Please note the information below is intended to provide generalized information that is appropriate in certain situations.  It is not intended or written to be used, and it cannot be used by the receipient, for the purpose of avoiding federal tax penalties that may be imposed on any taxpayer.  The contents of the information provided below should not be acted upon without specific professional guidance.  Please call us if you have any questions.

After Congress passed and the President signed into law the American Taxpayer Relief Act of 2012 (ATRA), dramatic individual income tax increases went into effect in 2013. The ATRA shifted America from a two dimensional tax system to a five dimensional tax system. The advent of a five dimensional tax system makes 2013 year-end tax planning imperative. On top of the regular income taxes and the Alternative Minimum Tax (AMT), ATRA introduced higher tax brackets for high income taxpayers, limitations on personal exemptions and itemized deductions (PEP and Pease), and a new net investment income tax (NIIT). These increases include the following:  

• The highest income tax bracket on ordinary income and short-term capital gains increased from 35% in 2012 to 39.6% in 2013
• The highest income tax bracket on long-term capital gains increased from 15% to 20%  
• A new 3.8% net investment income tax (NIIT) went into effect for high income individuals
• When the NIIT is added to the top income tax brackets, the tax rates could be as high as 43.4% for ordinary income and short-term capital gains and 23.8% for long-term capital gains
• Taxpayers over the applicable threshold amount for PEP may have some or all of their personal exemptions phased out
• Taxpayers over the applicable threshold amount for Pease may have up to 80% of their itemized deductions phased out  

Tax planning is necessary not only to help your family minimize or avoid these new tax increases, but also to ensure that your expected tax liability estimates for 2013 and beyond are correct. This letter will suggest some ways to avoid or minimize the adverse effects of these changes in 2013 and later years. Planning for these tax changes is a major undertaking so you should start the process as soon as possible.

Planning for the 3.8% NIIT 

For tax years beginning January 1, 2013, the tax law imposes a 3.8% NIIT on certain net investment income of individuals, trusts and estates. For individuals, the amount subject to the tax is the lesser of (1) net investment income (NII) or (2) the excess of a taxpayer's modified adjusted gross income (MAGI) over an applicable threshold amount.  

Net investment income includes dividends, rents, interest, passive activity income, capital gains, annuity income and royalties. Specifically excluded from the definition of net investment income are self-employment income, income from an active trade or business, gain on the sale of an active interest in a partnership or S corporation and IRA or qualified plan distributions. MAGI is generally the amount you report on the last line of page 1, Form 1040.  

The applicable threshold amounts are shown below.  

Married taxpayers filing jointly                               $250,000 

Married taxpayers filing separately                       $125,000 

All other individual taxpayers                                $200,000 

Estates and Trusts                                       $11,950  

A simple example will illustrate how the tax is calculated.  

Example. Al and Barb, married taxpayers filing jointly, have $300,000 of salary income and $100,000 of NII. The amount subject to the NIIT is the lesser of (1) NII ($100,000) or (2) the excess of their MAGI ($400,000) over their threshold amount of $250,000 for married taxpayers filing jointly ($400,000 -$250,000 = $150,000). Because NII is the smaller amount, it is the base on which the tax is calculated. Thus, the amount subject to the tax is $100,000 and the NIIT payable is $3,800 (.038 x $100,000).  

Fortunately, there are a number of effective strategies that can be used to reduce MAGI and/or NII and reduce the base on which the NIIT is paid. These include (1) Roth IRA conversions, (2) tax exempt bonds, (3) tax-deferred annuities, (4) life insurance, (5) rental real estate, (6) timing estate and trust distributions, (7) charitable remainder trusts, (8) charitable lead trusts, (9) other types of trusts, (10) installment sales, (11) gain and loss harvesting, (12) intra-family loans, (13) oil and gas investments and (14) maximizing above-the-line deductions. We would be happy to explain how these strategies might save your family large amounts of NIIT.

Estimated Tax Planning 

As a result of these recent tax increases, some taxpayers’ quarterly estimated tax liabilities may not be sufficient. Tax planning is imperative to ensure that your estimated tax liability is accurate and to avoid any penalties that may be imposed if your quarterly estimated tax liability is not accurate. Furthermore, tax planning is necessary to give you peace of mind come April 2014. We will be able to take into account your family’s financial situation, the new five dimensional tax system, and any tax planning strategies to provide you an up-to-date 2013 expected tax liability.  

Lastly, a plan needs to be put in to place concerning your state tax liability. Depending on your family’s financial situation and when you pay your state taxes, we may be able to reduce your federal tax payable, including the AMT.

Accelerating and Deferring Income 

An opportunity that should be noted is accelerating income into 2013 if you expect to be in a lower tax bracket in 2013 than in 2014 and later years. Perhaps the best way to accelerate ordinary income into 2013 and reduce income in later, higher tax bracket years would be to convert a traditional IRA to a Roth IRA in 2013, if a conversion otherwise makes sense. Ordinary income could also be accelerated by selling bonds with accrued interest in 2013 or selling and repurchasing bonds trading at a premium. Finally, taxpayers might consider exercising non-qualified stock options in 2013. Taxpayers with the opposite situation—higher ordinary income in 2013 than in 2014 and later years—might wish to defer income into 2014. Many of the same strategies listed above for reducing MAGI and/or NII may also be used to defer income.  

Similarly, capital gains could be harvested in 2013 if the taxpayer is in a lower tax bracket in 2013 than in 2014 and later years. This is especially true if the taxpayer has long-term capital gains and is in the 10% or 15% ordinary income tax brackets in 2013, as the long-term capital gains will be taxed at 0%. Moreover, if the taxpayer has gains in 2013, losses could be harvested to offset those gains.  

We are prepared to assist you in modeling scenarios and developing projections to help determine which strategies are right for you. Please don’t hesitate to contact us to schedule an appointment to begin discussing your options.