Karl W. Blovet & Associates

Tax Planning

2017 Tax Planning

 

Chances for tax reform this year are growing dimmer and dimmer. But tax planning is still an ongoing process. Your situation can change during the course of a year and you should react accordingly. Marriage, divorce, the birth of a child, death, a change in job, or loss of a job, and retirement are just some of the life events that trigger a special urgency for tax planning. Your marital status is determined on December 31. If you are married on December 31, you are considered married the entire year. If you were divorced on December 31, you will be considered single for the entire year.

Individual income tax brackets for 2017

They are only slightly wider than for 2016 because of mild inflation during the 12 month period from September 2015 through August 2016 that is used to determine the adjustments. Tax rates did not change.

Itemized deduction limitations

The write offs are slashed by 3% of the excess of AGI over $261,500 for singles, $287,650 for heads of households, and $313,800 for marrieds. The total reduction cannot exceed 80% of itemizations. Certain deductions are exempt from this provision.

Personal exemptions

Personal exemptions remain at $4,050 for filers and their dependents. The amount is phased out by 2% for each $2,500 of AGI over the same thresholds used for the itemized deduction phase out.

The 20% top rate for dividends and long term capital gains starts at a higher amount

Singles with taxable income above $418,400, household heads above $444,550, and joint filers above $470,700.

The rules regarding IRA rollovers have changed

Beginning in 2015, taxpayers may only make one IRA-to-IRA transfer in any twelve month period. However, trustee-to-trustee transfers between IRAs are not subject to this limitation. Rollovers from traditional IRAs to Roth IRAs are not limited.

Minimize tax on Social Security benefits

When Social Security recipient’s modified adjusted gross income (MAGI) plus 50% of Social Security benefits exceed certain base amounts, the benefits can be taxable. The MAGI thresholds are $25,000 for singles and $32,000 for marrieds filing jointly. If your income will be close to these thresholds you should consider deferring income, if possible, to avoid tax on the benefits.

Roth conversions

If you have not yet made a Roth conversion, doing so prior to year-end 2017 might be an opportunity worth serious consideration. Variables include your present income tax bracket, how close you are to retirement, and your access to other funds both to pay the conversion tax and to delay distributions from your Roth account later.

Maximize retirement plan opportunities

In 2017 you can contribute up to $18,000 to your 401(k), 403(b), and 457 plans if you are under age 50. If you will be age 50 by year end 2017 you can add an additional $6,000. If you are already on track to max out your contribution for the year, you may also qualify for a contribution to a traditional IRA or Roth IRA. The maximum contribution is $5,500, plus another $1,000 if you are age 50 or older by year end. If you are no longer contributing to a retirement account and instead getting ready to transition from working to retirement, now is an opportune time to determine which assets and benefits you will be drawing from, including establishing the timing of your distributions and determining when to begin receiving Social Security benefits.

Alternative Minimum Tax (AMT)

For 2017 the exemption amount for couples increased to $84,500 and $54,300 for singles and heads of household. The phase-out zones for the exemptions start at $160,900 for couples and $120,700 for singles and household heads. The exemption amounts and phase-out levels have been permanently adjusted for inflation.

Capital gain rates

Your capital gain rate depends on your tax bracket and the character of the gain. Therefore, the rate can be 0%, 15%, 20%, 25%, or 28%. There may also be a 3.8% net investment income (NII) tax levied on top of those rates. Now is a good time to review the current status of your capital assets (not exclusively, but primarily investable assets that would be subject to taxation if sold at a gain). Time the recognition of capital gains and losses during the year to minimize your net capital gains tax and maximize deductible capital losses. Many investors still have excess capital losses from past stock market declines that they may “carry over” to offset capital gains that would otherwise be taxable.

 Payroll taxes

For calendar year 2017, the employee-share of OASDI tax is 6.2 percent up to the Social Security wage base of $127,200 and the Medicare tax is 1.45% with an unlimited wage base.

Also, beginning on January 1, 2013 there is a 0.9% Medicare surtax on earned income and remains in effect for 2017. The surtax applies to wages and self-employment income.  It applies to single filers and heads of household when total earnings exceed $200,000 and $250,000 for married filing jointly taxpayers.  For earnings over the thresh-hold, the effective Medicare tax will be 3.8%, the usual 2.9% tax rate, plus an extra 0.9%.  The surtax only applies to the employee’s share of tax, employers do not owe the tax.

Casualty losses

Taxpayers in many states have already experienced natural disasters in 2017. A casualty loss can result from the damage, destruction or loss to your property from any sudden, unexpected or unusual event, such as a hurricane, tornado, earthquake, wildfire, or flood. Casualty losses are generally deductible in the year the casualty occurred, less ten percent of your adjusted gross income and a $100 per casualty deductible.

