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Despite Recent Compromise, No Long-Term Tax Certainty

Jason Stipp

Jason Stipp: So, John, I'd like to turn to 2013, and some of the things that need to be on investors' radars going forward on the tax front.

There was a lot of concern about the fiscal cliff and some of the Bush-era tax cuts that were set to expire. We did get a resolution on some of those issues. The Bush tax cuts on dividends and capital gains stayed where they were for most investors; however, higher-income investors are facing some higher tax rates on capital gains, on dividends, and on income.

So, a couple of questions for you. The first is, do those higher tax rates on higher-income individuals change how you are thinking about tax planning for them? And secondly, do you feel like there really is certainty there about taxes, or do you think even investors who didn't see a change should still worry about what the tax environment may look like in the future?

John Pitlosh: The law was definitely passed that put a lot of these things into stone, but the stability of what's going to happen going forward, that certainty still isn't there. Everyone outside of Washington knows that spending needs to go down and revenue needs to be raised. So, how are they going to do that? Are they going to do a Simpson-Bowles 1.0, a Simpson-Bowles 2.0, a Mitt Romney plan?

So, the form that all the deficit reduction and all these things could take is going to affect clients, and you can't plan on what's currently in place being there long term, at least from a rational point of view. And if that's the case, then you still need to maintain the same mentality that we had previous to the fiscal cliff year, and that's just maintain flexibility, keep your adjusted gross income down, and just don't rely on any long-term tax planning to be there for you.

So, just as a general theme, one of the things that we've done with a lot of our higher-income clients is making sure you're keeping that … AGI down. So instead of contributing to the Roth 401(k), we're maximizing the pre-tax 401(k), and we're making sure that they're doing a health savings account. We're making sure that if they have access to a deferred compensation [they are taking advantage of that]--anything that will reduce that pre-tax income on Page 1 of the 1040. That's what you want to keep down.

So, while things may have changed on paper, they really haven't in reality for most clients. So, our expectations is that things are likely to continue to change.

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Stipp: Some investors may be inclined to also contribute to a Roth if they have funds available because that will give them some flexibility later in the future; should tax rates go up, they'll have a pool of assets they can pull from tax-free.

We talked about conversions in 2012. I feel like conversions are probably going to continue to be on investors' radars in 2013. In fact, there is more opportunity now I think for conversions in 401(k)s to Roth 401(k)s.

If you're thinking about doing some of those conversions and you would rather pay tax now at what you think would be lower rates, what questions should you ask yourself to figure out, is this really a viable strategy for me?

Pitlosh: Well, just in terms of strategy, having flexibility and diversification across your taxable accounts is a huge benefit, because if you don't know what the situation or rates are going to be in any particular year for you, or based on what Congress does, having a pool of tax-free, having a pool of tax-deferred, having a pool of taxable assets will give you a lot of flexibility.

But in terms of determining when and how to do conversions, a lot of clients--anybody, Bill Gates--can contribute to a non-deductible IRA and then do a Roth conversion in the same year. So, that's always available to clients, in addition to the typical conversion of an IRA that they have outstanding, in addition to contributing to a Roth 401(k).

But the new thing this year that was in the law that was kind of interesting is that people are allowed to convert within their own pre-tax 401(k) into a Roth 401(k), and that's a new addition that will actually help a lot of clients with the planning in terms of how to maximize the amount that they can put into that tax-free account.

Stipp: So, as you're making the decision about that, you kind of want to keep in mind what are in these different pools, what is in my taxable, what is in my tax deferred, what is in my completely tax-free or Roth type of account, as you're trying to balance and make sure that you have at least some amount of assets in each of those buckets you're saying?

Pitlosh: Exactly. So, the same approach you have with investments in terms of diversification, unfortunately you need to maintain the same type of approach with where the assets are located and the types of accounts and how they are taxed.

Stipp: John, let's talk about AMT. So there was some good news there in their fiscal cliff resolution in that the patch that adjusts the AMT for inflation every year is no longer a patch but is going to be an automatic adjustment that happens. But can investors really breathe a sigh of relief about AMT?

Pitlosh: Well, they can from the simple fact that they don't have to worry about the difference in their AMT liabilities, so they can probably plan that aspect of estimated taxes or figuring out what their issues are, as opposed to waiting until the last week of each year, and then Congress letting everybody know if they are going to put a patch or not put a patch on. So, from a planning standpoint, that's actually improved

But from an overall reality, AMT is still here; it's not going away. The patch helps, the inflation adjustment helps, but if you live in a high-income state like California, New York, Massachusetts, or Connecticut, AMT is still going to be a reality with you if you're making anywhere in the six figures.

Stipp: OK. You also had a list of some other changes that are happening right now, and I'd just like to tick through some of those that should be on our radars. The first one, you say there's a strange new marriage penalty on high-income couples. Can you explain that?

Pitlosh: Right. So the law in theory fixed the so-called marriage penalty, by not penalizing people going from single file to married filing joint, so they have the same standard deduction now. It's just a doubling of that.

