Christine Benz: Hi, I'm Christine Benz for Morningstar.com.
With new tax rates going into effect for 2013, it's not too early to factor them into planning decisions.
Joining me to discuss this topic is Tim Steffen. He's director of financial planning for Baird's Private Wealth Management Group.
Tim, thank you so much for being here.
Tim Steffen: Thanks for having me.
Benz: Let's talk about the tax changes that are going into effect for the tax year 2013. For moderate-income people, you say there won't be a lot of changes that they should have on their radar.
Steffen: Most of the things that take effect this year--the new tax rates, capital gain rates, phase-outs--are really more geared for the higher-income folks. So your typical taxpayer, even at a more-than-moderate level of income, probably won't notice much of these changes at all.
Benz: You say one important thing, though, if you are a moderate-income person, that you should have your eye on is the fact that for long-term capital gains, we still have that 0% rate in effect for this tax year.
Steffen: Correct. For a married couple with taxable income in the mid-$70,000, they can have capital gains that are tax-free. When you figure that's gross income, when you add in deductions and exemptions, you can easily get to $90,000 or more of income, with room to do tax-free capital gains. That's one of the rare situations where selling and buying right back again is maybe a good idea. You can make some gains go away at no tax cost.
Benz: You're resetting your cost basis, essentially.
Steffen: That's exactly right. One thing to be concerned about is transaction costs, but if you're in a fee-based account, you can do the sell, realize the gain, buy it right back again at no cost, and essentially have a reset basis--a reset holding period, too, you've got to be aware of that, but reset basis more importantly.
Benz: Let's discuss the higher-income folks--these are the people who are potentially positioned to see bigger tax law changes that will have a bigger impact on them.
Let's discuss some of the headlines for them as they wind down this 2013 tax year.
Steffen: The two that got the most attention were the new top tax bracket. For married couples with taxable income over $450,000, we're back to the 39.6% rate that we had under the Clinton administration several years ago, and for singles that's $400,000 of taxable income. So not a lot of people affected by that, but it is a big jump up for those taxpayers.
Then the other big one, at that same income level, would be the new top rate on long-term capital gains. For the last several years, we've had primarily a 15% rate on capital gains. Now we've got a new 20% rate--a base rate anyways, not the full rate--but that's the base rate on capital gains taxes.
Benz: What is the base rate versus the full rate?
Steffen: So the base rate being 20%, then you add on to that some of the other taxes that take effect this year. For example, the new Medicare tax on investment income; that applies at a much lower level, $250,000 of adjusted gross income, so it's a different test. You'll get to that much quicker than you'll get to the $450,000 of taxable, but that's another 3.8%.
Then when you look at some of the other things that are taking effect this year, like some of the phase-outs, that actually increases your rate as well. You can get a top marginal rate on long-term gains of 25% even.
Benz: You have outlined some specific strategies, if you do fall into this rarified, very high-income area, some things that people should be thinking about as they're [approaching] the end of tax-year 2013. You say, think about accelerating some deductions. Why would one want to do that?
Steffen: Accelerating deductions, deferring income, those are the standbys when it comes to tax planning. Take advantage of the deductions as soon as you can, push the income off into your future, all things being equal.
So moving the deductions into 2013 to the extent you can allows you to get the tax benefit of those expenses sooner. So, rather than pay something in January, pay it in December and get the tax benefit a year earlier.
Benz: So even if I think I'm going to be in that same general tax level in 2014, you think it still makes sense to do this accelerating.
Steffen: All things being equal, taking the deduction this year will be a better, more accelerated tax benefit than it would be waiting a year.
The inverse is true on the income side. All things being equal, pushing the income into next year means you can delay the tax liability for another full year. Unfortunately, a lot of people don't have the ability to manage their income like that, but to the extent you can, that can be a great tax-deferral opportunity.
Benz: You say if you're making transactions, as well, that you should also mind your marginal tax rates as you're doing that. What does that mean, and how would I go about doing that?
Steffen: Capital gains are the easy one, because that's the easiest one for people to control. We've always thought in terms of the 15% tax rate … now, for somebody who's going to be crossing over that $250,000 threshold, for example, and would be subject to the new Medicare tax. Keep in mind that if you have a gain that's going to push you over that, the rate goes up, that gain is more expensive, you may rethink taking that gain this year as opposed to maybe next year.