However, if you have a casualty loss from a federally declared disaster, you can elect to treat the loss as having occurred in the year immediately preceding the tax year in which the disaster happened, and you can deduct the loss on your return or amended return for that preceding tax year. The election gives taxpayers the opportunity to maximize their tax savings in the year in which the savings will be greatest.

Payroll withholding

If you have significant income, or will have, not subject to withholding in 2017 you should increase your payroll withholding for the remainder of the year to ensure that it covers the required estimated payments in order to avoid underpayment penalties.

Gift/estate tax

The current estate tax is set at a maximum 40 percent rate and a $5.49 million exemption amount, indexed for inflation. Lifetime gift-giving, ideally on an annual basis, should continue to form part of a master estate plan. The annual gift tax exclusion per donee on which no gift tax is due is $14,000 for 2017 with $28,000 allowed to each donee by married couples. Making a gift in 2017 to take advantage of this annual, per-donee exclusion should be considered by anyone with even modest wealth.

2015 Year-End Tax Planning

 

Tax planning works best when it is practiced year-round, which will reduce the stress at year end that often occurs at this time of the year. 2015 is not presenting any major new tax law changes. Although, as in recent prior years, particularly important at year-end 2015 is the impact of certain tax benefits that expired with 2014 and that may, or may not, be retroactively renewed.

Tax benefits that ended in 2014

Tax benefits that expired on December 31, 2014 include but are not limited to:

  • the state and local sales tax deduction,
  • exclusion of up to $2 million of forgiven debt on a debtor’s primary home,
  • the ability of those 70 ½ and older to make distributions of up to $100,000 annually from their IRAs to a charity

Income/deduction shifting

The traditional year-end strategy of income shifting applies to year-end 2015. Time your income and deductions so that your taxable income is about even for 2015 and 2016 so your tax bracket does not spike in either 2015 or 2016. If you anticipate a higher tax bracket for 2016, you may want to accelerate income into 2015 and defer deductions into 2016. If you anticipate a leaner 2016, income might be delayed through deferred compensation arrangements, postponing year-end bonuses, maximizing deductible retirement contributions, and delaying year-end billings.

Minimize tax on Social Security benefits

When Social Security recipient’s modified adjusted gross income (MAGI) plus 50% of Social Security benefits exceed certain base amounts, the benefits can be taxable. The MAGI thresholds are $25,000 for singles and $32,000 for marrieds filing jointly. If your income is close to these thresholds you should consider deferring income, if possible, to avoid tax on the benefits.

Roth conversions

If you initiated a Roth conversion earlier in 2015 and that Roth account has declined in value since then, you should consider a “Roth reconversion.” Reconverting your Roth IRA back to a traditional IRA before year-end will allow you to avoid paying income tax on an account balance at its higher value.

If you have not yet made a Roth conversion, doing so at year-end 2015 might be an opportunity worth serious consideration. Variables include your present income tax bracket, how close you are to retirement, and your access to other funds both to pay the conversion tax and to delay distributions from your Roth account later.

 

 

Alternative Minimum Tax (AMT)

The exemption amount for couples increased to $83,400 and $53,600 for singles and heads of household. The phase-out zones for the exemptions start at $158,900 for couples and $119,200 for singles and household heads.

Capital gains and losses

Time the recognition of capital gains and losses at year-end to minimize your net capital gains tax and maximize deductible capital losses. Many investors still have excess capital losses from past stock market declines that they may now “carry over” to offset capital gains that would otherwise be taxable.

Payroll taxes

For calendar year 2015, the employee-share of OASDI tax is 6.2 percent up to the Social Security wage base of $118,500 and the Medicare tax is 1.45% with an unlimited wage base.

 

Also, beginning on January 1, 2013 there is a 0.9% Medicare surtax on earned income.  The surtax applies to wages and self-employment income.  It applies to single filers and heads of household when total earnings exceed $200,000 and $250,000 for married filing jointly taxpayers.  For earnings over the thresh-hold, the effective Medicare tax will be 3.8%, the usual 2.9% tax rate, plus an extra 0.9%.  The surtax only applies to the employee’s share of tax, employers do not owe the tax.

Life changes

Marriage, divorce, the birth of a child, death, a change in job, or loss of a job, and retirement are just some of the life events that trigger a special urgency for year-end tax planning. Your marital status is determined on December 31. If you are married on December 31, you are considered married the entire year. If you were divorced on December 31, you will be considered single for the entire year.

