Steve Parrish for Forbes writes: Are you having a good year? If so, that means the IRS is having a
good year too. This is a year when taxes are up, and tax planning is
more important than ever.
I had the honor of addressing a top notch group of attorneys,
accountants and financial advisors last week; and, in my talk I asked
the group, “Why are we hearing so much talk from clients about the 3.8%
Medicare surtax?”
Their answer was what I was expecting: “Because it IS a
big deal!” In a column earlier this summer
I discussed the tax and its implications. Since that time, I’ve
received a lot of questions on how to avoid this dreaded tax. So, let me
offer some straightforward suggestions.
As a reminder, here is how the tax works. If a married couple
filing jointly has net investment income (NII), the 3.8% is applied to
that NII to the extent they have modified adjusted gross income (MAGI)
over a threshold of $250,000. The threshold for a person filing single
is $200,000. Let’s say the married couple has a total of $300,000 MAGI
and $75,000 NII. Only $50,000 of their $75,000 NII will be subject to
the tax, because that is the amount which exceeds the $250,000 MAGI
threshold. They would have a Medicare Surtax of $1,900 ($50,000 times
3.8%).
The question at hand, however, is how can they avoid this tax? At the
aforementioned meeting, one attorney suggested that in the current tax
environment taxpayers should employ “burping” their income below tax
thresholds. The idea is that if the taxpayer can discharge some income
at certain levels, it avoids an accelerated build-up of further taxes.
This analogy can apply to various triggers in the tax code, but is
particularly appropriate to the Medicare surtax. Despite the complexity
of this 3.8% surtax, there are two basic ways to “burp” income to reduce
or avoid this tax: 1) reduce income (MAGI) below the threshold, or 2)
reduce the amount of NII that is subject to the tax.
Reduce Your Overall Income
If you are an employee of your company, you can direct some of your earned income to a qualified retirement plan
to reduce your taxable income. You can: 1) increase your contribution
to your 401(k) plan, 2) add dollars to the plan as part of a catch-up
contribution (if you’re age 50 or older) or 3) create a new qualified
plan. These pre-tax contributions lower the amount of wages that are
counted in MAGI.
Similarly, you can direct wages to a nonqualified deferred compensation plan.
This too reduces current taxable compensation. A caveat: this must be
set up in advance, and if your business is a “flow through” tax entity
(for example an S Corp or LLC), some of what you defer from wages will
appear in your owner share of earnings. MAGI would include those
earnings.
Spread out capital gains from a sale of company
stock or other business assets. With some tax modeling, it may be
possible to calculate how to spread out payments such that you keep
income below the threshold. In the example above where the couple’s MAGI
is projected to be $300,000, they might arrange a pending sale so that
they are spreading out capital gains over future years. They could
design the sale such that their income in the current year is now less
than $250,000; and, thereby they avoid having to worry about the tax.
Invest in tax free or tax deferred instruments. The
income derived from financial instruments can be the culprit in driving
taxable income over the MAGI threshold. If the income, however, is
coming from municipal bonds, deferred annuities or the growth of cash
value in a life insurance policy, such income is potentially not subject
to current inclusion in income.
Reduce Your Net Investment Income Even if your income is above the MAGI threshold, the 3.8% tax can be
lowered or eliminated by reducing the amount that it characterized as
net investment income.
Re-characterize income. Working with tax advisors,
you may be able to re-characterize some forms of income. For example,
with proper planning, what otherwise would be characterized as passive
income from a business (and therefore treated as NII), may be structured
to constitute wages (and not subject to the 3.8% tax).
Spread out capital gains. If this sounds like the
same idea as above … it is. Spreading out capital gains not only lowers
the income measured for the MAGI threshold, but also lowers your
investment income actually subject to the tax in any one year. Keep this
in mind if you’re planning to sell some of your company stock in the
near future.
Make gifts. Gifting doesn’t make income taxes go
away, but it may help avoid the 3.8% surtax. If you gift an appreciated
asset, upon sale of that asset, the gain is taxed to the donee, not you.
The 3.8% Medicare surtax is complex. The tax strategy is not.
Keep income below the threshold and/or limit the income that is subject
to the tax. Call it burping or call it tax modeling – it still saves
being subject to the dreaded tax.
Kailin Liu for Morningstar writes: Investing in a 529 college-savings plan allows you a significant break on your federal taxes:
tax-free compounding and withdrawals, provided the money is used for
qualified college expenses. Most 529 plans also offer some sort of a
state tax break on contributions by in-state residents, usually a
deduction but sometimes a credit.
