Tax strategies for the long horizon.

• Author: Keebler, Robert S.

New taxes and higher rates have dramatically increased the complexity of planning for many taxpayers; however, long-standing techniques for managing income and deductions and taking best advantage of tax-favored vehicles for retirement saving still hold sway

Bracket Management

With the introduction in 2013 of the 3.8% net investment income tax, the 20% capital gains rate, and the 39.6% income tax rate, and the reintroduction of the personal exemption phaseout (PEP) and Pease limitations, America shifted overnight from a two-dimensional federal tax system to a five-dimensional system. Virtually every financial decision now needs to be analyzed through the lens of the regular income tax, the alternative minimum tax, the net investment income tax, the new additional brackets for high-income taxpayers, and the PEP and Pease limitations. Going from a two-dimensional system to a five-dimensional system greatly increases complexity and requires an increase in sophistication in tax analysis methodology tax strategy, and tax planning software tools.

As Exhibit 1 shows, there are now seven ordinary income tax brackets--10%, 15%, 25%, 28%, 33%, 35%, and 39.6%--and three capital gains tax brackets--0%, 15%, and 20%. Furthermore, combining these tax brackets with the new 3.8% net investment income tax produces even more possible tax brackets; i.e., high-income taxpayers are subject to a 43.4% tax rate on ordinary investment income and a 23.8% tax rate on long-term capital gains. Taking into account the PEP and Pease limitations on income above the applicable threshold amounts effectively increases the tax rates even further.

These changes contribute to a growing realization among investors that it is not what they earn that counts but what they keep after taxes. The prudent investor carefully plans to reduce the drag of taxation on investment performance by analyzing financial decisions with all these changes in mind.

The first step in tax planning is to estimate taxable income over a five- to 15-year horizon. This longer time frame is desirable given the increased progressiveness of the Code. Then, planning to avoid the higher tax brackets and the net investment income tax can begin. Tax planning strategies include:

* Harvesting losses in high-income years;

* Harvesting gains in low-income years;

* Contributing to traditional IRAs in high-income years;

* Contributing to Roth IRAs in low-income years;

* Investing in tax-deferred annuities;

* Creating different types of charitable remainder trusts;

* Creating charitable lead trusts;

* Engaging...