Payroll withholding

If you have significant income not subject to withholding in 2015 you should increase your payroll withholding for the remainder of the year to ensure that it covers the required estimated payments in order to avoid underpayment penalties

 

Gift/estate tax

The current estate tax is set at a maximum 40 percent rate and a $5.43 million exemption amount, indexed for inflation. Lifetime gift-giving, ideally on an annual basis, should continue to form part of a master estate plan. The annual gift tax exclusion per donee on which no gift tax is due is $14,000 for 2015 with $28,000 allowed to each donee by married couples. Making a gift at year-end 2015 to take advantage of this annual, per-donee exclusion should be considered by anyone with even modest wealth.

 

Tax planning is an ongoing process. Your situation can change during the course of a year and you should react accordingly. Implementing mid-year strategies now may help you lessen the taxes you face for the entire year of 2015.

Life changes

Marriage, divorce, the birth of a child, death, a change in job, or loss of a job, and retirement are just some of the life events that trigger a special urgency for tax planning. Your marital status is determined on December 31. If you are married on December 31, you are considered married the entire year. If you were divorced on December 31, you will be considered single for the entire year.

The rules regarding IRA rollovers have changed

Beginning in 2015, taxpayers may only make one IRA-to-IRA transfer in any twelve month period. However, trustee-to-trustee transfers between IRAs are not subject to this limitation. Rollovers from traditional IRAs to Roth IRAs are not limited.

Minimize tax on Social Security benefits

When Social Security recipient’s modified adjusted gross income (MAGI) plus 50% of Social Security benefits exceed certain base amounts, the benefits can be taxable. The MAGI thresholds are $25,000 for singles and $32,000 for marrieds filing jointly. If your income will be close to these thresholds you should consider deferring income, if possible, to avoid tax on the benefits.

Roth conversions

If you have not yet made a Roth conversion, doing so prior to year-end 2015 might be an opportunity worth serious consideration. Variables include your present income tax bracket, how close you are to retirement, and your access to other funds both to pay the conversion tax and to delay distributions from your Roth account later.

Health care reform

Many individuals and their dependents without qualifying health insurance will owe a tax in 2015. Several exceptions apply, particularly for lower income families. The penalty is the greater of $325 for each adult and $162.50 for each family member under age 18 (but not to exceed $975) or 2% of household income less the amount of the taxpayer’s tax filing threshold.

Maximize retirement plan opportunities

In 2015 you can contribute up to $18,000 to your 401(k), 403(b), or 457 plans if you are under age 50. If you will be age 50 by year end 2015 you can add an additional $6,000. If you are already on track to max out your contribution for the year, you may also qualify for a contribution to a traditional IRA or Roth IRA. The maximum contribution is $5,500, plus another $1,000 if you are age 50 or older by year end. If you are no longer contributing to a retirement account and instead getting ready to transition from working to retirement, mid-year is an opportune time to determine which assets and benefits you will be drawing from, including establishing the timing of your distributions and determining when to begin receiving Social Security benefits.

Alternative Minimum Tax (AMT)

For 2015 the exemption amount for couples increased to $83,400 and $53,600 for singles and heads of household. The phase-out zones for the exemptions start at $158,900 for couples and $119,200 for singles and household heads. The exemption amounts and phase-out levels are now permanently adjusted for inflation.

Capital gain rates

Your capital gain rate depends on your tax bracket and the character of the gain. Therefore, the rate can be 0%, 15%, 20%, 25%, or 28%. There may also be a 3.8% net investment income (NII) tax levied on top of those rates. Mid-year is a good time to review the current status of your capital assets (not exclusively, but primarily investable assets that would subject to taxation if sold at a gain). Time the recognition of capital gains and losses during the year to minimize your net capital gains tax and maximize deductible capital losses. Many investors still have excess capital losses from past stock market declines that they may now “carry over” to offset capital gains that would otherwise be taxable.

Payroll taxes

For calendar year 2015, the employee-share of OASDI tax is 6.2 percent up to the Social Security wage base of $118,500 and the Medicare tax is 1.45% with an unlimited wage base.

Also, beginning on January 1, 2013 there is a 0.9% Medicare surtax on earned income and remains in effect for 2015. The surtax applies to wages and self-employment income. It applies to single filers and heads of household when total earnings exceed $200,000 and $250,000 for married filing jointly taxpayers. For earnings over the thresh-hold, the effective Medicare tax will be 3.8%, the usual 2.9% tax rate, plus an extra 0.9%. The surtax only applies to the employee’s share of tax, employers do not owe the tax.

