Tax Planning Ideas for 2013

Elaine E. Bedel, CFP® @ Bedel Financial Consulting, Inc. offers some Tax Planning Ideas for 2013.  She writes:  Recent legislation has increased the tax that many investors will pay on their investment earnings.  In order to reduce the impact, the earlier you implement certain strategies, the better.  The new taxes on investment income will reduce the benefit you have received in the past for investing in individual stocks and bonds, mutual funds, and real estate, as well as the interest you have been paid on the personal loans made to others.  There are several strategies that you can consider to lower the impact of the new tax provisions. However, to accomplish these strategies, it will be necessary to start early. 

New Investment Taxes

There are two tax laws that have increased the tax you will pay on your net investment income in 2013.  Investment income, also referred to as “unearned” income, includes interest, dividends, long- and short-term capital gains, rents, annuities, royalties, and any income from passive activities.

      The Patient Protection and Affordability Care Act (PPACA) of 2010 included a new 3.8% Medicare contribution tax that will be imposed on investment income beginning this year.  This is in addition to the ordinary income or capital gains tax that investment income is already subject to.  This additional tax of 3.8% will apply to single filers with adjusted gross income of $200,000 ($250,000 for joint filers).

·     Tax on investment income was further impacted by the American Taxpayer Relief Act (ATRA) passed on January 1^st that increased the long-term capital gain tax rate from 15% to 20% for single taxpayers with taxable income of $400,000 ($450,000 for joint filers).

Tax Reducing Strategies

1.   Investment Income Not Subject to New Tax:  If appropriate for your overall planning, you can consider investing in areas that are exempt from the new Medicare contribution tax.

·    Tax-exempt Income:  Tax-exempt income is not subject to the new 3.8% tax.  You earn tax-exempt income by investing in municipal bonds that are issued by a state, city, or other municipality.

·     IRA and Qualified Plan Distributions:  Any distribution taken from an IRA, 401k, 403b, or other qualified retirement plan is specifically exempt from the new 3.8% tax. This means that no portion of your retirement income will be subject to any investment tax.

2.       Manage Capital Gain: Since capital gain will be subject to the higher rate of 20% for some investors as well as the additional 3.8%, managing the creation of capital gain while still meeting your personal investment objectives will require careful planning. The strategies below should be considered where appropriate.

·         Installment Sale.  If you anticipate selling property, consider an installment sale that will spread the realized capital gain over the purchase period.  You pay tax on the capital gain in the year that you receive sale proceeds.  This may allow you to maintain an income level under the thresholds that trigger the higher 20% capital gains tax as well as the new 3.8% additional tax.  However, this strategy may not be appropriate if the total amount of the sale proceeds is needed immediately or if there is a concern regarding the credit worthiness of the buyer.

·         Property Swap.  A section 1031 real estate transaction allows you to trade your property for another. Any capital gain in your original property is transferred to the newly acquired property, allowing you to defer any capital gains tax until the newly acquired property is sold, perhaps when your overall income is below the thresholds.  This type of a transaction is not appropriate if you desire to receive cash versus owning other property.

·         Gift Appreciated Assets. 

o    To Charity: You do not pay capital gains tax on appreciated property, such as shares of individual stock, mutual fund units, artwork, or real estate, that is donated to a charity. Therefore, if you plan to gift cash to your favorite charity, it would be more beneficial to gift appreciated assets instead.  You receive a charitable tax deduction based on the fair market value and you avoid paying any tax on the asset’s capital gain.

o    To Family: If you gift an appreciated asset to other family members or others, the new owner will maintain your cost basis.  This means that the new owner will pay the capital gain based on what you originally paid for the asset. This strategy would be appropriate if the new owner has less income and may not be subject to the 3.8% additional tax or the higher 20% capital gains tax.

·         Permanently Avoid Capital Gain.  Any property that is inherited gets a “step up” in cost basis for the new owner. This means when the new owner sells the property, the cost basis is equal to the fair market value when inherited. By passing appreciated assets to others through your estate, any capital gain in the property is totally and permanently avoided.

·         Offset Capital Gains with Capital Losses.  Prior to year-end, review your portfolio and if you have realized any gains from selling investments during the year, consider selling investments that are trading at a loss.  The loss offsets the gain and avoids the capital gain tax as well as the 3.8% additional tax.

·         Charitable Remainder Trust (CRT).  CRTs provide income to the donor for a period of time and the proceeds to a charity at the end of the period. You can contribute appreciated assets to a CRT; sell the assets within the CRT; and avoid paying the capital gains tax. The income distributed to the donor is taxable, but will be spread over a specific period or the life of the donor.  A charitable deduction is also received by the donor in the year the CRT is funded. If you have a desire to benefit a charity while continuing to receive income, this vehicle should be considered.   

3.       Reduce Taxable Income:  The higher capital gains tax and the additional investment income tax of 3.8% are only applicable if your income exceeds certain thresholds.  Therefore, if you can reduce the income that is subject to tax, you may be able to remain under the thresholds.

·         Maximize Retirement Plan Contributions. By maximizing pre-tax contributions to an employer retirement plan (401k, 403b), a self-employed plan (Keogh, SEP, Solo 401k), or a deductible IRA, you will reduce your taxable income.  Lowering your taxable income may allow you to remain under the thresholds, so that your investment earnings from non-retirement portfolios may avoid the additional investment tax.  

·         Gift Income Producing Property.  If income is not needed and the value of the property is not necessary for your future financial security, you may consider gifting income producing property to other family members whose income is below the thresholds.

·         IRA Charitable Distribution.  If you are over 70 ½ years of age, you are eligible to distribute up to $100,000 to a charity. Since a qualified charitable IRA distribution can be counted as all or a portion of your required minimum distribution, by using your IRA for any charitable contributions, you are reducing your taxable income. 

·         Tax Advantaged Investments.  Another way to reduce income is through investments that provide non-cash tax deductions, such as depreciation. For example, the depreciation claimed on a rental house will first reduce any income from the rental property, and then other passive income.