There are no one-size-fits-all answers about whether to stay with
your home state's plan or pursue one of the best plans available
nationally. To reach a good decision, you'll need to weigh how much
you're saving in taxes by staying in-state alongside the potential costs
you'll incur if you invest in a subpar plan.
Understanding Your State Tax Break To reach a sound decision, the starting point is to find out
just what kind of a tax break your state offers 529 savers--or doesn't. Usually, investors in 529 plans can deduct at least a portion of
their contribution amount from their state income taxes if they invest
in their own state's plan. Naturally, state tax benefits associated with
529 plans depend on where the investor lives. Some states offer quite
generous 529-related tax benefits, while others offer no benefits at
all. In general, state tax benefits for 529s can be aggregated into a
few different buckets, listed below. Some states don't follow these
patterns (for instance, they offer a tax credit instead of a deduction),
but these cases are few and far between.
No tax benefits: Some
states offer no tax benefits for investing in a 529 plan. This can
either mean that the state offers no tax deductions for 529 savings or
that the state does not collect any income tax at all. The following
states offer no tax benefits for investing in a 529 plan.
States With No Tax Benefits
Alaska
California
Delaware
Florida
Hawaii
Indiana
Kentucky
Massachusetts
Minnesota
Nevada
New Hampshire
New Jersey
South Dakota
Tennessee
Texas
Utah
Source:
Morningstar
Tax parity:Tax
parity is an interesting inversion of a state having no tax benefits.
In this instance, the states are aiming to give their residents the
incentive to save for college, period, rather than the incentive to
invest in their home state's 529 plan. States that offer tax parity
provide state income tax benefits for resident 529 savers regardless of
which state's 529 they use. This means that a resident of Missouri (one
of the tax parity states) can invest in a 529 plan in Virginia while
still collecting Missouri's state income tax deductions for 529 savers.
States With Tax Parity
Arizona
Kansas
Maine
Missouri
Pennsylvania
Source:
Morningstar
Low tax benefits: A few
states offer income tax deductions for 529 savings but cap those
deductions at $1,000 or less. This means investors can deduct only the
first $1,000 they invest in their state's 529 plan. Any contribution
higher than that amount is not tax-deductible.
Low Tax Benefits
State
State Tax-Deduction Limit (Joint Filing)*
State Tax-Deduction Limit (Individual Filing)*
State Income Cap for Deduction (Joint)*
State Income Cap for Deduction (Individual)*
State Tax-Deduction Basis
Maine
250
250
200,000
100,000
Per Beneficiary
Vermont
500
250
--
--
Per Beneficiary
Rhode Island
1,000
500
--
--
Per Taxpayer
Source:
Morningstar
* Numbers in dollars
Medium tax benefits:These states offer income tax deductions of between $1,000 and $10,000.
Medium Tax Benefits
State
State Tax-Deduction Limit (Joint Filing)*
State Tax-Deduction Limit (Individual Filing)*
State Income Cap for Deduction (Joint)*
State Income Cap for Deduction (Individual)*
State Tax-Deduction Basis
Arizona
1,500
750
--
--
Per Taxpayer
Ohio
2,000
2,000
--
--
Per Beneficiary
Georgia
2,000
2,000
--
--
Per Beneficiary
Maryland
2,500
2,500
--
--
Per Beneficiary
Wisconsin
3,000
3,000
--
--
Per Beneficiary
Virginia
4,000
4,000
--
--
Per Account
Oregon
4,345
2,170
--
--
Per Taxpayer
Louisiana
4,800
2,400
--
--
Per Beneficiary
Nebraska
5,000
5,000
--
--
Per Taxpayer
North Carolina
5,000
2,500
100,000
60,000
Per Taxpayer
Montana
6,000
3,000
--
--
Per Taxpayer
Kansas
6,000
3,000
--
--
Per Beneficiary
Iowa
6,090
3,045
--
--
Per Beneficiary
Dist. of Columbia
8,000
4,000
--
--
Per Taxpayer
Source:
Morningstar
* Numbers in dollars
High tax benefits:These states offer income tax deductions of $10,000 and higher (generally the plan's contribution limit).