Casualty losses

Taxpayers in many states have already experienced natural disasters in 2015. A casualty loss can result from the damage, destruction or loss to your property from any sudden, unexpected or unusual event, such as a hurricane, tornado, earthquake, wildfire, or flood. Casualty losses are generally deductible in the year the casualty occurred, less ten percent of your adjusted gross income and a $100 per casualty deductible.

However, if you have a casualty loss from a federally declared disaster, you can elect to treat the loss as having occurred in the year immediately preceding the tax year in which the disaster happened, and you can deduct the loss on your return or amended return for that preceding tax year. The election gives taxpayers the opportunity to maximize their tax savings in the year in which the savings will be greatest.

Payroll withholding

If you have significant income, or will have, not subject to withholding in 2015 you should increase your payroll withholding for the remainder of the year to ensure that it covers the required estimated payments in order to avoid underpayment penalties.

Gift/estate tax

The current estate tax is set at a maximum 40 percent rate and a $5.43 million exemption amount, indexed for inflation. Lifetime gift-giving, ideally on an annual basis, should continue to form part of a master estate plan. The annual gift tax exclusion per donee on which no gift tax is due is $14,000 for 2015 with $28,000 allowed to each donee by married couples. Making a gift in 2015 to take advantage of this annual, per-donee exclusion should be considered by anyone with even modest wealth.

 

 

 

If you are creating a new business or unhappy with your current business structure, you need to consider the appropriate business entity. Whether to incorporate or form a limited liability company (LLC) is not always obvious. Under the Internal Revenue Code (IRC), a corporation is either a “C Corp” or an “S Corp.” An LLC is either a sole proprietorship (single member), a partnership (two or more members), a “C Corp,” or an “S Corp (if it meets all of the requirements and files a timely election).”

Tax issues to consider when choosing an entity: Sale of the business/liquidation. Tax rate exposure. Utilization of losses by the shareholders/members. Compensation/fringe benefit packages. Payroll tax liabilities and associated complexities. And state taxes.

Non-tax issues to consider: Limited liability protection for shareholders/members. The capital structure of the entity. Buy-sell agreements. The type of business/investment activity. And the applicable state law and other corporate legal formalities.

As indicated, there are many reasons to choose one structure over another. With that in mind, here is a brief description of these business entities

Sole Proprietorship

The simplest and least expensive structure. Works best if you are on your own, in a low risk business. No double taxation on profits, such as under a “C Corp.” Profits/losses reflected on Form Schedule C of the Form 1040. Unlimited liability for the owner and all income subject to the onerous “self-employment” tax.

Partnership

An unincorporated business that has two or more partners. There are two types: general and limited. In a general, partners share in management and are each 100% responsible for the partnership obligations. In a limited, there are general and limited partners. The general partners manage the business and are personally liable for obligations. The limited partners cannot participate in management, but share in the profits. Their liability is limited to the amount of their capital contributions. Profits are taxed only once, at the partners’ marginal tax rate.

C Corporation

They are taxed (federal and state) at the entity level and are subject to taxes on income generated by the business. Shareholders pay taxes (double taxation) on the profits distributed (dividends) to them. Liability is limited to the shareholder’s investment. They have an unlimited life and possess ease of transferability of ownership. Employment taxes can be minimized. Although, a reasonable salary must be paid.

S Corporation

Corporations with fewer than 100 shareholders can elect to be taxed under Subchapter S of the IRC. With some exceptions, the “S Corp” is not subject to federal tax at the entity level. Profits and losses flow through to the shareholders, to be reported on their tax returns at their marginal tax rates. Some states tax “S Corps” at the entity level. Employment taxes can be minimized for owners receiving a salary. Although, the amount of the salary must be reasonable compared to the profits being generated by the entity.

Market conditions are compelling investors to reassess their investment strategies. Investors again value investments that emphasize capital preservation. Fortunately, there are viable alternatives when seeking safety. Because safety means lower returns, you must maintain a strict policy of minimizing investment costs. Investments with a higher degree of safety can be found in bonds and annuities. The following discussion is not intended to recommend one investment over another, but to highlight the necessity to fully analyze any investment from an integrated tax, risk, return, and cost perspective.

Debt-Based Products

Bonds can offer a higher degree of principal protection than equity securities, but they are not as readily tradable. Due to liquidity factors, obtaining reasonable pricing requires considerable effort on an investor’s part. However, this effort is well rewarded because a bond’s fixed return component means that higher fees have a significant negative impact on returns. Options range from actively “pricing out” a bond issue, buying an initial bond issuance, or purchasing a low-cost bond fund. Bonds typically have a lower return potential than equities due to enhanced safety, although one can purchase junk bonds for higher returns, but with greater risk.

