributions
Total Tax: $104,740, consisting of $83,264 tax on ordinary income, $15,000 Capital gains tax (all taxed at 15%) and $6,476 Alternative Minimum Tax
Total Tax: $110,135, consisting of $86,200 tax on ordinary income tax, $15,465 Capital gains tax, $1,440 Health Insurance Tax, $3,580 3.8% Medicare surtax and $3,450 Alternative Minimum Tax
All things considered, while you can take a few steps to lessen the tax bite (discussed below), if you are a higher income taxpayer ($250,000 married filing jointly or $200,000 single), then it’s time to get used to some higher taxes overall. Now I have your attention, and you are wondering “what can I do to minimize this?”. Following are some suggestions and items which should be considered, taking into account other non-tax factors such as cash flow needs, overall investment strategy, etc.
Managing Income and Deductions
Because many tax benefits are tied to or limited by your adjusted gross income (AGI), it’s important to be able to estimate your 2013 and 2014 AGI. In addition, when considering whether to accelerate or defer income or deductions, please be aware of the impact these tactics may have on your AGI and, by extension, your ability to maximize itemized deductions that are tied to AGI.
- Evaluate investments to determine if a change in those is appropriate to reduce Net Investment Income (i.e. switch from corporate bonds to taxexempt bonds, consider buy and hold strategies instead of sales, investment in growth stocks rather than high dividend paying stocks).
- Create Material Participation in passive loss activities in which you are actively involved.
- Re-examine grouping of passive activities to meet the material participation test.
- Capital loss harvesting to offset capital gains.
- Income smoothing strategies that help you avoid high income years, including use of installment sales, timing of stock option exercises, etc.
- Charitable Remainder Trusts for holding long-term assets expected to appreciate substantially.
- Timing of Qualified Plan and IRA distributions if there is a need for more than required minimum distributions.
- Use of tax-deferred annuities.
- Use of single premium life insurance policies instead of holding high income investments directly.
- Maximize above-the-line deductions such as Health Savings Accounts, the self-employed health insurance deduction, use of deductible contributions to retirement plans, and deferred compensation plans.
- Consider a like-kind exchange for the sale of appreciated property.
- Distribute up to $100,000 of your RMD’s from a traditional or Roth IRA to charity without incurring any income tax on the distribution (you will also forgo the charitable deduction, but reducing AGI can provide more benefit to other deductions). This provision is scheduled to expire at the end of 2013.
- To avoid capital gains, consider giving appreciated property instead of cash to charity.
If you expect your AGI to be higher in 2013 than in 2014, or if you anticipate being in the same or a higher tax bracket in 2013, you may benefit by deferring income into 2014 or accelerating deductions into 2013. Deferring income will be advantageous provided the deferred amount does not bump your income next year to a higher tax bracket. Remember to take into consideration any unusual deductions or credits that may be available to you from one year to the next, as well as the effect a higher AGI will have on reducing the benefit of itemized deductions. Some additional ways to defer income or accelerate deductions include:
- If you are self-employed and on the cash-basis, you can delay year end billing to clients so that payments will not be received until 2014.
- Interest income earned on Treasury securities and bank certificates of deposit with maturities of one year or less is not includible in income until received. To defer interest income, consider buying short-term bonds or certificates that will not mature until next year.
- If you anticipate a state income tax liability for 2013 consider making the payment before the end of 2013.
- You can use a credit card to charge donations in 2013 even though you will not actually pay the bill until 2014. Additional Tax Planning Considerations
- When trusts are involved, evaluate the ability to minimize the total tax using beneficiary distributions based on the beneficiary’s tax situation as well as the trust. Trustees should consider distributing income traditionally retained by the trust to beneficiaries so that the same income is taxed at the beneficiary level, if it will result in lower overall tax.
- The election to deduct state and local sales taxes instead of state and local income taxes is scheduled to expire at the end of 2013.
- For 2013, a dependent child can earn up to $2,000 of unearned (investment) income before the kiddie tax kicks in.
- Until 2016, tax incentives are available to taxpayers who install certain energy efficient property, such as photovoltaic panels, solar water heating property, fuel cell property, small wind energy property and geothermal heat pumps. A credit is available for the expenditures incurred for such property up to a specific percentage, except that a cap applies for fuel cell property. Regrettably, the property purchased cannot be used to heat swimming pools or hot tubs. So if you have made any improvements to your home or plan to by the end of 2013 don’t forget - you may qualify for this credit.