High Tax Benefits
State
State Tax-Deduction Limit (Joint Filing)*
State Tax-Deduction Limit (Individual Filing)*
State Income Cap for Deduction (Joint)
State Income Cap for Deduction (Individual)
State Tax-Deduction Basis
Arkansas
10,000
5,000
--
--
Per Taxpayer
Alabama
10,000
5,000
--
--
Per Taxpayer
Michigan
10,000
5,000
--
--
Per Taxpayer
North Dakota
10,000
5,000
--
--
Per Taxpayer
Connecticut
10,000
5,000
--
--
Per Taxpayer
New York
10,000
5,000
--
--
Per Taxpayer
Missouri
16,000
8,000
--
--
Per Taxpayer
Illinois
20,000
10,000
--
--
Per Taxpayer
Oklahoma
20,000
10,000
--
--
Per Taxpayer
Mississippi
20,000
10,000
--
--
Per Taxpayer
Pennsylvania
28,000
14,000
--
--
Per Beneficiary
West Virginia
265,620
265,620
--
--
Per Beneficiary
New Mexico
294,000
294,000
--
--
Per Beneficiary
South Carolina
318,000
318,000
--
--
Per Taxpayer
Colorado
350,000
350,000
--
--
Per Taxpayer
Source:
Morningstar
* Numbers in dollars
Case Study: The Buchanans To help model the trade-offs of staying with a home-state 529
versus pursuing an out-of-state plan, we'll use one family, the
Buchanans, as an example. Let's assume that Daisy and Tom Buchanan have a
combined household income of $500,000 and a state income tax rate of
10%. They will save $25,000 in their 529 account this year. We also
assume that the Buchanans invested in an age-based option and that the
best-performing age-based options did not outperform the
worst-performing age-based options by more than 5 percentage points.
First, the no brainer: If the Buchanans' state has no state tax
benefits for 529 investors or offers tax parity--meaning that they can
obtain a tax benefit even if they invest outside of their home state's
plan--they are free to pick from the best 529 plans in the country. (Click here for a list of top-rated 529 plans. )
If their state does offer tax benefits for investing in-state,
before investing elsewhere it's important for them to quantify the
magnitude of forgone tax benefits against potentially better performance
in another plan. The amount of forgone tax benefits depends on a
household's state income tax level, the amount they intend to invest,
and their state's income-tax-deduction limit. (See charts above.) Those
who would leave a substantial chunk of change (relative to their total
assets) on the table may want to stay put, while those who won't lose
much money by going out of state may find a better deal elsewhere. It's
important to note that if the in-state option is of average or better
quality, it becomes very difficult to make up the lost tax savings by
pursuing another plan.
For instance, if the Buchanans live in a state with a $10,000
deduction limit, they would leave at least $1,000 (their 10% state
income tax rate times $10,000) on the table by investing out of state.
Given their $25,000 investment, passing on $1,000 is like waving goodbye
to an automatic 4% boost to returns, which will be difficult to make up
even in the strongest plan available nationwide. (Note that the
performance differential between the top and bottom deciles of age-based
options up to age 18 has been around 2 to 5 percentage points during
the trailing three-year period). However, if the Buchanans live in a
state with only a $1,000 deduction limit, they would only forgo $100 in
tax savings (10% of the $1,000 limit) by investing outside of their
state's plan, which adds up to only 0.40% of their $25,000 asset base.
It's much more likely that they can make up 0.40% in one of the nation's
strongest plans via better performance or lower fees. Individual
households can follow this framework to crunch the numbers for their
unique situations.
"The government policies designed to make college more
affordable could be creating market frictions which enable investment
firms to charge excess fees," Bogan said, adding that federal regulation
may be needed "to preclude financial management companies from
appropriating the benefits intended for individuals."
Bogan's analysis will appear in a forthcoming issue of the journal Contemporary Economic Policy.
In the early 2000s, Section 529 of the Internal Revenue Code was
amended to create investment plans that would encourage parents to save
for their children's education. As a result almost every state offers
"529 plans" that allow parents to deduct contributions from their state income tax. Like 401(k) retirement plans, 529 plans usually invest in a group of mutual funds.
Analyzing data from 2002 to 2006, Bogan found that the greater the
tax advantage a state offered, the higher the fees charged by investment
managers, even after controlling for such factors as the amount of
competition in a state and the administrative structure of the plan. The
statistics support an assertion that investment management companies
set their fees based on the amount of tax saving offered by the state,
she said. And if the state is receiving a share of the fees charged by
plan administrators, Bogan added, it has an incentive not to regulate
those fees, creating a "moral hazard risk."
Bogan offers the example of parents investing $10,000 a year in a
typical plan, starting when a child is born. Tax savings will amount to
around $500 a year, depending on the investor's federal tax
bracket, and the parents would invest that money back in the plan. But
fees – based on the growing value of the fund – will quickly reach $585 a
year. "By year four or five…the annual asset-based fees completely
cannibalize the state taxable income benefit," Bogan reported. At the
end of 18 years, the 529 fund could be worth thousands less than an
ordinary mutual fund, depending on the fees charged.
