Navigating the New Tax Headwinds

By • Dennis Wolfe, CFP®

DennisWolfe

So, what changed in 2013 and continues to affect us this year?

Income Taxes The highest income tax bracket increased to 39.6% from 35.0% for individuals earning $406,750 or more and joint filers earning $457,600 or more a year. The maximum corporate income tax rate remains 35%.

Long-Term Capital Gains and Dividends Capital gains and dividend taxes increased to 20% from 15% for individuals and families in the new 39.6% bracket.

New Medicare Taxes As part of the healthcare reform bill, an additional 3.8% Medicare Surtax on investment income for individuals earning more than $200,000 a year and joint filers earning more than $250,000 a year took effect as well as a 0.9% surtax on wages in excess of the same thresholds.

Personal Exemptions Personal exemption phaseouts were reinstated with exemptions reduced by 2% for each $2,500 of income that exceeds a threshold of $254,200 for individuals or $305,050 for joint filers.

Itemized Deductions The limitation on itemized deductions was also reinstated, reducing the value of most itemized deductions by 3% of adjusted gross income (AGI) in excess of $254,200 for individuals and $305,050 for joint filers (but no more than 80% of impacted itemized deductions).

Estate and Gift Taxes The maximum federal gift and estate tax rate increased to 40% with a $5,340,000 (2014) exemption amount indexed for inflation; exemption portability was also made permanent.

Alternative Minimum Tax (AMT) Annual AMT adjustments for inflation were made permanent.

What can we do in 2014?  

Although we are all obligated to pay our fair share of taxes, few of us would be pleased to pay taxes unnecessarily. Because taxes lower the actual return on your investments, you should understand and implement legitimate ways to minimize taxes on your investment portfolio. Several approaches and strategies exist, including the following:

Do year-end tax planning. The basic strategy for year-end tax planning is to time your income so that it will be taxed at a lower rate, and to time your deductible expenses so that they may be claimed in tax years when you are in a higher tax bracket. Year-end planning involves not only a review of your income and deduction status but also the use of a marginal tax rate analysis to help you minimize taxes.

Generally speaking, taxes should be postponed whenever possible. However, there can be circumstances that warrant paying your taxes sooner rather than later – for instance, if you anticipate being in a higher tax bracket in the future, or if you know that new or higher taxes are to take effect in the near term.

Manage the tax efficiency of your portfolio. Tax efficiency is essential to maximizing portfolio returns. Simply put, tax efficiency is measured by how much of an investment’s return remains after taxes are paid. Certain investments generate more taxable distributions than others. Evaluate each of your investments and after-tax returns. Also, review your portfolio’s turnover ratio and historical distributions to get a sense of your annual tax liability, and take steps to add more tax-efficient investments to minimize taxes. 

Harvesting tax losses is a method of selling securities at a loss to offset a capital gains tax liability. Tax gain/loss harvesting is typically used to limit the recognition of short-term capital gains, which are normally taxed at higher federal income tax rates than long-term capital gains. Likewise, if you have any capital loss carry forward, you should review your portfolio for capital gain opportunities to make use of the capital losses.

Rebalance your portfolio to include more tax-advantaged investments such as municipal bonds and dividend-paying stocks, especially for those in higher tax brackets.  When rebalancing your portfolio, consider using new money coming into the account versus selling off certain investments to avoid incurring unnecessary capital gain taxes. Alternative sources include bonus money, gifts, or stock option conversions.

While these tax planning strategies may help you to reduce Medicare taxes and your overall tax bill, don’t lose sight of your risk tolerance and long-term financial goals.

Capitalize on employer salary deferral and health savings plans. If your employer offers a salary deferral plan like a 401(k), SIMPLE IRA, 403(b) or 457 plan, maximize your contributions to the plan to reduce your AGI and taxes over the long term. During 2014, you can defer up to $17,500 a year, $23,000 if you’re age 50 or over, into a 401(k) or 403(b) plan.

