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Financial advisers are devising playbooks for top U.S. earners to help them minimize the effects of various higher taxes taking effect in 2013.
“I think about it as an obstacle course,” said Sandi Bragar, director of planning at Los Angeles-based Aspiriant, a wealth-advisory firm with more than $7 billion in assets under management. “You have to figure out what to duck under.”
Top earners this year face tax-rate increases and some limits on deductions from the budget agreement the U.S. Congress passed Jan. 1 as well as new taxes from the 2010 health-care law. Advisers are recommending strategies such as shifting investments, donating stock directly to charities and maximizing contributions to retirement plans.
“There are definitely some things we are talking to our clients about,” because of the tax law changes, said Chris Johnson, a director in the wealth and investment management division of London-based Barclays Plc. (BARC) “I think you’re going to see a shift in behavior.”
The ladder of tax increases affecting high earners is complicated because there are several rungs, some of which are based on taxable income and others on adjusted gross income, Bragar said. The added bite will affect taxes they pay for 2013, and not the current filing season that starts this month.
The top federal income-tax rate of 39.6 percent -- up from 35 percent -- starts at taxable income exceeding $450,000 a year for married couples and $400,000 for individuals. Those same earners will pay as much as 23.8 percent on long-term capital gains and dividends this year compared with a maximum 15 percent last year. That includes a new 3.8 percent surtax on investment income as a result of the 2010 health-care law.
Congress also reinstated limits for this year on the value of personal exemptions and deductions, known as Pep and Pease, which affect married couples with adjusted gross income of more than $300,000 a year or $250,000 for singles.
Consider a married couple with $1 million in combined income and deductions of $90,000 for their state income taxes, $50,000 in charitable donations and $50,000 in mortgage interest, or a total of $190,000. With the Pease limitation, they lose $21,000 in available deductions, said Johnson, who is based in New York.
“There may be some interesting tradeoffs,” he said.
High earners may curtail their donations or consider the mortgage-interest deduction when deciding how much of a loan to take, if the limits make their interest payments less valuable for tax purposes, he said. Some homeowners may choose to restructure their mortgages through refinancing, he said.
For top earners with investments there’s a renewed focus on tax efficiency because of higher rates, said Mitchell Drossman, national director of wealth planning strategies for U.S. Trust, a unit of Bank of America Corp. (BAC)
“Part of it is asset allocation and part of it is asset location,” he said.
Long-term capital gains, or those on investments held more than a year, still receive preferential tax treatment though Congress raised the top rate to 20 percent from 15 percent in the budget deal.
By comparison, some hedge funds trade frequently and generate short-term gains, which are taxed as ordinary income at rates as high as 39.6 percent, plus a 3.8 percent Medicare surtax. “That’s highly tax inefficient,” Drossman said.
Investors should consider purchasing assets that generate income taxed at ordinary rates including high-yield and emerging-market debt through tax-deferred retirement plans. They should also buy tax-efficient assets such as municipal bonds and commodities through a taxable account, said Dean Junkans, chief investment officer at Wells Fargo & Co. (WFC)’s private bank.
“The cost of ignoring those strategies has gone up for a lot of investors,” Junkans said.
Top earners who want to shift investments from taxable accounts to tax-deferred ones, or vice versa, have to plan ahead -- often over a span of more than one year, Junkans said. Transfers may involve liquidating some holdings, which can generate their own tax consequences, he said.
A focus for high earners should be to harvest losses throughout the year to offset later gains, said Bragar of Aspiriant. “That’s one of the everyday blocking and tackling that every investor can do” to save on taxes this year or in the future, she said.
Taxpayers can deduct up to $3,000 a year of capital losses that exceed capital gains to reduce ordinary income. They also can carry forward an unlimited amount of excess losses to offset gains in subsequent years, according to Internal Revenue Service rules.
Maximizing contributions to retirement accounts such as a 401(k) plan can help families reduce their income, said Susan Bruno, an accountant and financial planner at Beacon Wealth Consulting LLC. “Sometimes that’s overlooked,” she said. “People are too busy.”
A 401(k) plan generally lets employees defer a portion of their wages to the account on a pretax basis. Contributions are limited to $17,500 for 2013, while those age 50 or older may set aside an additional $5,500, according to the IRS.
Top earners who are charitable should give appreciated property such as stocks held for more than a year to an eligible charity directly, advisers say. That way they don’t have to pay tax on the gains and would receive a deduction for the fair market value of the securities, said Bragar of Aspiriant.
Clients with charitable intent who are trying to keep their income below some of the thresholds for rate increases also should consider a charitable distribution from their individual retirement accounts, as it can reduce their income for tax purposes, Bragar said. Congress extended the benefit through 2013, which lets people older than 70 1/2 transfer up to $100,000 from their IRAs directly to charity.
Getting the most out of such strategies requires planning throughout this year, Bragar said.
“It’s like a game of tax limbo,” she said.
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