Same thing as you move up into the bracket, which is $450,000 for the top capital-gains rate. It may make sense to push that gain off for a year.
Ultimately, this should be an investment decision first and not a tax decision. But if, from an investment standpoint, you're willing to wait a little longer, and it puts you into a lower tax rate next year, that might be the right thing to do.
Benz: You also say that for people who are paying estimated taxes--a lot of retirees do this as well as some self-employed individuals--that they should really make sure they are paying at the right rate in 2013. Why is that so important?
Steffen: If you're somebody who is going to affected by some of these tax increases, the inclination is, well, I owe these additional taxes, when do I have to pay that? Do I have to pay it right away? The answer in many cases is, no, you can wait until you actually file your return.
The rules get a little tricky, but as long as, in most cases, you're paying in the same as you paid last year, the extra tax you owe for 2013 can be delayed until you file your return. There are some exceptions to that, but generally that's how the rules work.
Benz: Extra liquidity may be also a helpful thing to have on hand--a little extra cash if you are, again, someone who is in one of the higher-income bands. The idea is just that you have the cash on hand to make those extra tax payments, correct?
Steffen: Until you've sat down and run the numbers, you may not realize how much you are affected by some of this. If you're somebody who is at those higher income levels, they're coming at you from a number of different directions this year with the tax increases. You may think you've got it covered from a capital-gains standpoint, but the phase-outs or the Medicare taxes will add extra taxes you maybe didn't anticipate. So, be ready for what may be a bit of sticker shock come April.
Benz: On the plus side for people who are in a position to give away assets if they are a high-income earner, you say that paying attention to the higher gift tax thresholds is something that they should be plugged into.
Steffen: The annual exclusion on gifting has jumped up this year. You can do a $14,000 gift to any individual, frankly--usually it's parents to kids or grandkids. It was $13,000 last year; it's up to $14,000 now.
If you're going to do the five-year accelerated gifting to a 529 plan, that number is now $70,000 as opposed to what it was a year ago. So that increase allows families to do significantly more gifting than maybe they've done in the past.
Benz: How about IRAs going to charity--what's the deal on that?
Steffen: Absolutely. That's a big one. That's back. It's still good for the end of this year anyway, through the end of 2013, and then we go through the whole "is it going to come back again" discussion next year.
This year, with the bigger emphasis on AGI with all these new taxes, and in particular the phase-outs of itemized deductions, this idea of giving money directly from your IRA to charity is really valuable. In the past, it was always kind of a breakeven. It didn't, in most cases, make a difference if you did or not. This year, though, it really has some impact for those who are going to be subject to phase-outs. So if your income for a married couple is over $250,000 and you're looking at maybe the Medicare taxes, or over $300,000 and you're looking at the phase-outs, keeping that AGI low is a great strategy, and this gifting from the IRA is a way to do that.
Benz: Also of interest, finally, to high-income households is what's been going on with the estate tax. We finally do have a little bit of clarity for the foreseeable future. The estate-tax exemption is really quite high currently. What does that mean from a planning perspective?
Steffen: Well, the best thing we've got is certainty. Everything has been extended permanently with inflation adjustments. Now permanent only means as long as the next tax law change comes into effect. But we know we don't have this million-dollar cliff staring us in the face like we did a year ago at this time. We've got a $5.25 million exemption for 2013. They just announced it's going to go up a little bit more for 2014. We've got some certainty in there and the ability for families to make pretty substantial gifts.
We also have the portability. If one spouse doesn't use all of their exemption at their death, the excess can carry over to the other spouse, which is a nice safeguard on the estate-planning side.
Benz: Now, on the flipside, I know there are lot of families who know that they will not be in that general area of having assets that high at their death. Does it make sense to maybe dismantle some of those trusts and so forth that they might have put in place so that they would be able to take maximum advantage of some of those exclusions?
Steffen: In most cases, no. If you did some sophisticated trust planning a year ago to take advantage of the gifting, those things are typically irrevocable anyway; there's not much to really undo.
But even with the exemption being as high as it is, trusts still make a lot of sense. They provide for a uniform disposition of assets upon your death. They help you avoid probate. They can provide some asset protection for your heirs. There are a lot of reasons to keep a trust in place well beyond the estate tax issues that you might have been trying to avoid.
Benz: Tim, thank you so much for being here. We appreciate you sharing your insights.
Thanks for watching. I'm Christine Benz for Morningstar.com.