Tag: income tax projection

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Income Tax Planning

New Tax Law – Don’t Let the Tax Tail Wag the Dog – Part 2 of 2

Part 1 of this post focused on the two investment-related tax areas of the new tax law that went into effect on January 1st – (a) the Medicare investment income tax and (b) long-term capital gains and qualified dividends. It made the point that while the amount of potential income tax liability resulting from exposure to one or both of these changes may be significant, neither one in and of itself, or in combination for that matter, should cause you to overhaul an otherwise appropriate retirement income planning investment strategy.

After preparing income tax projections using current vs. prior tax law, your CPA or other income tax professional will be able to determine two things: (a) the total amount of your additional projected income tax liability attributable to various changes in the law, and (b) the amount of your additional projected income tax liability attributable to specific changes in the law, including the Medicare investment income tax and 20% long-term capital gains and qualified dividends tax.

Once you determine the amount of your projected income tax liability attributable to specific changes in the law, the next step is to determine (a) the applicable income threshold type and amount that you have exceeded, and (b) the projected amount of excess income over the applicable threshold amount. In the case of the Medicare investment income tax, the threshold type is modified adjusted gross income (“MAGI”) and the amount is $200,000 if single or $250,000 if married filing joint. If your additional projected income tax liability is attributable to long-term capital gains and/or qualified dividends, the threshold type is taxable income and the amount is $400,000 if single or $450,000 if married filing joint.

Whether you’re affected by the Medicare investment income tax or the 20% (vs. 15%) tax on long-term capital gains and dividends, the next step is to determine the various components of income that comprise your gross income. Once you do this, you need to determine which specific non-investment related components can be reduced, as well as the amount of reductions for each component, in order to reduce the amount of your projected income tax liability attributable to changes in the tax law.

It’s important to keep in mind that some types of income can be reduced indirectly. An example of this is taxable salary which can be reduced significantly by various types of pre-tax deductions as available, including, but not limited to, 401(k) plan and cafeteria plan contributions. Another example is self-employment income which can be reduced by self-employment expenses.

In addition to determining which specific non-investment related components can be reduced, it’s also important to determine if any losses can be created or freed up as another means of reducing gross income. This can include capital losses to offset capital gains, net operating losses, as well as passive activity loss carryovers that can be freed up as a result of the sale of a rental property. The latter strategy can be a double-edged sword since this may also result in a capital gain that may increase exposure to the Medicare investment income tax and/or the 20% capital gains tax.

Since the starting point for determining exposure to both the Medicare investment income tax and 20% capital gains tax calculations is adjusted gross income (“AGI”), the next step is to determine potential deductions for AGI, or “above-the-line” deductions, that you may not be currently taking advantage of. This includes self-employed retirement plan contributions, self-employed health insurance premiums, and health savings account (“HSA”) contributions, to name a few.

If your issue is the 20% capital gains tax, in addition to reducing your AGI, there’s another way that you can potentially reduce your exposure to this tax and retain the 15% favorable capital gains tax. Keeping in mind that the threshold type in the case of the 20% capital gains tax is taxable income which is calculated by subtracting itemized deductions and personal exemptions from AGI, you may be able to increase your itemized deductions in order to reduce your taxable income.

As you can see, there are things you can do to reduce your exposure to the Medicare investment income tax and 20% capital gains tax without changing your investment strategy. If you have an otherwise appropriate retirement income planning investment strategy, don’t let the tax tail wag the dog.

Categories
Income Tax Planning

New Tax Law – Don’t Let the Tax Tail Wag the Dog – Part 1 of 2

The new tax law which went into effect on January 1st, which is actually a combination of provisions from two different tax bills – the American Taxpayer Relief Act of 2012 (ATRA) and the Health Care and Education Reconciliation Act of 2010 – penalizes individuals with certain types and amounts of income. See parts 1 and 2 of The 2013 Tax Law Schizophrenic Definition of Income published on January 7th and January 14th for a discussion of the affected income types and threshold amounts, including a summary table of same.

As pointed out in the two posts, there are now five different definitions of income affecting seven different tax areas as a result of the new legislation. What I have found interesting as a CPA retirement income planner is the fact that while only two of the seven affected tax areas are directly related to investments, these two areas have commanded the vast majority of the media’s attention to date.

The two investment-related tax areas, both of which were discussed in detail in the two posts, are (a) the Medicare investment income tax and (b) long-term capital gains and qualified dividends. The Medicare investment income tax affects those with modified adjusted gross income (“MAGI”) in excess of $200,000 if single or $250,000 if married filing joint while long-term capital gains and qualified dividends are problematic if taxable income exceeds $400,000 if single or $450,000 if married filing joint.

The penalty for crossing these thresholds is 3.8% of the lesser of net investment income or MAGI in excess of the specified threshold amounts in the case of the new Medicare investment income tax and a 20% vs. 15% tax rate on long-term capital gains and qualified dividends. While the amount of potential additional income tax liability resulting from exposure to one or both of these changes may be significant, neither one in and of itself, or in combination for that matter, should cause you to overhaul an otherwise appropriate retirement income planning investment strategy.

