Also, long-term capital gains will be charged an extra 3.8% surtax earmarked for Medicare.
Jumping from a 15% to a total 23.8% take essentially means that America's wealthiest are seeing a nearly 60% rise in long-term capital-gains taxes this year. A sobering fact that explains why Chris Zander, chief wealth advisory officer of Evercore Wealth Management in New York City, says that "taxpayers must think differently now than they did in prior years."
With that in mind, we asked four experts for some year-end ideas to bring up with your advisors:
Dan Schrauth, JPMorgan Private Bank
Giving to charity is one of the year's biggest plays. "Last year, clients were focused on gifting to utilize the available gift-tax exemption of $5 million for an individual and $10 million for a couple," says Schrauth, a wealth advisor at JPMorgan Private Bank who specializes in ultrahigh-net-worth clients. This year, with the higher taxes firmly in place, clients are poring over the nonprofit sector, trying to find new and effective ways to minimize their taxes with charitable donations.Schrauth says that those who don't have charity fatigue after all they did last year, and who hold an appreciated asset, should consider gifting it to a donor-advised fund -- charitable vehicles, preapproved by the Internal Revenue Service. The biggest are run by Fidelity and Schwab. (See our related trust article, "A Donor-Advised Fund For You".)
"If a client had a big taxable event during 2013," says Schrauth, who has offices in San Francisco and Palo Alto, "this would be the perfect year to offset that tax liability with a meaningful charitable donation to a donor-advised fund." Basically, you make a gift to the fund, which then passes that present to a charity.
More clients are using such funds in lieu of private family foundations, he says, because they are easier to maintain and a person can contribute illiquid investments to them and get a charitable income-tax deduction based on the fair-market value of the assets. The kind of illiquid assets that get the higher fair-market-value tax deduction, in this scenario include hedge funds, private-equity funds, and interests in companies that aren't publicly traded.
That's significant, says Schrauth, because "a similar contribution of an illiquid asset to a private foundation would allow the donor to get a deduction only equal to the asset's basis," generally defined as the donor's acquisition price, plus any related purchasing costs.
The downside of a donor-advised fund is that you can't direct its investment strategy, as you can with a family foundation. A family foundation can invest in a cherry-picked hedge fund, which might not be possible through a donor-advised fund. In addition, individuals don't have total control over the gift made by a donor-advised fund. You can recommend a gift to your alma mater, but it's harder to target a specific research project at its medical school.
There's also a nice play -- but one that is expiring this year -- if you have stock in a so-called qualified small business. The holding must have been acquired at original issuance and be a direct investment in a company that is structured as a C Corp; it must also be an active business and have gross assets that don't exceed $50 million at the time of issuance.
"If the taxpayer holds the stock for a period of time and later sells it, under the most ideal scenario, he or she will pay no cap-gains taxes at the federal level on up to $10 million of gain," says Schrauth, who advises a lot of Silicon Valley investors.
This tax holiday is effective for qualified small-business stock acquired from Sept. 28, 2010, through Dec. 31, 2013, but the position must be held for at least five years to count. If the acquisition is made in 2014 or beyond, you will effectively pay a 14% tax on the first $10 million in gains on any of the qualifying investments, but that's still pretty good. There's also a rollover available. Holders for at least six months of the small-business stock that qualifies can defer an unlimited gain, if the proceeds of the sale are reinvested within 60 days in another qualified small-business stock.
"If you are an investor who is thinking of making an imminent investment in a qualified small-business stock, be sure to make it before the end of 2013 versus Jan. 1, 2014, or later," the advisor urges.
Allison Shipley, PwC
For those in the top tax brackets, municipals are often more attractive than taxable bonds because the latter get hit with an extra tax, notes Shipley, a Miami-based principal at the PwC accounting firm. Taxable bonds, but not munis, are subject to the Medicare-related 3.8% net investment income tax. This often helps make the muni-bond yield significantly higher than the after-tax yield of the taxable bond.Shipley also advises a judicious culling of portfolio losses. If you hold bonds that have fallen in value, typically due to rising interest rates, consider selling them through a swap, harvesting losses that can lower your tax bill. "If you do not repurchase the same bond, but purchase a different bond with similar attributes, it will not be considered a wash sale," she says.