Treasury Securities

Treasury securities are backed by the full faith and credit of the U.S. government. They are considered the safest investment available. The major drawback is that yields on these securities have fallen to historic lows. The prior budget surplus has reduced the offering of these securities, but they still can be purchased directly from the U.S. government (www.treasurydirect.gov/). Directly purchasing from the government is a distinct advantage in that you can obtain a market-based price without having to negotiate with a third party on pricing and/or to incur trading commissions. The Treasury now only issues notes that mature in 10 years or less (the 30-year bond is no longer issued). Treasury interest is free from state income taxation.

Treasury Inflation Protected Securities

Treasury inflation protected securities (TIPS) are a relatively new investment option whereby an investor is protected against inflation. These bonds pay a lower fixed rate, but the principal value is adjusted upward to offset inflation (based on the Consumer Price Index). In the current low interest rate environment, this feature is highly appealing if interest rates start to increase. A major drawback is that the principal adjustment is taxable as credited, but not paid until maturity. The use of a tax-deferred or tax-free account (such as a Roth IRA) would make this tax problem irrelevant.

Agency Securities

Agency securities are debt instruments issued by a governmental entity that is part of the U.S. government. Because they are typically not backed by the full faith and credit of the U.S. government (only indirectly backed), they generally pay a slightly higher rate of interest than Treasury securities.

Ginnie Maes

Ginnie Maes securities represent pools of mortgages that are backed by the full faith and credit of the U.S. government. You can purchase a Ginnie Mae directly ($25,000 minimum), but the use of a low-cost Ginnie Mae mutual fund is probably a better approach. Funds can offer greater diversification in underlying pools and professional management. The major risk is that principal is typically paid back when interest rates fall, and therefore, Ginnie Maes would tend to lose value.

Municipal Bonds

Municipal bonds have the tax advantage that their interest payments are free from the regular federal tax. However, the alternative minimum tax (AMT) can be applicable if they are “private activity bonds issued after August 7, 1986.” The AMT is affecting more taxpayers with the imposed 2001 scheduled tax rate decreases. Private activity bonds tend to offer higher yields due to this distinct tax disadvantage. Another disadvantage is that state income taxation of municipal bond interest occurs if it is not issued from the state in which the taxpayer resides. The interplay of the federal regular income tax, alternative minimum tax and state income taxation necessitates a high degree of tax planning to maximize after-tax returns.

Corporate Bonds

Corporate bonds generally offer the highest yields but without the safety level of government-backed bonds. Additionally, they are taxable on the federal and state levels. You can obtain corporate bond pricing data from the National Association of Securities Dealers, Inc. (NASD) for approximately “500 investment-grade corporate bonds” at www.nasdbondinfo.com/asp/home.asp. One alternative is to invest in preferred and convertible preferred shares instead of corporate bonds.

Other Debt-Based Products

Other debt-based products are bank-based certificates of deposits (CDs), saving accounts, money market accounts and savings bonds. Savings bonds (HH, EE or inflation indexed) in certain circumstances are ideal investment vehicles. For the highest yielding money market funds and bank accounts, you can find yields at www.imoneynet.com and www.bankrate.com. However, a higher yield, as always, can indicate additional risks. A bank investment has the advantage of being federally insured up to $100,000. Money market funds are not insured, and losses, while infrequent, do occur.

Annuities

Annuities have income tax advantages, but they typically are loaded with excessive fees. A $50,000 annuity can generate brokerage fees of up to $4,000, which virtually negates the tax advantage. Proceeds in excess of the investment are taxable as ordinary income upon withdrawal. Also, amounts withdrawn before age 59 ½ are subject to a 10-percent early withdrawal penalty. Additional complicating factors are surrender fees and annual operating fees. It is essential that you seek independent assessment prior to purchase; we can assist you in this area.

Fixed Annuities

Fixed annuities offer a high degree of payout certainty (as long as the underlying company is financially viable). However, they are typically expensive to purchase, resulting in lower overall return potential. Web sites such as www.immediateannuity.com and www.brkdirect.com can be used to obtain competing rates of return. Caution is necessary in verifying an insurance company’s financial credit worthiness. Moody’s reported that American International Group, MetLife, Aegon and Prudential Financial each had over $1 billion in credit “exposure” from bond investments in Worldcom, Enron, Qwest, Williams, TYCO, Dynegy, Global Crossing, Adelphia Communications, Kmart and Xerox. In total, life insurers “held about $23 billion” in these companies, most of which were considered “financially stable” until recent events. State guaranty plans offer only limited protection.

