With the end of the year approaching, it’s time to make some moves to lower your 2013 tax bill. This column is the first of two installments on that subject. But first, let’s cover some necessary background information.
Income Tax Rates Are Unchanged for All but Higher-Income Individuals
For most individuals, the federal income-tax rates for this year are the same as last year: 10%, 15%, 25%, 28%, 33%, and 35%. However, the American Taxpayer Relief Act (ATRA), passed at the beginning of this year, increased the maximum rate to 39.6%. That rate only affects singles with taxable income above $400,000, married joint-filing couples with income above $450,000, and heads of households with income above $425,000. For 2014, the tax bracket cutoffs are slightly higher, as shown in the table at the end of this column.
Capital Gain and Dividend Tax Rates Are Unchanged for All But Higher-Income Individuals
The federal income-tax rates on long-term capital gains and dividends for this year are also the same as last year for most individuals: either 0% or 15%. However, the ATRA raised the maximum rate to 20% for singles with taxable income above $400,000, married joint-filing couples with income above $450,000, and heads of households with income above $425,000. For 2014, the thresholds for the 20% maximum rate will be $406,750, $457,600, and $432,200, respectively. Folks with taxable income below these levels will pay a 15% federal rate on long-term gains and dividends or 0% for gains and dividends that would otherwise fall within the 10% or 15% brackets (see the tables at the end of this column for the 10% and 15% brackets).
Two New Medicare Surtaxes for Higher-Income Individuals
The 2010 Obamacare legislation included two new Medicare surtaxes that kicked in this year. The new 0.9% surtax hits salary and self-employment income collected by higher-income folks. The new 3.8% surtax hits net investment income collected by higher income folks.
The 0.9% Surtax: The new 0.9% Medicare surtax is charged on salary and/or net self-employment income above $200,000 for an unmarried individual and salary and/or net self-employment income above $250,000 for a married joint-filing couple.
The 3.8% Surtax: If your modified adjusted gross income (MAGI) exceeds $200,000 if you are unmarried or $250,000 if you are married and file jointly, all or part of your net investment income can be hit with the new 3.8% Medicare surtax. The definition of investment income includes long-term capital gains, dividends, interest and a host of other items. The 3.8% surtax applies to the lesser of your net investment income or the amount by which your MAGI exceeds the applicable threshold. MAGI means “regular” adjusted gross income (AGI), from the last line on page 1 of your Form 1040, increased by certain tax-exempt income from outside the U.S. which you probably don’t have. See my earlier columns for some advice on how to minimize or avoid the 3.8% surtax: How to avoid new 3.8% tax on investment income and Tips for avoiding 3.8% investment income tax
Strategy: Time Investment Gains and Losses for Tax Savings
As you evaluate investments held in your taxable brokerage firm accounts, carefully consider the tax impact of selling appreciated securities (currently worth more than you paid for them). For most people, the federal income-tax rate on long-term capital gains is still much lower than the rate on short-term gains. For that reason, it often makes sense to hold appreciated securities for at least a year and a day before selling in order to qualify for the lower long-term capital gains rate.
Selling some loser securities (currently worth less than you paid for them) before year-end can be a tax-smart move. The resulting capital losses will offset capital gains that you racked up earlier this year, including high-taxed short-term gains from securities that you owned for one year or less. This year’s maximum federal rate on short-term gains is 39.6%, and the new 3.8% Medicare surtax may apply too — which can result in a combined federal rate as high as 43.4%. Ouch! But you don’t have to worry about paying a high rate on short-term gains that you’ve successfully sheltered with capital losses. You’ll pay 0% on those gains, and 0% is good!
If your capital losses for this year exceed your capital gains, you’ll have a net capital loss for 2013. You can use it to shelter up to $3,000 of this year’s high-taxed ordinary income from salaries, bonuses, self-employment, and so forth ($1,500 if you’re married and file separately). Any excess net capital loss is carried over to 2014 and beyond until you use it up. So it won’t go to waste. In fact, selling enough loser securities to create a bigger net capital loss to carry over to next year and beyond might make perfect sense. You can use it to shelter both future short-term gains and future long-term gains that might otherwise be taxed at higher rates than those that apply this year.
Strategy: Set Up Loved Ones to Pay 0% Rate on Investment Income
The federal income-tax rate on this year’s long-term capital gains and dividends is still 0% for gains and dividends that fall within the 10% or 15% rate brackets (see the table at the end of this column for the brackets). While your income may be too high to take advantage of the 0% rate, you probably have loved ones who can benefit. Consider giving them some appreciated stock or mutual fund shares. They can sell the shares and pay 0% federal income tax on the resulting long-term gains. Remember: the gains will be long-term as long as your ownership period plus the gift recipient’s ownership period equals at least a year and a day. Giving away dividend-paying stocks is another tax-smart idea. As long as the dividends fall within the gift recipient’s 10% or 15% rate bracket, they too will qualify for the 0% federal rate.
Warning: If your gift recipient is under age 24, the Kiddie Tax rules could potentially cause some of his or her capital gains and dividends to be taxed at the parent’s higher rates. That would defeat the purpose. Contact your tax adviser if you have questions about how the Kiddie Tax works.
Strategy: Convert Traditional IRA into Roth Account
The best scenario for the Roth conversion deal is when you expect to be in the same or higher tax bracket during retirement. While some higher tax rates have already kicked in for this year, there’s certainly no guarantee that more tax hikes are not in our future.
Of course, there is a current tax cost for doing a Roth conversion. That’s because the conversion is treated as a taxable liquidation of your traditional IRA followed by a non-deductible contribution to the new Roth account. Here’s the advantage: after the conversion, all the income and gains that accumulate in your Roth account, and all your withdrawals, will be federal-income-tax-free — assuming you only take qualified withdrawals. Qualified withdrawals are those taken after: (1) you’ve had at least one Roth account open for more than five years and (2) you’ve reached age 59 1/2. With qualified withdrawals, you avoid having to pay higher tax rates that may exist during your retirement years. Put another way, the current tax hit from a Roth conversion is unwelcome, but it could be a very reasonable price to pay for the future tax savings. But please talk to your tax pro before pulling the trigger on a conversion. There are lots of variables to consider.
Information taken from www.marketwatch.com