One often-overlooked benefit that helps you reduce your taxable income is an employer health savings plan or flexible spending account. Contributing to a health savings plan is not only wise to prepare for medical events, it also uses pre-tax dollars, reducing your taxable income. Additionally the IRS just changed the rules allowing a $500 flexible spending account carryover into future years.

Use IRA and Roth IRA strategies to reduce taxes in future years. The maximum contribution to a traditional or Roth IRA in 2014 is $5,500, $6,500 if you’re age 50 or over. You may also be able to deduct IRA contributions, even if you participate in a retirement plan at work, if your modified AGI is under $70,000 for individuals or $116,000 for joint filers. Roth IRA contributions are completely phased out for taxpayers with modified AGI of $129,000 or greater (single) and $191,000 or greater (married filing jointly).

Fully funding a nondeductible IRA or Roth IRA may not immediately reduce your adjusted gross income, but there is a possibility it could in future years. You also may want to consider a Roth IRA conversion, which will reduce your taxable income in later years since Roth distributions are excluded from net investment and ordinary income. Keep in mind though that your adjusted gross income will increase in the year of conversion, which may increase your taxable income and potentially subject more of your net investment income to the surtax in the year of the conversion. Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount is subject to its own five-year holding period.  Converting a traditional IRA into a Roth IRA has tax implications. Investors should consult a tax advisor before deciding to do a conversion.

Consider investing in a permanent life insurance policy. Investing in yourself and your family with a permanent life insurance policy can provide several benefits. In addition to the protection and assurance that your family will be taken care of in the event of death, accumulating cash value in life insurance can also offer tax-deferred growth and tax-advantaged retirement income.  Guarantees are based on the claims paying ability of the issuer.

Align investments with account types. Certain investments may be better suited for certain account types from a tax standpoint. One often overlooked strategy would be to carry income-producing investments in a tax-advantaged account such as a 401(k) or IRA where taxes are deferred until later years. Hold long term stocks and municipal bonds in a traditional brokerage account.

Consider the retirement years. It’s important to manage income taxes on your investments in retirement. In addition to considering the capital gains consequences of investment decisions, you should manage and control your investment income so that your Social Security benefits either will not be taxed or will be taxed only minimally. In addition, you must ensure that required minimum distributions from retirement plans do not push you into a higher tax bracket.

Develop a charitable giving plan. Charitable giving can reduce your tax burden and also provides a sense of satisfaction by benefiting your favorite causes. Generally, donations to qualified charities count as an itemized deduction for that tax year. This includes cash, real estate, goods or other assets.
The deductibility of charitable gifts is based on several factors, such as the donor’s income, the nature of the donation, and the charity receiving the donation. A sound plan can help offset an increase in taxes.

When creating a charitable plan, consider these options.

1. Give appreciated securities that you’ve held for more than 12 months to avoid capital gains.

2. Establish a donor advised fund to make future donations and claim the current income tax deduction.

3. Contribute highly appreciated assets to a charitable remainder trust (CRT) to defer recognition of income over time.

In Closing While many of us paid more taxes in 2013, upper income taxpayers felt the greatest impact of the new tax laws.  However, there are a number of opportunities for nearly all taxpayers to potentially reduce their tax burden. Making adjustments to your overall financial plan or investment portfolio with the sole intent to minimize taxes may not be appropriate given your longer-term goals. Consult with your financial professional and tax advisor to review your individual circumstances before making any tax-related adjustments to your financial plan or portfolio. This will help you to determine how to remain on track with your financial goals while simultaneously minimizing your overall tax exposure.

The information provided is general in nature, is not a complete statement of all information necessary for making an investment decision, and is not a recommendation or a solicitation to buy or sell any security. Investments and strategies mentioned may not be suitable for all investors. Diversification and strategic asset allocation do not ensure a profit or protect against a loss. Investments are subject to market risk, including possible loss of principal. The process of rebalancing may carry tax consequences. Changes in tax laws may occur at any time and could have a substantial impact upon each person’s situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of Raymond James & Associates we are not qualified to render advice on tax or legal matters.