Tag: long-term capital gains

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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.

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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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Income Tax Planning

The 2013 Tax Law Schizophrenic Definition of Income – Part 2 of 2

Per last week’s blog, as a result of President Obama’s signing on January 2nd of the American Taxpayer Relief Act of 2012 following changes legislated by the 2010 Health Care Reform Act effective beginning in 2013, there are now five different definitions of income affecting seven different tax areas. Exhibit 1, which was also included in last week’s post, summarizes 2013 individual federal income-based tax law changes, comparing each one with the law in effect in 2012.

Please see last week’s post for a discussion of the first three definitions of income. This week’s post examines the last two.

Adjusted Gross Income Exceeding $250,000 or $300,000

Once your adjusted gross income (AGI) exceeds $250,000 if single or $300,000 if married filing jointly, your income tax liability will increase as a result of two affected tax areas: (1) Itemized deductions limitation and (2) Personal exemption phaseout. Although neither of these provisions was effective in 2012, both have been part of prior years’ tax law.

Itemized Deductions Limitation

The limitation on itemized deductions, known as Pease after the congressman who helped create it, was originally part of the Economic Growth and Tax Relief Reconciliation Act of 2001, was phased out beginning in 2006, and was repealed in 2010.

Back in 2013, the itemized deductions limitation reduces most otherwise allowable itemized deductions by 3% of the amount by which AGI exceeds the specified threshold of $250,000 or $300,000, depending upon whether you’re filing as a single or married filing joint taxpayer. Itemized deductions can’t be reduced by more than 80%. In addition, the reduction doesn’t apply to deductions for medical expenses, investment interest, casualty and theft losses, and gambling losses.

Personal Exemption Phaseout

The personal exemption phaseout is another reincarnation of prior tax legislation. Since 1990, the personal exemption has been phased out at higher income levels. The 2001 tax act phased out the phaseout beginning in 2006 with repeal in 2010.

Back in 2013, 2% of the personal exemption amount, projected to be $3,900, is eliminated for each $2,500 of AGI in excess of $250,000 for single filers and $300,000 for those using married filing joint tax filing status.

Taxable Income Exceeding $400,000 or $450,000

Welcome to 2013 tax law income definition #5 affecting two more income tax areas. If your taxable income exceeds $400,000 if single or $450,000 if married filing jointly, your income tax liability will be further increased by two different tax provisions: (1) Income tax bracket and (2) Long-term capital gains and qualified dividends.

Income Tax Bracket

The top tax bracket of 35%, which was in effect from 2003 through 2012, jumps by 4.6% to 39.6% beginning in 2013 for those individuals whose taxable income exceeds the single and married filing joint thresholds of $400,000 or $450,000, respectively. The last time that the 39.6% rate was part of the tax law and was also the top tax rate was in 2000.

Long-Term Capital Gains and Qualified Dividends

Beginning in 1982, tax rate reductions reduced the tax rate on long-term capital gains, i.e., capital gain income from assets held longer than one year, from 28% to a maximum of 20%. The rate was further reduced from 20% to 15% beginning in 2003 and also began applying to qualified dividends.

The 20% maximum rate on long-term capital gains and qualified dividends has returned in 2013 for those individuals whose taxable income exceeds the $400,000 or $450,000 threshold depending upon filing status.

Summary

With the exception of the Medicare Earned Income Tax and Medicare Investment Income Tax discussed in last week’s post, the other five affected tax areas resulting in higher federal income taxes in 2013 are reincarnations of prior tax law. Everyone with employment or self-employment income of any amount with limited exception will pay more tax in 2013 than they did in 2012, all else being equal. In addition, income tax liability will increase for anyone with certain types of income exceeding specified thresholds starting at $200,000 or $250,000 depending upon filing status. The cumulative effect of the various changes and associated increase in federal income tax liability will be significant for many people.

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IRA

To IRA or Not to IRA?

Retirement Income Center

Without going into the details, IRA contributions may be deductible, non-deductible, or partially deductible. Assuming that you’re eligible to make a deductible contribution, should you do it? As with all financial decisions, it depends upon the facts.

Let’s assume that you’re married, you’re both 50 years old, neither one of you is an active participant in an employer-sponsored retirement plan, and your marginal federal income tax rate is 25%. Given this scenario, you would be eligible to make deductible IRA contributions of up to $6,000 each, for a total of $12,000. Forgetting about a potential state income tax deduction, assuming you make maximum contributions, you will reduce your income tax liability by $3,000 ($12,000 x 25%). Looking at it another way, the cost of your IRA contributions is $9,000 ($12,000 less income tax savings of $3,000).

Since your spouse and you are both 50 years old, you’re both eligible to make IRA contributions for another 20 years until age 70-1/2. Assuming that you both continue not to be active participants in an employer-sponsored retirement plan, you will be able to make deductible IRA contributions totaling at least $240,000 ($12,000 x 20), excluding potential additional contributions permitted by legislated contribution limit increases. Per Exhibit 1, after making contributions totaling $240,000, 25%, or $60,000 of which was financed by federal income tax savings, resulting in net out-of-pocket total contributions of $180,000 ($240,000 less income tax savings of $60,000), and assuming earnings of 5%, the total value of both of your IRA’s in 20 years is projected to be approximately $417,000.

That’s pretty awesome. Why wouldn’t you implement this plan? Keeping in mind that a deductible IRA plan is a tax-deferral plan, even though you may receive income tax deductions of $12,000 a year, or a total of $240,000 over 20 years, you, and potentially your heirs, will eventually pay income tax on 100% of your contributions. This must occur beginning at age 70-1/2 when you will be required to take minimum withdrawals from your plan that are calculated each year using the value of your IRA on December 31st of the previous year and your current age. Furthermore, the tax rate on your IRA withdrawals may be greater than the rates at the time when you made your contributions, resulting in greater tax liability than the tax savings you received from your contributions.

As an alternative, especially if you have other qualified retirement plans, you may want to consider taking the same $12,000 and instead make nondeductible contributions to a nonretirement investment account. Administratively, this will be easier since, unlike the IRA situation where you must deposit $6,000 into two separate accounts each year assuming you’re married, you can deposit 100% of your contributions into a single account. Furthermore, unlike an IRA which has an annual contribution limit of $5,000 or $6,000 if you are at least 50 years old, there is no cap on the amount of contributions that may be made to a nonretirement investment account.

To the extent that the investments in your nonretirement account don’t produce current taxable income, they will enjoy tax-deferred growth similar to an IRA. Unlike an IRA where withdrawals are taxable as ordinary income, withdrawals from nonretirement investment accounts are nontaxable. Instead, the sales of securities needed to produce the withdrawals are subject to capital gains. Assuming the securities that are sold have been held for at least a year, under current tax law, any gains, i.e., the excess of sale prices over purchase prices, will be taxed at favorable long-term capital gains rates which in most cases is 15%. To the extent that there is a loss on any sale, it can be offset against capital gains from other sales. Total capital losses in any year are deductible to the extent of capital gains plus an additional $3,000, with any net excess losses carried forward to future years. The availability of existing capital loss carryovers makes this alternative plan even more attractive (See last week’s post, Sizeable Capital Loss Carryover? Rethink Your Retirement Plan Contributions).

Even though a nondeductible nonretirement investment account plan may be preferable to a deductible IRA plan in certain situations, there is greater discipline associated with implementing and maintaining the former plan. Unlike a deductible IRA plan, the absence of the incentive of an annual tax deduction associated with a nonretirement plan generally requires an automatic contribution plan to be in place to ensure that regular contributions are made to the plan each year.