Variable Annuities

Variable annuities are essentially mutual funds with tax deferral. They offer a limited insurance element to qualify under the tax law. There are low expense annuity options available, but “many variable annuities carry substantial fees, as high as 4% annually.”

Dividend Paying Stocks

Dividend paying stocks are now looking much more attractive. Companies, such as Disney, even converted from the standard quarterly distribution to an annual distribution. Dividend yields had dropped to one percent, but are now above two percent. Although, there is no guarantee that any company will pay dividends.

Real Estate Investment Trusts

Real estate investment trusts (REITs) speculate in real estate properties. They typically have a high dividend yield because, in order to qualify for favorable tax treatment, they must distribute 90 percent of their income back to the shareholders. REITs have had a remarkable performance in the current market conditions, but as history shows, the best performing asset classes do not maintain their status indefinitely. REITs can be equity or mortgage based or a combination of both. Mortgage-based REITs subject investors to additional credit risks and were often considered part of the prior problem with this asset class. REITS can be issued on a variety of rental properties.

Guarantee Funds

Guarantee funds are sold on their ability to guarantee investors at least the return of their initial investment (principal). The funds have high fee structures, are limited in the assets in which they can invest and typically offer a principal guarantee only after several years. As the market falls, they are forced to sell more of their equity holdings and place the proceeds into bond-based products. In essence, you obtain an expensive balanced fund (containing both debt and equity) that will move more towards bond-based funds when the markets fall. As the funds invest in more bonds, their yearly tax effect will increase, and therefore, they are not “tax friendly.” Sales charges over five percent are not uncommon, and these funds have an average annual expense ratio of 1.5 percent.

Tax-Integrated Investing

Besides offering an independent assessment of investment alternatives, we can assure that the tax impact of different investments is fully and correctly integrated in financial planning. Investors and/or their advisors all too often ignore the following:

1. Tax-exempt interest considerations

  • How does the AMT affect the situation?
  • Is interest on municipal bonds taxed at the state level?

2. Treasury securities

  • Ability to defer income taxation to the next tax year
  • Advantageous avoidance of state income taxation
  • Ability to match maturity of a Treasury security with the tax obligation

3. Use of tax-deferred accounts to invest in unfriendly tax investments (interest paying, TIPS, etc.)

4. Utilization of the new capital gains rates of 18 percent and 8 percent

5. Proper use of tax losses

6. Consideration of transfer taxes and stepped-up basis issues

Conclusion

The current market downturn has forced investors to reassess their financial plans. Emphasis needs to be placed on investments with better return characteristics, as opposed to recommending a particular investment product. We believe that clients require unbiased information, not a sales pitch. Due to the fact that most brokers work on a commission basis, a direct conflict of interest exists between brokers and their clients. We can ensure that you are fully aware of the tax, risk, return, and cost factors of investing.

On January 1, 2013, the American Taxpayer Relief Act (ATRA) of 2012 was passed by the United States Congress, and was signed into law by President Barack Obama the next day.

Highlights of the Act include but not limited to the following:

Income tax rates. Individual income tax rates will remain at 10%, 15%, 25%, 28%, 33% and 35% with only individuals earning more than $400,000 ($450,000 for joint filers) subjected to the higher rate at 39.6% for income above that threshold.

Capital gain and qualified dividend rates. Taxpayers in the 35% and lower tax bracket continue the 15% rate.  Lower income earners in the 10% and 15% tax brackets will have a 0% rate.  Individuals earning more than $400,000 ($450,000 for joint filers) will pay a 20% tax on capital gains and qualified dividends.  With the new 3.8% Medicare surtax on net investment income, the maximum rate will effectively increase to 23.8% for many higher-income payers.  More on the 3.8% Medicare surtax later in this update.

Itemized deduction (Pease) and personal exemption phase (PEP) outs. The “Pease” (named after Senator Pease) limitation on itemized deductions was reinstated, affecting individuals making $250,000 ($300,000 for joint filers). This provision reduces the total amount of itemized deductions by 3% of the amount that adjusted gross income (AGI) exceeds the threshold amount.  The reduction cannot exceed 80% of the otherwise allowable deductions. Personal exemptions are reduced by 2% for each $2,500 of AGI over the $250,000 for single filers and $300,000 for joint filers.  Exemptions are totally phased out when AGI exceeds $372,500 for single filers and $422,500 for joint filers.

Permanent alternative minimum tax (AMT) relief. ATRA permanently increased the AMT exemption amounts to $51,900 for single filers, $80,750 for joint filers, and $40,375 for married filing separately. The exemption amounts will automatically increase in future years based on the rate of inflation.