- Self-employed individuals are allowed to claim 100% of the amount paid during the taxable year for insurance that constitutes medical care for themselves, their spouses and dependents as an above-the-line deduction, without regard to the general 10% of AGI floor.
- If you have a stock holding due to the exercise of an incentive stock option during this year that is now below the value at the exercise date (underwater), consider selling the shares before the end of the year to avoid the AMT tax due on the original exercise of the option.
- If you are currently underwater on your home and you are considering selling or getting a loan modification, you absolutely should get this done in 2013. Qualified mortgage debt that your lender discharges in 2013 is not treated as taxable income. However, if Congress fails to act (hard to imagine that, I know) then any debt discharged on or after January 1, 2014, will be considered income and will subject to tax.
In 2013 the annual deductible contribution limit for individuals who are not active participants in an employer sponsored pension plan for an IRA is $5,500. A $1,000 “catch-up” contribution is allowed for taxpayers age 50 or older by the close of the taxable year. Individuals who are active participants in an employer pension plan also may make deductible contributions to an IRA, but their contributions are limited in amount depending on their AGI. For 2013, the AGI phase-out range for deductibility of IRA contributions is between $59,000 and $69,000 of modified AGI for single persons (including heads of households), and between $95,000 and $115,000 of modified AGI for married filing jointly. Above these ranges, no deduction is allowed.
Contributions to Roth IRAs are still limited to those with an adjusted gross income of less than $100,000, but there is no income limitation for taxpayers who wish to convert an existing IRA to a Roth IRA. The immediate tax bite will be substantial (i.e., the amount converted is fully taxable), but with a top marginal tax rate of 43.8% the ability to withdraw the earnings from a Roth IRA tax free later makes conversions relatively more compelling - especially if your income and tax rate will be lower in current years. Moreover, if you make a Roth conversion and the assets drop in value, within a certain time frame you retain the right to undo the transaction and then reconvert the assets, thus dramatically lowering the tax cost associated with the conversion.
The §401(k) elective deferral limit is $17,500 for 2013. If your §401(k) plan has been amended to allow for catchup contributions for 2013 and you will be 50 years old by December 31, 2013, you may contribute an additional $5,500 to your §401(k) account, for a total maximum contribution of $23,000 ($17,500 in regular contributions plus $5,500 in catchup contributions).
Estate and Gift Tax Planning
In 2013 the gift tax annual exclusion is $14,000 per recipient per donor (meaning $28,000 per married couple, but they must file a gift tax return to split the gift), and annual exclusion gifts do not reduce your estate and lifetime gift tax exclusion of $5.25 million. Qualifying tuition payments and medical payments - that is, payments made directly to the service provider – also do not count against this limit.
Tennessee abolished its gift tax effective January 1, 2012, therefore gifts under the annual exclusion amounts above will incur no gift tax. Tennessee still does, however, have an inheritance tax until December 31, 2015. Tennessee’s taxable threshold for estates increases from $1.25 million to $2.5 million on January 1, 2014 and rises to $5 million on January 1, 2015.
Again, we encourage you to evaluate these options with the guidance of your professional advisors (investment advisors, attorneys and LBMC). We look forward to the opportunity to work with you on alternatives to help reduce the impact of the tax increases for you.
Please contact us with any questions. Members of the LBMC Wealth Management Team are ready to help.
Greg Erickson is a Partner with LBMC’s Tax Services practice. He specializes in tax strategy, estate planning and gifting strategies.
Cindy Harper, a Certified Public Accountant and Personal Financial Specialist, has diversified accounting, tax and management advisory services experience in various industries. She regularly works with closely-held businesses and their owners on a wide range of tax issues, as well as high wealth individuals and families to maximize their wealth building and protection strategies.
This information is for general guidance only, and does not constitute legal advice, tax advice, accounting services, investment advice, or professional consulting. The information should not and may not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisers. Before making decisions or taking actions, consult a professional adviser who has been provided with all pertinent facts relevant in your particular situation. Tax articles are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer.