Articles About Income Tax Planning

Social Security benefits first became partially taxable in 1983, and the rule was expanded in 1993 to its current form. As the rules stand now, rising income can subject 50% or even 85% of Social Security benefits to taxation, until a maximum of 85% of all Social Security benefits are included in income for tax purposes.

The reason the taxability of Social Security matters is not just that it raises a client's tax burden in the aggregate, but that it can boost a client's marginal tax rate far above the tax bracket alone; those in the 15% tax bracket may actually face marginal rates of 22.5% to 27.75%, and those in the 25% tax bracket can see marginal tax rates spike as high as 46.25%!

Fortunately, this rate eventually reaches a cap - when the maximum amount of Social Security benefits are being taxed - and the client's tax rate returns to normal. Nonetheless, while clients are going through the income levels where Social Security phases in - which can begin with as little as $25,000 of income for individuals - tax rates rise high enough that more proactive tax planning, from Roth conversions to the use of annuities and asset location strategies, becomes crucial to manage a client's overall tax exposure!

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Since 2007, higher-income individuals and couples have been required to pay an additional income-related monthly adjustment amount (IRMAA) on their Medicare Part B premiums; a similar rule took effect in 2011 for Medicare Part D premiums. The ultimate impact can potentially be significant; although only a small number are affected, those at the highest income levels in 2015 (used to determine premiums in 2017) will see their Medicare Part B premiums rise from a base of $134.00/month up to $428.60/month. (Notably, though, those eligible for the "hold harmless" rules will have Part B premiums capped at $109.00/month for 2017.) In addition, Part D premiums will cost as much as an extra $72.90/month in addition to the base rate of the plan itself, under the IRMAA rules.

Although the higher premium amounts are a cost, because they're determined based on income and may change from year to year, they effectively equate to an "indirect tax" in the form of a higher burden on higher income levels. In turn, this means that the income thresholds for Medicare Part B and D premiums should itself be treated as a "tax bracket" that can be planned and managed around, as a form of proactive income tax planning. Strategies that might create income, or defer income resulting in a greater concentration down the road, must be evaluated for not only their outright tax consequences, but their indirect tax consequences in the form of higher Medicare premiums!

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The non-deductible IRA has long been a financial planning tool, albeit one that has become far less popular in recent years, given the tax preferences for both qualified dividends and long-term capital gains.

However, with the new 3.8% Medicare surtax on net investment income that took effect in 2013, a new incentive has emerged: even with ordinary income treatment, the non-deductible IRA provides a way to permanently avoid the surtax, which would otherwise apply to interest, dividends, and capital gains, as well as income from other tax-deferred vehicles like deferred annuities.

The strategy is especially appealing to those who are in the peak income years of their career, where a Roth conversion is unappealing due to the high current tax bracket (and other IRAs that will be aggregated), tax deferral is valuable, and a permanent avoidance of the 3.8% Medicare tax provides yet another added value... especially if the account will hold fixed income investments that were going to be taxed at ordinary income rates anyway.

Fortunately, the strategy is available regardless of how high income rises (and in fact, is best at high income levels), and while the value of the strategy is limited by the IRA contribution limit of $5,500 in 2013 2015, several years of compounded efforts can still potentially produce a significant tax savings in the future!

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Effective financial planning for clients often has tax-related consequences, which in turn requires a good understanding of not only the tax laws themselves, but also the client's tax rates. Unfortunately, though, significant confusion abounds regarding what tax rates should be used when analyzing various problems. Is it the client's tax bracket? Or a marginal tax rate? Or an effective tax rate? When should each be used? The key is that in the end, marginal tax rates should be used to compare strategies, and effective tax rates should be used to compare people.

Accordingly, if you want to know who commits a larger portion of their total income to their tax obligations, use an effective tax rate. But if you want to know whether to do that Roth conversion/IRA withdrawal/annuity investment/sale for a capital gain or loss/etc., the marginal tax rate is what should be used. In point of fact, this actually means that the marginal tax rate is really the only rate that should be used for financial planning scenarios!

The caveat, however, is that in practice determining a client's marginal tax rate requires more than just looking at his/her tax bracket... so be certainly to calculate the marginal tax rate correctly, too!

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Amongst the various "extenders" included in the American Taxpayer Relief Act of 2012 (ATRA) was the reinstatement of rules allowing an individual to make a "Qualified Charitable Distribution" (QCD) from an IRA to a charity with favorable tax consequences, assuming the individual has reached the minimum 70 1/2 age, stays within the $100,000 dollar limit, and meets other requirements regarding the distribution and the receiving charity. Unfortunately, though, bringing back QCDs retroactively for 2012 was of limited use when the law wasn't even passed until the first week of 2013 and the 2012 tax year was already closed!