"Households would be well advised to educate themselves about each
specific educational savings plan prior to investing," Bogan concluded.
"The government policies designed to make college more
affordable could be creating market frictions which enable investment
firms to charge excess fees," Bogan said, adding that federal regulation
may be needed "to preclude financial management companies from
appropriating the benefits intended for individuals."
Bogan's analysis will appear in a forthcoming issue of the journal Contemporary Economic Policy.
In the early 2000s, Section 529 of the Internal Revenue Code was
amended to create investment plans that would encourage parents to save
for their children's education. As a result almost every state offers
"529 plans" that allow parents to deduct contributions from their state income tax. Like 401(k) retirement plans, 529 plans usually invest in a group of mutual funds.
Analyzing data from 2002 to 2006, Bogan found that the greater the
tax advantage a state offered, the higher the fees charged by investment
managers, even after controlling for such factors as the amount of
competition in a state and the administrative structure of the plan. The
statistics support an assertion that investment management companies
set their fees based on the amount of tax saving offered by the state,
she said. And if the state is receiving a share of the fees charged by
plan administrators, Bogan added, it has an incentive not to regulate
those fees, creating a "moral hazard risk."
Bogan offers the example of parents investing $10,000 a year in a
typical plan, starting when a child is born. Tax savings will amount to
around $500 a year, depending on the investor's federal tax
bracket, and the parents would invest that money back in the plan. But
fees – based on the growing value of the fund – will quickly reach $585 a
year. "By year four or five…the annual asset-based fees completely
cannibalize the state taxable income benefit," Bogan reported. At the
end of 18 years, the 529 fund could be worth thousands less than an
ordinary mutual fund, depending on the fees charged.
"Households would be well advised to educate themselves about each
specific educational savings plan prior to investing," Bogan concluded.
"The government policies designed to make college more
affordable could be creating market frictions which enable investment
firms to charge excess fees," Bogan said, adding that federal regulation
may be needed "to preclude financial management companies from
appropriating the benefits intended for individuals."
Bogan's analysis will appear in a forthcoming issue of the journal Contemporary Economic Policy.
In the early 2000s, Section 529 of the Internal Revenue Code was
amended to create investment plans that would encourage parents to save
for their children's education. As a result almost every state offers
"529 plans" that allow parents to deduct contributions from their state income tax. Like 401(k) retirement plans, 529 plans usually invest in a group of mutual funds.
Analyzing data from 2002 to 2006, Bogan found that the greater the
tax advantage a state offered, the higher the fees charged by investment
managers, even after controlling for such factors as the amount of
competition in a state and the administrative structure of the plan. The
statistics support an assertion that investment management companies
set their fees based on the amount of tax saving offered by the state,
she said. And if the state is receiving a share of the fees charged by
plan administrators, Bogan added, it has an incentive not to regulate
those fees, creating a "moral hazard risk."
Bogan offers the example of parents investing $10,000 a year in a
typical plan, starting when a child is born. Tax savings will amount to
around $500 a year, depending on the investor's federal tax
bracket, and the parents would invest that money back in the plan. But
fees – based on the growing value of the fund – will quickly reach $585 a
year. "By year four or five…the annual asset-based fees completely
cannibalize the state taxable income benefit," Bogan reported. At the
end of 18 years, the 529 fund could be worth thousands less than an
ordinary mutual fund, depending on the fees charged.
"Households would be well advised to educate themselves about each
specific educational savings plan prior to investing," Bogan concluded.
The final value of a college savings plan depends on management
fees. Parents purchasing a mutual fund portfolio for a newborn child and
investing $10,000 each year until the child starts college (18 years)
would finally have almost $415,000 …more
(Phys.org) —Government efforts to make it easier to save for
college have unintended consequences, according to a Cornell economist.
When you get a tax deduction for contributing to a college savings plan,
your savings may be more than consumed by higher fees charged by plan
administrators, according to research by Vicki Bogan, associate
professor in the Charles H. Dyson School of Applied Economics and
Management. Parents may be better off putting their money in ordinary,
non-tax-exempt investments, she suggested.
"The government policies designed to make college more
affordable could be creating market frictions which enable investment
firms to charge excess fees," Bogan said, adding that federal regulation
may be needed "to preclude financial management companies from
appropriating the benefits intended for individuals."
Bogan's analysis will appear in a forthcoming issue of the journal Contemporary Economic Policy.
