By Kelly Rienhart, CPA
It is safe to say that if you are not close with
your tax and financial planning professional,
now is the time to make that connection. With
all that is written on the ramifications of last
year’s fiscal cliff legislation and the ongoing
discussions on how tax laws will fair with the
budget crises on hold, it is difficult to make
heads or tails of it all.
There is one concept however that everyone
gets: taxes went up.
There are two tax increases which will have
a major impact on most middle to high income
taxpayers for 2013. Without proper year-end
planning this will come in the form of an unwanted
For the highest income taxpayers the marginal tax rate went up to a maximum of 39.6 percent, long-term capital gains went up from 15 percent to 20 percent and a new Net Investment Tax surtax of 3.8 percent will be added to these already increased rates. In addition to these tax hikes, Alternative Minimum Tax continues to play a big part in tax bills.
The Issue: Not only did the tax rate increase 4.6 percent up to 39.6 percent for the highest tax bracket but it also increased for most people with income over $200,000. In addition, married individuals above $250,000 (single $200,000) may be subject to the new surtax or Net Investment Tax. This would increase the rate to an astounding 43.4 percent. In a high tax states, like New York, this brings the total tax bill to over 52 percent.
The Problem: The pressing concern with rate hikes of this nature is not everyone will have adjusted their withholding and estimated tax payments throughout 2013 to compensate for these changes. Tax professionals typically do their best to estimate what tax withholding and payments for the current year when they prepared your taxes.
However, no one is able to predict the future and even the slightest changes in your income can have a major impact at these new rates. If you are a middle to high income taxpayer, it is imperative that you make year-end tax planning part of your annual holiday plans.
Tax Planning Ideas: For most people the best tax advice is to defer your income into retirement. It applies to everyone and it allows you to grow your money tax free. Most American households are grossly underfunding their retirement plans. Perhaps Congress has finally motivated us to save more in retirement. If you own a business and have some control over the retirement plan(s) your business offers, look into some of the newer concepts in retirement such as defined benefit plans coupled with 401K plans.
Plans such as these can potentially allow you to put away hundreds of thousands of dollars rather than the normal amounts you are used too. Not every business qualifies for these plans nor has the available cash to fund them, but it is still important that you investigate your retirement plan alternatives. If you are an employee, seek a financial planner and start to budget your personal finances to allow you to contribute more to retirement.
The Issue: The Net Investment Tax (NIT) is 3.8 percent on various types of unearned income (investment income) and will apply to any single taxpayer over $200,000 or married taxpayer over $250,000. The tax is only applied to investment income and not wages, active business income, retirement distributions, or municipal bonds. It includes interest, dividends, capital gains and passive business investments.
For example, if you are married and make $200,000 and in the 33 percent tax bracket; your interest would be taxed at 36.8 percent and the capital gains that are now being taxes at 20 percent would be taxed at 23.8 percent.
The Problem: The problem lies mainly with in the types of investment portfolios many people now hold. With the fall of interest rates there has been the need to turn to different investment vehicles such as large partnerships to find viable investments with acceptable returns.
While these investments are in businesses they are not “business income” but passive income for tax purposes. What passive income means in simple terms is any business you invest in but either participate minimally or do not participate at all. For some people this is investments in real estate, oil and gas or similar businesses. This income is now subject to the additional 3.8 percent even though you may think of it as business income. Another problem may arise in the form of capital gains. Long-term capital gains went from 15 percent to 20 percent and are also subject to the NIT.
Planning Ideas: The tax implications of the NIT will eventually force people to plan their portfolios more carefully. It is clear that your tax and financial professional must work in concert to maximize your returns. Tax now plays a larger role in the types of investments you make and the type of income it produces. For example, a New York municipal bond is not subject to Federal or State income tax and is not subject to the NIT.
It could make the case that bonds might be more attractive than they were 12 months ago. Another example would be balancing dividend paying vs. growth stocks or mutual funds. Growth stocks that pay minimal dividends now look more attractive today. It isn’t as easy as just looking at an investments historical return within this new NIT climate.
The Issue: Over the last several years many taxpayers have listened to their tax preparer telling them their tax bill is higher this year due to Alternative Minimum Tax (AMT). You probably went away from the conversation confused. AMT was originally designed to make sure that higher income taxpayers paid their fair share of taxes and didn’t use excessive write-offs to bring their tax rate down to the lower brackets. Unfortunately, to the surprise of many, what was originally designed for high income taxpayers is now affecting middle income taxpayers. Congress fixed some of these problems in January but AMT still remains something to watch.
The Problem: AMT is especially troublesome for people with a significant amount of income from long-term capital gains, qualified dividends, or those who are in high tax states such as New York. The fact that New York is one of the highest tax states puts New Yorkers at more risk for AMT then most others. The AMT rate is 28 percent of your taxable income after a long list of adjustments for deductions you took or income that was taxed at lower rates (capital gains, dividends). Although the 28 percent AMT tax rate is much lower than most the higher marginal rates, after AMT adjustments the AMT tax rate can be a surprise.
Planning Ideas: AMT is tied to a multitude of moving parts within your tax return. This makes it difficult to generalize any one resolution. It is important to be actively engaged in tax planning to understand the full picture of how AMT will alter your tax liability. For example, year-end tax planning commonly calls for accelerating deductions into 2013 to reduce your tax liability.
To do this many people prepay their state income tax to reduce their tax liability. Sound advice, unless AMT is in play and it negates these efforts. Invest in a year-end tax estimate to insure that all of these factors are taken into consideration therefore eliminating the surprise.
The new tax rates will most likely create a large number of unhappy taxpayers come tax time next year. It is important to understand that the main benefit to year-end tax planning is gaining an understanding of what you potentially owe. It is not only an insurance policy, but peace of mind that you won’t have any major surprises on your tax return. It allows you to plan your cash flow and minimize the tax impact whenever possible.
The days of complicated tax strategies to reduce your taxes are long past. As new tax laws continue to pass in growing numbers, new ideas are born in tax planning but they are ever changing and therefore require more attention than an annual visit to your tax and financial planning professional.
Reinhart, CPA, is managing partner of Reinhart & Associates LLC (www.reinhart-cpa.com). He can be reached at Kelly@reinhart-cpa.com or 518-306-4138.
Photo Courtesy of Reinhart & Associates