But all the laws, whether it be the Medicare surtax or the new income tax rates or some of the limitations on itemized deductions, they all seem to penalize high-income married filing joint people. So just to give you an example, I have a couple of client who are both professionally working clients, and they are making roughly $400,000 each. Because they are married in 2013, in theory they are going to pay about $40,000 to $50,000 more in taxes just for the simple fact that they are married as opposed to if they were to each file single.

So, it's kind of a strange way of writing the law, and I'm not sure how they came up with it, but it's an unusual result that I'm sure if people are thinking about delaying marriage, this is one excuse for them.

Stipp: You mentioned some limits on itemized deductions. You also say there's a reinstatement of limitation on that. What's the deal with the itemized deductions now?

Pitlosh: The Pease limitation is something that was kind of phased out over the Bush-era tax cuts and it's disappeared. It was off the radar for a couple of years, and now it's back in full force, and it applies to people who are making a little over, married filing joint couples, over $300,000, and it's going to reduce the amount of their itemized deductions, or certain itemized deductions, which are a key to high income individuals.

So, it's going to reduce or phase out the amount of charitable deductions, medical expenses, mortgage interest. So a lot of the things that aren't picked up by AMTs, some of them will actually get limited on this Pease limitation. That limitation can be up to 80% of itemized deductions, but it's about $0.03 on every dollar above the AGI threshold for the individual or married filing joint couple.

Stipp: You also write that there's another year of qualified charitable distributions for folks aged 70 1/2 and over. What's the story with that?

Pitlosh: So the qualified charitable distribution is actually a pretty good bonus for people that are higher income and are also charitably minded, because one of the things that we're alluding to earlier is [the importance of lowering] … the AGI, so being able to lower that without having everything show up on the Schedule A so that it gets limited.

So the benefit of the qualified charitable distribution is essentially you're rolling money over from your IRA directly to a public charity of your choice. As long as it qualifies, you're able to essentially move that money out, and not have it get limited in any way by some of these phase-outs that we're talking about.

Because it only applies to people that are aged 70 1/2 and older, these people are subject to requirement of distributions. And the other benefit of this qualified charitable distribution is that distribution or that rollover to a charity actually counts towards that requirement. So, it's a benefit in a couple of different ways.

Stipp: We also got another year of a sales tax deduction as an itemized deduction.

Pitlosh: Right. While this might not be a big deal for people in states like California or New York where they have a high state income tax, for people in Florida and Texas, where they don't have that state income tax, but they still itemize their deductions, the ability to have this general sales tax available as a replacement for the income tax deduction can benefit clients in a lot of ways. So, that's another huge plus that's still on there, but it's only on there for another year.

Stipp: Two items related to Medicare: Additional Medicare tax on wages and also on unearned income. What is that tax know about it?

Pitlosh: So, this was part of the ObamaCare fund tax revenue, and there are actually two issues here. There's a tax that's going to get applied to people that make over a certain amount of money on their wages, and that's added on to their Medicare tax. So, … essentially, … married filing joint people will add almost a percent, 0.9%, to their Medicare wages over the $250,000 threshold.

The caveat or the strange planning issue with this tax is that if you're a couple and one of you is making $100,000 and the other one is making $190,000, so total they're making $290,000, well, essentially the withholding isn't going to pick up on this, because each person isn't making over the threshold. So, people need to be aware that if you're married filing joint and each of you have some income, and the total income is likely to be over the threshold, that you're doing a proper withholding.

So, really the tax isn't new. A lot of people have written about the subject. But from a planning standpoint, make sure that you're doing a proper withholding or … at least that it's on your radar.

Stipp: John, we've been talking about a lot of these issues that will affect individuals' tax returns. But you say there is also concern or things that should be on the radar for folks that use trusts in some way or another. What should they be thinking about at a high level? How might changes affect them?

Pitlosh: A lot of people have done thoughtful planning in terms of trusts and putting money into irrevocable trusts for the benefit of a spouse or some children. But when a trust becomes its own taxable entity, you need to watch out, and get some more thoughtful advice from your tax advisor or attorney. The issue you run into is that while individual tax rates are at a very high income level--so you don't hit the 39.6% tax bracket [until] $400,000-$450,000 depending on how you're filing--but for a trust, you only have to have an income of $11,950 inside that trust in order to hit the 39.6% tax bracket. If you don't do any proper planning with that, or take some of the issues that come along with that into account, not only could you be getting hit with that 39.6% at a very low [income], but you could also be getting hit with that Medicare surtax, which is a 3.8% at a very rate, and you also get subject to that long-term capital gain at the 20% rate as opposed to the typical 15% rate for the average individual investor. So, if this comes up, you just need to make sure that you talk to your CPA, that they are aware of it, or your attorney.

Stipp: John, it sounds like unfortunately, there is no shortage of things that need to be on investors' radars with respect to taxes, but thank you for helping us keep track of some of the big ones and for joining me today.

Pitlosh: Sure. Thanks for having me.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.