New brackets, net investment income tax expand scope of tax planning.
Author | Sarenski, Theodore J. |
Position | Personal tax planning |
WITH THE INTRODUCTION OF THE 3.8% NET investment income tax (Sec. 1411), and the return of the 20% capital gains rate (Sec. 1(h)) and the 39.6% income tax rate (Sec. 1(i)), America shifted overnight at the start of 2013 from a two-dimensional tax system to a four-dimensional system.
There are now seven income tax brackets (10%, 1.5%, 25%, 28%, 33%, 35%, and 39.6%) and three capital gains brackets (0%, 15%, and 20%) (Sec. 1.). There is also' a maximum 25% capital gains rate for depreciation recapture and a maximum 28% capital gains rate for gain on collectibles (Sec. 1(h)).
Virtually every financial decision for higher-income taxpayers now needs to be analyzed through the lens of the regular income tax, the alternative minimum tax (AMT), the net investment income tax, and the new additional brackets.
The complexity of going from a two-dimensional system to a four-dimensional system is exponential, not linear, and requires a quantum leap in tax analysis methodology, tax strategy, and tax planning software tools.
PEP and Pease Limitations
Also new for 2013 are the reinstatement of the personal exemption phaseout (PEP) (Sec. 151(d)(3)) and limitation on itemized deductions (Pease limitation) (Sec. 68), both applicable when adjusted gross income (AGI) exceeds $250,000 for singles, $275,000 for heads of households, $300,000 for married taxpayers filing jointly and surviving spouses, and $150,000 for married taxpayers filing separately.
The PEP reduces personal exemptions by 2% for every $2,500 of income above the threshold amount for single taxpayers Or married taxpayers filing jointly or by 2% for every $1,250 of income above the threshold amount for married taxpayers filing separately (Sec. 151(d)(3)). The Pease limitation cuts itemized deductions by the lesser of 3% of AGI above the threshold amounts or 80% of the itemized deductions otherwise allowable for the tax year (Sec. 68). Deductions not included in the Pease calculation are investment interest, medical expenses, nonbusiness casualty and theft losses, and wagering losses (Sec. 68(c)).
Net Investment Income Tax
The net investment income tax for individuals applies to the lesser of net investment income or the excess of modified adjusted gross income (MAGI) over the applicable threshold amount (Sec. 1411(a)). The thresholds are $250,000 for married taxpayers filing jointly, $125,000 for married taxpayers filing separately, and $200,000 for all others (Sec. 1411(b)).
Gross investment income includes interest, dividends, annuity distributions, rents, royalties, income from passive activities, and net capital gain from the disposition of property other than the disposition of property held in a trade or business that is not a passive activity with respect to the taxpayer or a trade or business of trading in financial instruments or commodities (Sec. 1411(c)). It does not include salary, wages, bonuses, distributions from IRAs or qualified plans, any income taken into account for self-employment tax purposes, gain on the sale of certain active interests in a partnership or S corporation, or items that are otherwise excluded or exempt from income, such as interest from tax-exempt bonds, excluded gain on the sale of a principal residence (Sec. 121), tax-free gain on like-kind exchanges (Sec. 1031), excluded gain on the sale of small business stock (Sec. 1202), and gain on tax-free exchanges of life insurance policies (Sec. 1035).
Gross investment income is reduced by deductions properly allocable to such income or net gain (Sec. 1411(c)(1)(B)). Some examples of allowable deductions are investment interest expense, investment advisory fees, and brokerage fees. Nondeductible items include net operating losses, charitable deductions under Sec. 170, and personal exemptions. MAGI is defined as AGI plus the net foreign earned income exclusion (Sec. 1411(d)).
Analysis Methodology and Perspective
For more than 20 years the vast majority of income tax planning has focused on short-term tactics, looking at a period of two or perhaps three years. However, with the return of the 39.6% and 20% income tax and capital gains rates, respectively, plus other changes mentioned above, many retired clients or taxpayers nearing retirement need to project their income and deductions over a five- to 10-year period.
A clear example is the effect of required minimum distributions (RMDs) from an IRA at age 70 1/2. Exhibit 1 projects the future tax consequences of RMDs over 15 years at 2% inflation for a hypothetical married 65-year-old with an IRA with $5 million in principal and other taxable income totaling $192,200 in 2013, who starts taking RMDs in 2018. He gets pushed into the 35% bracket in 2018 and eventually into the 39.6% bracket. Additional illustrations of some of the effects for this hypothetical client and scenario of applicable marginal income and capital gains tax rates and the PEP and Pease limitation are available online at tinyurl.com/PFPDec2013.
Three Leading Tax Strategies
Three leading tax strategies for eliminating or reducing taxable income in the higher tax brackets or net investment income subject to the net investment income tax are harvesting income and gains, Roth IRA conversions, and tax-efficient investing.
Harvesting Income and Gains
Harvesting losses has been a key part of financial...
To continue reading
Request your trialCOPYRIGHT GALE, Cengage Learning. All rights reserved.