In the early 2000s, Section 529 of the Internal Revenue Code was
amended to create investment plans that would encourage parents to save
for their children's education. As a result almost every state offers
"529 plans" that allow parents to deduct contributions from their state income tax. Like 401(k) retirement plans, 529 plans usually invest in a group of mutual funds.
Analyzing data from 2002 to 2006, Bogan found that the greater the
tax advantage a state offered, the higher the fees charged by investment
managers, even after controlling for such factors as the amount of
competition in a state and the administrative structure of the plan. The
statistics support an assertion that investment management companies
set their fees based on the amount of tax saving offered by the state,
she said. And if the state is receiving a share of the fees charged by
plan administrators, Bogan added, it has an incentive not to regulate
those fees, creating a "moral hazard risk."
Bogan offers the example of parents investing $10,000 a year in a
typical plan, starting when a child is born. Tax savings will amount to
around $500 a year, depending on the investor's federal tax
bracket, and the parents would invest that money back in the plan. But
fees – based on the growing value of the fund – will quickly reach $585 a
year. "By year four or five…the annual asset-based fees completely
cannibalize the state taxable income benefit," Bogan reported. At the
end of 18 years, the 529 fund could be worth thousands less than an
ordinary mutual fund, depending on the fees charged.
"Households would be well advised to educate themselves about each
specific educational savings plan prior to investing," Bogan concluded.
"The government policies designed to make college more
affordable could be creating market frictions which enable investment
firms to charge excess fees," Bogan said, adding that federal regulation
may be needed "to preclude financial management companies from
appropriating the benefits intended for individuals."
Bogan's analysis will appear in a forthcoming issue of the journal Contemporary Economic Policy.
In the early 2000s, Section 529 of the Internal Revenue Code was
amended to create investment plans that would encourage parents to save
for their children's education. As a result almost every state offers
"529 plans" that allow parents to deduct contributions from their state income tax. Like 401(k) retirement plans, 529 plans usually invest in a group of mutual funds.
Analyzing data from 2002 to 2006, Bogan found that the greater the
tax advantage a state offered, the higher the fees charged by investment
managers, even after controlling for such factors as the amount of
competition in a state and the administrative structure of the plan. The
statistics support an assertion that investment management companies
set their fees based on the amount of tax saving offered by the state,
she said. And if the state is receiving a share of the fees charged by
plan administrators, Bogan added, it has an incentive not to regulate
those fees, creating a "moral hazard risk."
Bogan offers the example of parents investing $10,000 a year in a
typical plan, starting when a child is born. Tax savings will amount to
around $500 a year, depending on the investor's federal tax
bracket, and the parents would invest that money back in the plan. But
fees – based on the growing value of the fund – will quickly reach $585 a
year. "By year four or five…the annual asset-based fees completely
cannibalize the state taxable income benefit," Bogan reported. At the
end of 18 years, the 529 fund could be worth thousands less than an
ordinary mutual fund, depending on the fees charged.
"Households would be well advised to educate themselves about each
specific educational savings plan prior to investing," Bogan concluded.
Government efforts to
make it easier to save for college have unintended consequences,
according to a Cornell economist. When you get a tax deduction for
contributing to a college savings plan, your savings may be more than
consumed by higher fees charged by plan administrators, according to
research by Vicki Bogan, associate professor in the Charles H. Dyson
School of Applied Economics and Management. Parents may be better off
putting their money in ordinary, non-tax-exempt investments, she
suggested.
Government efforts to
make it easier to save for college have unintended consequences,
according to a Cornell economist. When you get a tax deduction for
contributing to a college savings plan, your savings may be more than
consumed by higher fees charged by plan administrators, according to
research by Vicki Bogan, associate professor in the Charles H. Dyson
School of Applied Economics and Management. Parents may be better off
putting their money in ordinary, non-tax-exempt investments, she
suggested.
Government efforts to
make it easier to save for college have unintended consequences,
according to a Cornell economist. When you get a tax deduction for
contributing to a college savings plan, your savings may be more than
consumed by higher fees charged by plan administrators, according to
research by Vicki Bogan, associate professor in the Charles H. Dyson
School of Applied Economics and Management. Parents may be better off
putting their money in ordinary, non-tax-exempt investments, she
suggested.
Government efforts to
make it easier to save for college have unintended consequences,
according to a Cornell economist. When you get a tax deduction for
contributing to a college savings plan, your savings may be more than
consumed by higher fees charged by plan administrators, according to
research by Vicki Bogan, associate professor in the Charles H. Dyson
School of Applied Economics and Management. Parents may be better off
putting their money in ordinary, non-tax-exempt investments, she
suggested.
