The higher tax rates passed by Congress this year have some top U.S. earners seeking last-minute strategies to lower their tax bite as year-end calculations turn up unpleasant surprises.
“There are many, many high-income taxpayers now who are finding themselves facing tax rates in excess of 50 percent,” said Suzanne Shier, a tax strategist and director of wealth planning at Chicago-based Northern Trust Corp. (NTRS:US) “That really gets their attention.”
High earners are seeing a combination of federal tax increases for 2013: a top marginal rate of 39.6 percent, up from 35 percent; a 20 percent tax on long-term capital gains and dividends, up from 15 percent; and a new 3.8 percent tax on investment income. Also, limits on exemptions and deductions are taking effect for this tax year.
Some top earners are only now realizing they may owe much more by April 15 because they’ve been paying quarterly estimated taxes based on their liability for 2012, which the Internal Revenue Service allows in a “safe-harbor” rule, said Elda Di Re, a partner at Ernst & Young LLP.
Others are absorbing the effects as they rush to implement strategies before Dec. 31 to limit the tax bite on earnings, market gains and stakes in businesses.
State taxes can push the bill higher for some high earners. In California, the top rate is 13.3 percent on income exceeding $1 million.
Investors with significant portfolios are seeing some of the biggest increases this year, said Martin Kalb, co-chairman of the global tax group at Greenberg Traurig LLP.
For wealthy taxpayers, the rate on long-term capital gains and qualified dividends now can be as much as 25 percent, including the new surtax and limits on deductions, Kalb said. That’s a 67 percent increase from 2012. The rate on other investment income such as royalties, interest and rents can exceed 43 percent.
“Clients are a little startled at the amount of additional taxes they are paying,” said Maury Cartine, a partner at Marcum LLP whose clients include private equity and hedge fund managers.
According to an analysis by Cartine, a married couple in New York with $600,000 in wages, $100,000 in qualified dividends and $300,000 in long-term capital gains -- as well as $145,000 in itemized deductions for real estate taxes, mortgage interest and state and local taxes -- would pay about 17 percent, or $37,000, more in U.S. taxes this year.
By comparison, a family with $600,000 in wages, no investment income and $105,000 in itemized deductions would see about a 2 percent, or $3,000 increase, he said.
Congress set the top tax rate for income above $450,000 for married couples or $400,000 for individuals, after deductions. Those are the same thresholds for the top levy on long-term capital gains and dividends.
Additionally, two new taxes to help finance the 2010 health-care law -- a 3.8 percent surtax on investment income and 0.9 percent added levy on wages -- apply to income of more than $250,000 a year for married couples and $200,000 for individuals.
Lawmakers also reinstated phaseouts of personal exemptions and itemized deductions for adjusted gross income exceeding $250,000 for individuals and $300,000 for married couples.
“It’s going to be a big surprise when they find out they aren’t going to be able to take all of their itemized deductions,” said Tracy Green, a vice president in tax and financial planning in the advisory unit of Wells Fargo & Co. (WFC:US)
With less than two months left in the tax year, advisers and accountants are focusing on clients with closely held business stakes, mutual-fund holdings, charitable donations and retirement accounts to help maneuver around higher rates.
To minimize the effect of the 3.8 percent tax, high earners are reviewing their interests in S corporations and other flow-through entities to see if they can become active rather than passive participants, said William Zatorski, a partner in PricewaterhouseCoopers LLP’s private company services practice. Business income from active participation isn’t subject to the surtax and that shift in S corporations doesn’t trigger self-employment tax, he said.
This year’s stock market rally -- the Standard & Poor’s 500 Index returned 25 percent through October -- has tax implications for many investors with mutual funds, said Green of Wells Fargo Advisors.
“This year the chances of having long-term capital gain distributions are going to be pretty good,” she said.
Mutual fund companies are releasing estimates of distributions this month, which investors can use to plan, Green said. Those intending to sell a fund should do so before distributions, while investors seeking to buy shares should wait until after, she said.
Some high earners may have to shift their usual year-end strategies because the new top rate means they are no longer subject to the alternative minimum tax, or AMT, said Di Re of Ernst & Young. Taxpayers not subject to the minimum tax can pre-pay state income or real estate taxes before Dec. 31 to lower their taxable income, Zatorski of PwC said.
Bumping up charitable donations is another strategy, Kalb of Greenberg Traurig said. Taxpayers with gains in publicly traded stocks can donate them to a public charity or their own private foundation. They’d be eligible for a charitable deduction equal to the fair value of the security, and would avoid the long-term capital gains rates, he said.
Individuals age 70 1/2 or older should consider giving as much as $100,000 to a qualified charity directly from an individual retirement account, Wells Fargo’s Green said. The donation can meet all or a portion of the annual required minimum distribution for IRA owners and isn’t recognized as income.
Also, high earners can maximize contributions to tax-advantaged retirement plans and realize some losses to offset capital gains, Green said.
Another recommended strategy is to defer income by investing in private-placement life insurance and private annuities. These are designed for high net-worth individuals, Kalb said.
Beyond 2013, high-income investors can add tax-exempt bonds or convert some retirement savings to Roth accounts, Green said. When savers put money into Roth IRAs and Roth 401(k)s, they pay taxes on the money upfront in exchange for tax-free withdrawals later.
Funds that capture losses throughout the year to offset gains will be especially attractive to investors because the strategy can reduce net income reported on tax returns at year-end, Shier of Northern Trust said.
Once high earners figure out this year’s strategy, advisers are saying they should keep an eye on moves in Congress that could change their future tax picture.
House and Senate panels are considering making the biggest changes to the U.S. tax code since 1986. Representative Dave Camp, chairman of the House Ways and Means Committee, wants to lower the top individual rate to 25 percent in a way that would require eliminating or curbing many tax breaks. Camp, a Michigan Republican, has said he will release a plan this year.
Passage of any revisions would be difficult and wouldn’t happen until sometime in 2014, at the earliest.
The possibility of more tax changes has some high earners taking advantage while they can of breaks such as the sales tax deduction, Kalb said. That benefit, which allows deducting sales tax instead of state income tax, is set to expire Dec. 31 along with some other breaks.
“A lot of my clients are looking to buy very expensive assets that will pay a lot of sales tax, especially in Florida,” which doesn’t have a personal income tax, Kalb said. “If someone buys a $2 million boat this year they can get the deduction for sales taxes.”
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