A wash sale, you will recall, is the IRS-frowned-upon sale of a loss-making security to capture the tax-loss benefits, only to repurchase the same security at the lower price at some nearby date.
So the key to a successful maneuver for tax purposes is to buy a different bond, but with attributes and duration similar to those of the paper you are selling. "This way, you are not changing the basic nature of your overall investment portfolio, but it will reduce your net taxable capital gains," says Shipley. "Of course, if you are already in a net-loss position, this is no help for you."
Shipley is also advising clients to minutely pore over their business holdings, looking for active investments. The benefit? "While passive investments are subject to the net investment income tax, that is not the case for active investments," she points out. People should review what business activities they have, and whether those businesses might qualify as active businesses, in which case, they will not be subjected to the 3.8% tax.
The rules defining what are active and passive investments are complex, determined by several tests. If an individual spends more than 500 hours on a business activity in a given year, then he or she is deemed to materially participate in that business, and income from that business is considered active and not subject to the additional 3.8% tax.
Divide your time among multiple ventures? Don't despair. There are ways you, too, can organize your affairs to lower your tax bill. Hours devoted to various businesses can be aggregated and collectively qualify as active investments, if the taxpayer is careful to pool similar businesses into an intellectually justifiable grouping. In certain circumstances this aggregating also can apply to those who invest a lot in real-estate deals, claims Shipley.
Of course, the IRS would not be the IRS if it did not also require a good paper trail, documenting why you are qualified to sidestep the Medicare surtax. "When you file your return in April, you will need to attach that grouping election with your tax return," says Shipley.
Chris Zander, Evercore Wealth Management
Families sitting on nongrantor trusts, in which the trust income is taxable, should get into gear before the end of the year, says Zander, chief wealth advisory officer at Evercore, a New York City firm. That's because any trust income above $11,950 gets hit with the highest federal rate of 39.6%, plus the 3.8% Medicare tax, and state income taxes are piled on top of that. And it's the same problem for capital gains inside the trust: Income over $11,950 will be taxed at 23.8% (20%, plus the 3.8% Medicare tax), again not including whatever morsels your state is going to grab.What's a family to do? If the trustee has the power to distribute income to beneficiaries, this probably is the year to do so, provided the beneficiaries are at a lower tax rate.
The tax profile of the trust and the beneficiary must be studied, to make sure the move makes sense, and it can get delicate if you start piling income on young family members before they can handle it. "On the nonfinancial side, be sure that the distribution to the beneficiary makes sense and saves taxes for the family," Zander comments.
Tracy Green, Wells Fargo Advisors
You may possibly, if the stars are aligned, reduce current taxes and potentially lessen future ones, says Green, a vice president and financial planning specialist with Wells Fargo's Tax and Financial Planning Team in St. Louis.In particular, individuals who have flexibility on when they can receive certain income payments should consider timing them. Self-employed folks will, for example, want to look closely at their expected income and expenses in the coming years. Analyze, with your advisor, whether you should accelerate or defer certain income or expenses to control your taxable income in 2013–and possibly thereafter.
Let's assume the legally mandated minimum distributions from IRAs are increasing the tax liability of someone 70½ years of age or older. Green urges they check out the "qualified charitable distribution" benefit, which allows pensioners to make up to a $100,000 donation directly from their IRAs to charities of their choice.
"The distribution still counts toward the required minimum distribution but will not be included in their adjusted gross income," says Green. Because the individual retirement account distributions are excluded from the septuagenarian's adjusted gross income, the move might even help keep his or her income below the $200,000 threshold when a 0.9% Medicare tax kicks in for single filers.
Too young to qualify? Consider reducing income by contributing the maximum possible to 401(k) plans, IRAs or SEP-IRAs ( a hybrid between a pension fund and an IRA.) Taxpayers who are 50 or older can also take advantage of catch-up contributions of up to $5,500 for several qualified retirement plans, including 401(k)s.
The limit on annual contributions to an IRA has risen to $5,500, plus a $1,000 catch-up. But be smart. "When considering whether or not to defer income, you will need to determine whether the tax savings is more important than the benefits of receiving and enjoying a higher income this year," Green says.
There is, after all, nothing so dumb as a tax dodge that leads to a lesser quality of life.
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