To accommodate, Congress included two special lookback rules under ATRA - the first allows QCDs done in January of 2013 to be treated as a 2012 QCD, and the second allows December 2012 IRA distributions to be recharacterized as a QCD if a comparable amount of cash is donated to a charity after the IRA distribution but before the end of January, 2013. While these two rules are nice to have, though, the reality is that neither may be very useful, except for a few unique situations, such as those who already plan to max out their QCDs up to the $100,000 limit for 2013 and are looking to donate more. In addition, most clients will still benefit more by contributing appreciated securities to a charity, than by donating cash (with or without the QCD treatment). Nonetheless, the new rules do open up some useful planning scenarios for some client situations, and with only a few weeks available to take advantage of the rules, the time window is short to decide whether or not to take advantage of the two new special 2012 lookback rules for QCDs!

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The last-minute fiscal cliff compromise - H.R. 8, which will also be known as the American Taxpayer Relief Act of 2012 (or "ATRA") - extends the majority of tax cuts that were scheduled to expire at the end of 2012, in addition to retroactively reinstating some rules that had expired in 2011. However, the legislation also introduces a number of changes as well - including a new top tax bracket of 39.6%, and an increase in the top long-term capital gains and qualified dividend rate to 20%. And some old rules that had lapsed and were scheduled to come back have in fact returned, such as the Pease limitation (phaseout of itemized deductions) and the Personal Exemption Phaseout (PEP). In addition, a new rule will allow 401(k) participants to complete intra-plan Roth conversions.

For planning purposes, though, the good news is that not only was the fiscal cliff largely "averted" with last minute legislation, but the changes under ATRA are permanent. On the other hand, making some rules permanent - such as not only the current gift and estate tax exemption, but also the portability of a deceased spouse's unused exemption - will change income and estate tax planning going forward.

In this article, we take a first look at the details of the H.R. 8 fiscal cliff legislation and some of its financial planning implications.

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In early December, the IRS and Treasury issued a series of Proposed Regulations for the two new Medicare taxes scheduled to begin on January 1, 2013 - the 3.8% Medicare tax on unearned income (generally, a 3.8% surtax on net investment income), and the 0.9% Medicare tax on earned income (i.e., wages and self-employment income), applied to "high income" individuals above certain thresholds. Although the new rules are still proposed and may ultimately be amended or changed, the Treasury and IRS nonetheless indicated that they can be relied upon by taxpayers. However, given the limited time to cultivate these regulations - including addressing potential loopholes - the rules did indicate that taxpayers should not try to read between the lines to find loopholes in the proposed regulations, and that the IRS will closely review transactions that manipulate net investment income to eliminate Medicare tax exposure.

While there were no huge surprises in the guidance, it does provide important clarification on a wide range of issues that planners and their clients must contend with heading into 2013, including how the Medicare tax rules interact with other parts of the tax code, and serves as a reminder to complete any last minute capital gains harvesting that high-income clients may wish to engage in before 2013 begins (including a special opportunity for Charitable Remainder Trusts!)!

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Given the costs associated with investment advice, clients often want to maximize any available tax benefits to help mitigate the cost. Fortunately, the IRS does allow a tax deduction for certain investment-related expenses, and while the treatment isn't ideal - a miscellaneous itemized deduction subject to the 2%-of-AGI floor, and an AMT adjustment - something is better than nothing. In fact, the IRS even allows investment advisory fees to be deducted when paid on behalf of retirement accounts like IRAs and 401(k) plans. Alternatively, the IRS also allows investment advisory fees to be paid directly from a retirement account - which effectively allows the fee to be paid with 100% pre-tax dollars.

However, an important caveat is that while retirement accounts can cover their own fees, paying any other fees from such accounts can trigger highly adverse results, including taxable distributions, early withdrawal fees, and even a prohibited transaction disqualification of the entire retirement accounts! In the end, the power of tax deferral means that most clients will probably simply pay fees from taxable accounts and claim whatever tax deduction they can, but clients with shorter time horizons - including and especially retirees - should consider paying fees directly from their IRAs and other retirement accounts... but be certain those fees are only for the associated retirement accounts!Read More...

Under the Defense of Marriage Act (DOMA), the Federal tax law only affords treatment to married couples when the marriage is between a man and a woman, and denies marital treatment for same-sex couples, regardless of whether the couple is recognized as married under state law. However, in the recent Windsor v. United States court case, a New York District Court declared the applicable Section 3 of DOMA to be unconstitutional, and ruled that a same-sex couple should be eligible for the marital deduction for Federal estate taxes, resulting in a $363,000 estate tax refund. The case will likely end up in the Supreme Court, and in fact appears to be on the fast track to get there soon. If DOMA is ultimately declared unconstitutional, it will result in a dramatic shift in planning for same-sex couples, opening the door for marital treatment for estate tax marital deduction, intra-couple gifts, and numerous income tax deductions, credits, and other benefits afforded to married couples. At this point, DOMA is still the law of the land, but same-sex couples may wish to begin filing protective refund claims in case DOMA is ultimately struck down in the coming year.Read More...