The close of every year seems to bring its own uncertainty from a tax-planning perspective. Last year we faced the expiration of certain temporary tax provisions and the commencement of automatic federal government spending cuts. In October 2013, the President and Congress temporarily agreed on funding the government and increasing the national debt limit. But these issues will be back in play early in 2014 and could result in tax law changes that affect income-tax and financial planning.
For the time being, the best approach is to focus on how to limit your exposure to the many new or increased taxes in 2013 and beyond.
Tip 1: Manage higher taxes
Many taxpayers will be faced with higher tax bills in 2013 as a result of:
The temporary reduction in the Social Security tax from 6.2% to 4.2% that expired at the end of 2012. This means an increase of $2,000 in taxes for $100,000 of wages.
The tax rate on wage income that increased from 35% in 2012 to 40.5% in 2013, the tax rate on interest income that increased from 35% to 43.4% and the tax rate on capital gains and dividends that rose from 15% to 23.8% for high-income taxpayers.
The Affordable Care Act, which was passed in 2010, that increased the Medicare tax from 1.45% to 2.35% for high-income taxpayers starting in 2013.
Two strategies that can help minimize these taxes:
Avoid a transaction, such as selling stock, which would push you into a higher tax bracket.
Accelerate any deductions that you control, for example, pay your January mortgage in December to get the interest deduction in 2013.
Note that tax considerations are only one factor when determining whether to buy, hold or sell an investment.
Tip 2: Understand the new investment income tax
The new 3.8% tax on investment income created under the Affordable Care Act became effective in 2013. The income threshold for this tax is $200,000 for individuals and $250,000 for joint filers.
For those affected, there are short-term and long-term strategies that can help minimize this tax burden.
A short-term strategy involves trying to manage your tax position to keep below the threshold for the 3.8% tax, or to minimize investment income in any year where you will exceed the threshold.
A long-term strategy is to consider investment options that avoid the tax, or change the types of investments you hold to include more that are not subject to the tax. For example, by converting some of your traditional individual retirement account (IRA) to a Roth IRA and paying the income tax in 2013, you are changing one retirement income source for another that does not generate taxable income, and so does not create risk of increasing the amount subject to the tax.
People who think they cannot be affected by high-income thresholds need to understand that the income amounts are not indexed for inflation. Over time, more and more taxpayers will be subject to the tax—even if their real or inflation-adjusted earnings are the same.
Tip 3: Consider converting retirement assets
Recent increasing tax rates created a unique opportunity to accelerate gain and pay taxes at lower rates. Individuals who converted assets from a traditional before-tax IRA to an after-tax Roth likely benefitted. Now that tax rates are higher, you may think the opportunity has passed. But tax rates may head even higher given budget deficits and the national debt.
After-tax Roth IRAs generate tax-free income, subject to you holding the account for five tax years and reaching age 59½. If you have a traditional 401(k) or IRA, you can convert that asset to a Roth IRA by paying the tax on the gain or before-tax value of the asset. While any conversion tax liability in 2013 will need to be paid with your 2013 income tax return, it may make sense to convert some funds to a Roth IRA and diversify your retirement assets from a tax perspective. In addition to possibly paying tax on the gain at lower rates, a Roth IRA offers other benefits, such as not being subject to age 70½ required minimum distributions, and limiting the impact of Medicare surcharges and the 3.8% investment tax, as discussed above.
Tip 4: Contribute to an IRA
Many individuals do not realize they can contribute to an IRA each year regardless of their income or whether they have a retirement plan at work. The only requirements for making a contribution to an IRA are that you have earned income of at least the amount contributed and you have not reached age 70½.
While you have until the due date of your income tax return in April of 2014 to make your 2013 IRA contribution, delaying the contribution until then results in you losing some of the opportunity for tax-favored growth. So consider making your 2013 contribution now and your 2014 contribution in January 2014. Depending on your income, you may be able to contribute directly to a Roth IRA and enjoy tax-free growth. Even if you earn too much to contribute directly to a Roth IRA, you can fund a traditional IRA and then convert some or all of the funds to a Roth IRA, as discussed above.