As with all major tax law changes, and I’ve been through many, including the Economic Recovery Tax Act of 1981 (ERTA), the Tax Reform Act of 1986 (TRA), and the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRA), to name a few of the biggies, the first step in evaluating how the legislation will affect you is to prepare an income tax projection for the current and future tax years. The number of years that you choose to include in your projection depends upon a number of factors that are beyond the scope of this post. Needless to say, preparation of your projection by a CPA specializing in income taxation or by another income tax professional is recommended.

In order to determine how specific tax law changes will affect you, a baseline tax projection using prior law before the various changes took effect should be prepared. The next step is to prepare a projection under the new tax law. This will enable you to determine the total amount of your additional projected income tax liability attributable to various changes in the law. Once you know this, you can fine tune your analysis to determine the amount of additional projected income tax liability attributable to specific individual changes in the law. Your analysis should include types of income, affected tax areas, and additional income tax liability resulting from exceeding specified threshold amounts.

Assuming that your income tax projection reveals that you’re projected to incur more than a nominal amount of additional income tax liability that’s attributable to various types and amounts of investment income, you need to read Part 2 of this post in order to learn what to do next.

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IRA Roth IRA

Two Great Roth IRA Conversion Candidates

Retirement Income Center

In the two previous blog posts, I examined four scenarios where it’s possible to convert a portion, and possibly all, of a traditional IRA to a Roth IRA while incurring minimal or no income tax liability attributable to the conversion, and, as such, qualify as ideal Roth IRA conversion candidates.

This week’s blog presents two additional Roth IRA conversion candidates that I would classify as “great,” but not “ideal,” candidates. Both scenarios have the potential for the IRA owner or beneficiaries to end up with more assets than they would if they don’t do a conversion, however, there could be a sizeable amount of income tax liability attributable to the conversion, depending upon the situation. The two scenarios are as follows:

  1. Substantial basis in IRA
  2. Surviving spouse in low tax bracket not dependent on IRA with children in high tax bracket

Substantial Basis in IRA

Whether or not you’re considering a Roth IRA conversion, if you’re an IRA owner, it’s important to know the amount of your basis in your IRA. What does this mean? If the origin of your IRA is entirely from deductible IRA contributions or other deductible retirement plan contributions assuming your IRA was rolled over from a qualified retirement plan, such as a 401(k) plan, then your basis is $0. When you either take distributions from your IRA or do a Roth IRA conversion, 100% of your distributions or conversion amount will be taxable.

On the other hand, suppose that part or all of your IRA came from either nondeductible IRA contributions or after-tax contributions from a qualified retirement plan that was rolled over to your IRA. In this case, distributions from your IRA or Roth IRA conversions that are attributable to your nondeductible IRA contributions or qualified retirement plan after-tax contributions will be nontaxable. All prior year, as well as current year, nondeductible and after-tax contributions are required to be reported to IRS on Form 8606 – Nondeductible IRAs.

As an example, I had a client recently approach me about converting his wife and his IRA accounts to Roth IRA accounts. The combined value of their IRA accounts is $98,000 with a basis arising from nondeductible IRA contributions totaling $67,000. Assuming they convert 100% of their respective IRA accounts to Roth IRA accounts, they would recognize ordinary income equal to the difference between the account values of $98,000 and their basis of $67,000, or $31,000. This is less than one-third of the total value of their IRA accounts.

Even though my clients are in a combined 45% federal and state marginal income tax bracket, resulting in income tax liability of approximately $14,000 attributable to a Roth IRA conversion, this is only 14% of the total combined value of their IRA accounts of $98,000. Taking into consideration the fact that my clients are in their early 40’s, they may never need to take distributions from their IRA accounts, they have nonretirement funds from which to pay the tax attributable to the conversion, and the stock market is currently priced well below its highs of a couple of years ago, I encouraged them to pursue a conversion of 100% of their respective traditional IRA accounts to Roth IRA accounts.

Surviving Spouse in Low Tax Bracket Not Dependent on IRA With Children in High Tax Bracket

The second great candidate for conversion of a portion, or all, of a traditional IRA to a Roth IRA is a surviving spouse who meets the following three criteria:

  1. Low tax bracket
  2. Not dependent on IRA
  3. Has one or more children who are in a high tax bracket

The goal here is to reduce, or potentially eliminate, income tax liability that the surviving spouse’s beneficiaries will incur upon inheriting a traditional IRA since they will be required to take minimum distributions each year from their inherited IRA’s. Anyone in this situation should have a multi-year income tax projection prepared to determine the amount of traditional IRA that should be converted to a Roth IRA in the current and future years while keeping the surviving spouse in a relatively low tax bracket.

While both of these scenarios are not ideal Roth IRA conversion candidates since they could result in a sizeable amount of income tax liability upon conversion, they nonetheless present great opportunities to end up with greater assets than without doing a Roth IRA conversion, especially when beneficiaries are considered.