How to Reduce the Sting of New, Higher Taxes

It was a rough ride on Capitol Hill to come up with the fiscal cliff deal, but there is good news for consumers: the uncertainty over what taxes will look like for the foreseeable future is finally over. A number of changes introduced during George W. Bush's time in office have been made permanent and Congress updated the Alternative Minimum Tax, or AMT, to automatically adjust based on inflation each year. This removes much of the angst about what future tax rates will be and makes it possible do do some planning.

Here's the bad news: the folks in Washington, D.C., have arbitrarily decided a number that makes people “wealthy” and those people can expect to pay significantly more in taxes starting this year.

However, even if your income doesn’t run into six digits, you’re going to see a bigger bite out of your paychecks thanks to tax increases. The amount that is deducted for Social Security tax is going up nearly 50% to 6.2%. That rate was that high before the 2008 economic crisis, but in an attempt to help spur a recovery,  in 2011 politicians figured that lowering the so-called OASDI(1) tax to 4.2% would increase the amount of take-home pay folks received and ultimately increase consumer spending. (2)

What’s that? You didn’t notice the increase in your paycheck over the last few years? Don’t worry, you didn’t miss anything. The biggest impact this policy had was to add hundreds of billions of dollars to our national debt. As I pointed out last February, an extensive study of 34 industrialized countries by the non-partisan Tax Foundation concluded that "payroll tax cuts have no impact on long-term economic growth." But, hey, never let the truth get in the way of a great political story.

Of course, in addition to paying more in Social Security tax, the “wealthy” are also going to see other types of tax increases, notably on income and capital gains.

For instance, once the income of a married couple (who file jointly) exceeds $450,000(2), their marginal tax rate rises from 35% to 39.6%. Below are the projected tax rates and brackets for 2013 as estimated by CCH:

Notice that in the 10% and 15% brackets, the income levels for married taxpayers are double that of a single individual; a “marriage penalty” begins when you get to the 25% bracket. Whereas a single person would still be in the 25% bracket with an income of $87,850, the upper income limit for married couples in this bracket is less than twice that amount. The disparity grows until it reaches the top bracket: married couples are subject to the highest tax rate when their income hits $450,000- not 200% (twice) as much as a single person, but just 11% more.

Your income also determines the tax you will pay on interest, capital gains, qualified dividends and investment returns this year. Technically, the top rate rises from 15% to 20%- a 33% increase. But in reality, it’s 59% higher, thanks to the new Medicare surtax on unearned- i.e. investment- income. According to Thomson Reuters, here are the rates for 2013:

Tax Rate on Dividends & LT Capital Gains

Keep in mind that if you make a profit on the sale of your home this is considered a capital gain and is subject to the applicable rate above.(3) Of course, depending upon your marital status, you get to reduce the taxable profit by either $250,000 (single) or $500,000 (married). Thus, this exclusion could completely eliminate your taxable profit. “Bear in mind, this [tax break] does not apply to a vacation home,” reminds Bob Scharin, senior tax analyst for Thomson Reuters. It only applies to your principal residence.

Furthermore, he points out, “You could be hit by the 3.8% surtax [on capital gains] before the higher tax rate on capital gains.” That’s because, in the case of a married couple filing a joint return, the Medicare surtax applies once your MAGI hits $250,000, while the higher capital gains rate doesn’t kick in until your MAGI reaches $450,000 or more.

“If you’re below the $200,000 [single] or $250,000 [married/joint] threshold you’re not going to be affected” by the recently-enacted tax increases. If your income exceeds these amounts, you’re going to be affected by some of the changes. “If your income is greater than $400,000 [single] or $450,000 [married/joint], you’re affected by all of the changes.”

To find out how your federal tax bill might change, visit the Tax Foundation’s “My Tax Burden” calculator.

Frankly, if your income is high enough that it throws you into the top bracket or makes you subject to the Medicare surtax, there isn’t a lot you can do. Here are a few strategies to consider, with the caveat that you should consult with a tax and possibly a legal expect before pulling the trigger:

Make gifts of appreciated assets to relatives in a lower tax bracket

For instance, suppose you are providing more than 50% of the support for a parent. Instead of cash, consider giving your dad appreciated property- shares of a mutual fund or appreciate stock, for instance. Dad then sells the shares to generate the income he needs “If his income is low enough, he might be paying zero to 15% on the gain rather than you paying 20% and potentially the additional 3.8% surtax," says Scharin.

Reminder: there are limits on how much property you can gift before you start to affect something called your “unified credit,” the amount you can leave to heirs estate tax-free at your death. Also, be careful about transferring property to minors; they could be subject to the “kiddie tax,” negating any benefit of making the gift.

Think about municipal bonds

Since the interest that munis pay is not subject to federal (and sometimes state) income tax, they always look more attractive when tax rates go up. This is especially true now because of the Obamacare surtax. As Scharin points out, “The 3.8% Medicare surtax is on taxable investment income only.”

Consider “like-kind” exchanges for real estate you want to sell

This only works for real estate owned for investment or business purposes, not a personal residence. The tax code allows you to essentially swap your property for a similar piece of real estate owned by someone else and avoid paying tax on the transaction. “For instance,” says Scharin, “Suppose you’re getting on in years and no longer want to be responsible for doing repairs on a small apartment building you own. You can exchange that for another type of investment property where, say, the tenants are responsible for the upkeep.”

Look at life insurance

The cash value of a life insurance policy is not subject to current income tax. When you die and the policy is paid out, the proceeds pass tax-free to your beneficiary. “There are estate planning considerations,” says Scharin.

Convert to a Roth account

As you probably know, Uncle Sam is a little short on cash these days. As a result, our political leaders have decided to loosen the rules on Roth conversions inside company retirement plans. Yes, folks,it’s now easier than ever to save for your nest egg! Gone are most of the restrictions that made this difficult to do. Essentially, all it takes are two conditions: 1) your company 401(k), 403(b), 457, etc. plan includes a Roth component, and 2) the plan specifically permits you to convert assets held in the pre-tax side of the plan to the after-tax Roth side.

Why are they being so nice to us? Because converting requires that you pay the income tax you avoided when your original contribution went into the pre-tax side of your plan. You convert = Uncle Sam collecting more tax money.

Why would you want to do this? Because once in a Roth account, your money grows tax -free forever. Essentially, Congress is looking for a way to raise money today as opposed to the future when you’re retired and drawing income from your account.

You should really consult a tax expert before doing this, because, according to Scharin, “You don’t want the conversion amount to push you into a higher bracket.” While the amount converted is considered “earned income” and, thus, not subject to the Medicare surtax, when added to your other sources of income, it could raise your total income above the $250,000 threshold. That would make your unearned income- dividends, capital gains, interest on bank accounts- subject to the 3.8% tax, a tax that might not have applied if you had not done the conversion.

If none of the above suggestions make sense for your particular situation, be patient. In Scharin’s words, “It’s quite certain that tax laws will change.”

1. Old Age and Survivors Disability Insurance.

2. The reduction applied only to employees. Employers did not get a break; they have continued to contribute 6.2%.

3. If you have owned your home for at least a year, you qualify for long-term capital gains treatment; otherwise, the profit is taxed at your higher, “ordinary income” rate.

Ms. Buckner is a Retirement and Financial Planning Specialist and an instructor in Franklin Templeton Investments' global Academy. The views expressed in this article are only those of Ms. Buckner or the individual commentator identified therein, and are not necessarily the views of Franklin Templeton Investments, which has not reviewed, and is not responsible for, the content. 

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