Payroll tax holiday ends. The two-year old payroll tax holiday was not extended.  This now returns the employee’s portion of FICA tax to 6.2% from the reduced 4.2%.

Estate and gift tax rates. Estate tax exemptions were increased to $5,250,000 per person and indexed for inflation using 2011 as the base.  Prior to passing ATRA, the exemption amount was set to decrease to $1 million, with the top tax rate increasing to 55%.  By passing the Act, Congress permanently increased the estate tax exemption and unified the exemptions from gift tax and generation-skipping transfer tax (“GST Tax) at the same amount with a top tax rate of 40%. The annual gift tax exclusion increases to $14,000 per donee. Portability of the estate tax exemption between spouses was renewed.

Social Security and Medicare. The wage base increased to $113,700 for 2013 ($110,100 in 2012). Also, benefits increased by 1.7% in 2013.  The basic Medicare Part B premium increased to $104.90 per month.  The Part B and D premiums are higher for upper income individuals if their modified adjusted gross income (MAGI) for 2011 exceeded $170,000 for couples or $85,000 for single individuals.  MAGI is AGI plus tax exempt interest, EE bond interest used for education, and excluded foreign earned income.  The total surcharges on upper income recipients can be as large as $297.40 a month per person.

Additional changes in tax rules for 2013 that were not finalized until January 1, 2013, included the following:

  • The personal exemption amount increased to $3,900.
  • Health savings account (HSA) deductions increased to $6,450 for family coverage and $3,250 for single coverage.  HSA owners born before 1959 can deduct an additional $1,000.
  • Contributions to flexible spending accounts were capped at $2,500.
  • The maximum 401(k) contribution increased to $17,500 for 2013.  Individuals born before 1964 can contribute up to $23,000. The limits apply to 403(b) and 457 plans as well.
  • 401(k) participants may convert to a Roth 401(k) even if they have not reached the age of 59-1/2.
  • The contribution limits for IRAs increase to $5,500. Individuals born before 1964 may contribute an additional $1,000.

The Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010 imposed the following new taxes effective for  years beginning on January 1, 2013:

Effective January 1, 2013 is the 3.8% Medicare surtax on net investment income.  It applies to unearned income for single filers and heads of household who have MAGI above $200,000.  For joint filers the tax applies to unearned income if MAGI is over $250,000. Investment income includes interest, dividends, capital gains, annuities, royalties and passive rental income.  Tax free municipal bond interest and retirement plan distributions are not included in the definition of investment income.

Effective January 1, 2013 is a 0.9% Medicare surtax on earned income.  The surtax applies to wages and self-employment income.  It applies to single filers and heads of household when total earnings exceed $200,000 and $250,000 for joint filers. For earnings over the threshold, the effective Medicare tax will be 3.8%, the usual 2.9% tax rate, plus an extra 0.9%.  The surtax only applies to the employee’s share of tax. Employers do not owe it. Employers will withhold the surtax once an employee’s wages exceed the threshold amounts. Employees will then calculate the actual tax due on their Form 1040.

Most people have filed their 2011 Income Tax Returns by now; therefore planning for 2012 should start immediately. Here are eight things the IRS suggests that you should do.

Adjust your withholding. Don’t provide the IRS with an interest free loan. If you had a large overpayment, now is a good time to review your withholding and make adjustments. The reduction in withholding improves your cash flow for the entire year. If you had a substantial underpayment, make adjustments so that interest and penalties are not assessed.

Store your returns and supporting documents in a safe place. If you receive an IRS Notice, or are examined, you will need to access the information quickly. You also need the information to prepare the 2012 income tax returns.

Organize you record keeping. Establish a central location where everyone in your household can place tax-related records all year long.

Review your payroll earnings statement. Make sure the proper withholdings are occurring and that your retirement plan contributions, medical insurance premiums, and flexible spending account contributions are as desired.

Shop for a tax professional early in the year. If you desire to use a professional to plan, strategize, and make financial planning decisions throughout the year, then search now. Choose a professional wisely. You are ultimately responsible for the accuracy of your returns.

Prepare to itemize deductions. If your expenses typically fall just below the amount to make itemizing advantageous, planning to bundle deductions into 2012 may be beneficial.

Strategize tuition payments. The American Opportunity Tax Credit will expire after 2012; therefore it may be advantageous to pay 2013 tuition in 2012.

Keep up with tax law changes. Meet with your tax professional during the year to discuss changes in the law and to discuss changes in your personal circumstances.

This year in particular, year end tax planning is full of uncertainties. This makes it even more difficult than previous years. If you believe that tax rates will not rise in 2011, including the 15% top rate on qualified dividends and long term capital gains, here is what most taxpayers should consider doing:

Accelerate deductions from 2011 to 2010 and defer income into early 2011 (do not jeopardize collection of the income), unless you expect to be at a higher marginal tax rate in 2011.

If you qualify to itemize deductions shift state and local income taxes into 2010. Pay your estimated tax payment s due in January, 2011 in December, 2010. This is not a strategy if you expect to be subject to the dreaded “alternative minimum tax” in 2010. Accelerate charitable contributions into 2010. If possible, make the donations using appreciated investments held more than one year. Do not donate investments that have declined in value. Pay your January, 2011 mortgage payment in December of 2010.

If you plan to do a Roth IRA conversion, converting in 2010 allows you to spread the resulting tax over 2011 and 2012. If you wait until 2011 to convert, the two year spread is not available.

Harvest capital losses, matching losses with capital gains to produce a net loss of $3,000. If you have a capital loss carry forward (from 2009 and earlier years), harvest capital gains if it fits your overall investment strategy in order to take advantage of the tax benefit.

Making Work Pay Credit: This provision allows a credit against income tax up to $400 for individuals whose modified adjusted gross income does not exceed $75,000 and $800 for married couples whose modified adjusted gross income does not exceed $150,000. It applies retroactively to January 1, 2009 and will be repeated in 2010. Taxpayers may take this credit through a reduction in payroll withholding or when filing their returns for the year.

$250 Economic Recovery Payment: This provision allows a one-time payment of $250, for 2009 only, to taxpayers on fixed incomes (primarily Social Security recipients).

First Time Home Buyer Tax Credit: The credit is increased to $8,000 for purchases made after December 31, 2008 and before December 1, 2009. It also eliminates any required repayment to the IRS. The credit is phased out for taxpayers with income in excess of $75,000 for individuals and $150,000 for married couples.

New Car Deduction: For the purchase of a new car in 2009, taxpayers are allowed a deduction for state and local sales taxes and excise taxes. Taxpayers do not need to itemize deductions to take advantage of this benefit. The deduction is phased out for individuals with income in excess of $125,000 and married couples with income in excess of $250,000.

Alternative Minimum Tax: This provision raises exemption amounts above the 2008 levels. The patch was designed to insulate approximately 26 million middle-income taxpayers from the AMT in 2009.

Unemployment Compensation: The provision excludes up to $2,400 of unemployment compensation from the recipient’s gross income for 2009.

Transit Benefit: The new law increases the current $120 per month income exclusion amount for transit passes to $230 per month.

COBRA Benefits: The provision allows individuals who are involuntarily separated from employment between September 1, 2008 and January 1, 2010 to elect to pay 35% of his/her COBRA coverage and have it treated as paying 100%.

Every year thousands of taxpayers overpay their income taxes because they use the standard deduction when itemizing deductions would be more advantageous. The causes are bad record keeping and simply not knowing or understanding the law. What follows is a basic review of what expenses qualify:

Taxes: State and local income taxes, real estate taxes, and personal property taxes are all deductible. Federal taxes, social security tax, and sales tax are not deductible.

Medical Expenses: You can deduct unreimbursed expenses for you, your spouse, and your dependents to the extent they exceed 7.5% of your adjusted gross income (AGI). This includes expenses for doctors, dentists, hospital care, prescriptions, nursing services, and medical aids. Also included are, insurance premiums, long term care premiums (within limits), and transportation and lodging.

Interest Expense: You can deduct interest paid on your primary residence and one second home. Also included are, first and second mortgages up to $1 million and home equity loans up to $100,000. Points are generally deductible and points incurred to refinance are amortized over the term of the loan. Interest paid on money used to acquire investments are deductible within certain limits.

Contributions: Donations to qualified organizations are deductible to the extent you receive no benefit in return. The organizations include churches, schools, libraries, and qualified charities. You can make donations in cash, check, or credit card. You can also deduct the fair market value of property other than cash. You must keep detailed records for donations of property other than cash, moreover you need a receipt for cash donations of $250 or more. All organizations must be located within the USA.

Casualty and Theft Losses: Losses from a fire, theft, or disaster are deductible within certain limits.

Miscellaneous Deductions: Included are certain unreimbursed employee expenses, investment expenses, gambling losses, and tax planning and tax preparation fees. Most of these expenses are subject to a 2% AGI floor.

To benefit the most, an awareness of the deductions that apply to you and good records are very important. If you have questions, please contact us.