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New Rules, Old IRS – What to Remember This Tax-Filing Season

March 14, 2014
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By  Richard M. Rosso

Learn more about Richard on NerdWallet’s Ask an Advisor

The American Taxpayer Relief Act of 2012 (ATRA) has created planning challenges for individuals who earn $200,000 or more.

You’ll need to navigate financial land mines when it comes to tax-savings strategies. Depending on your earnings you could be subject to new Medicare taxes on wages and net investment income along with higher tax rates on ordinary income, dividends and capital gains. The potential phase-out of itemized deductions is another tax obstacle to deal with now.

Singles who earn more than $400,000 and married couples filing jointly who earn more than $450,000 will be hit the hardest as they face a top marginal tax rate of 39.6%, up from 35% in 2012. On top of that is the .9% Medicare surtax on earned income in excess of $250,000 if married filing jointly, $200,000 for single filers.

Another blow to this group is the increase to long-term capital gain and dividend tax rates from 15% to 20%. In addition, a 3.8% Medicare tax on net investment income has the potential to bring the rates to 23.8%–at total increase of 59% compared with 2012.

Also, the phase-out of itemized deductions has returned. Called the “Pease Limitation,” it reduces total itemized deductions by the lesser of 3% of excess income over certain AGI thresholds or 80% of the amount of itemized deductions allowable for the taxable year. Those with adjusted gross incomes of $250,000 (individual) or $300,000 (married couples) will trigger the reduction. The formula is complicated and should be discussed with a qualified tax advisor.

Ostensibly, those who make $400,000 or more are going to hurt the most by ATRA.

Financial planning is complicated for those who make between $200,000 and $450,000 because a series of income events may trigger investment surcharges as well as the phase-out of itemized deductions. One would need to work jointly with a knowledgeable financial planner and tax advisor to create a strategy that may alleviate or postpone triggers.

Here are several tax-savings ideas that may help you in 2014 (and beyond).

1). Targeted investment placement is more important than ever. Especially for those in the highest marginal tax bracket who will experience a bigger tax bite on dividend, investment income and capital gains.

Ordinary income producing investments like taxable bonds, real estate investment trusts and high-yielding dividend stocks should be owned within tax-deferred accounts like IRAs and company retirement accounts.  For those who earn less than $400,000, dividends will remain at a 15% tax rate however, those with adjusted gross incomes over $200,000 (single filers) and $250,000 (married filing jointly) can still face the 3.8% Medicare Contribution tax on net investment income.

Mutual funds should be examined for tax efficiency to determine optimum placement (taxable vs. tax-deferred accounts).  Your financial partner should be able to help you examine fund choices for tax-adjusted returns and potential capital gains exposure. Mutual funds with less favorable tax efficiencies should be purchased and held in tax-sheltered accounts if possible.

Municipal bonds and master limited partnerships remain attractive in taxable accounts. Exchange-traded funds which are less expensive and generally more tax efficient than mutual funds would be preferable in taxable brokerage accounts.

2). Annuities and permanent life insurance should be considered.  Generally, annuities allow for tax deferral of investment income and/or dividends and capital gains, which can be beneficial for high tax bracket individuals seeking favorable savings options once company retirement plan contributions have been maximized.

Cash or permanent life insurance may be a greater consideration since a significant amount of wealth may be accumulated and sheltered from taxation.  For those who require insurance, ATRA has made whole life insurance a more attractive option for individuals in high marginal tax brackets when compared with term coverage.

3). Begin or increase retirement plan contributions.  If you’re self-employed and do not have a retirement plan started, consider a SEP-IRA which I call an “IRA with muscles.” For 2013, an employer (you) may contribute to your employee (you again) the lesser of 25% of an employee’s gross compensation (20% of your net adjusted self-employment income) or $51,000.  You may contribute up to the IRS tax filing deadline of April 15, 2014.

SEP contributions for self-employed individuals are “above-the-line” deductions. They are deducted from gross income to arrive at adjusted gross income and do not need to be itemized. So they’re effective for minimizing the bite of higher marginal taxes and possibly the 3.8% surtax.

For maximum impact, consider a defined benefit plan or a solo 401(k) if you’re a business owner with stable cash flows (to maintain annual funding) or a high-income sole proprietor. Defined benefit plans are powerful; high earning self-employed individuals can fund them with six figures annually (over $200,000).

If you’re an employee, look to increase your 401k or company retirement plan contributions going forward. For 2014 your annual funding limit is $17,500. Those 50 and older are able to make an additional $5,500 catch-up contribution. Contributions are considered “above-the-line” deductions as well.

4). Simplified option for home office deduction now available. The home office deduction has been a challenge to figure out. The standard version is based on calculating the prorated expenses, including mortgage interest allocated to the portion of your home used as a home office deduction.

The new simplified option offered by the IRS (began in 2013) can reduce record keeping dramatically. It limits deductions to $1,500 however the calculation is greatly simplified: It’s based on $5 a square foot of home used for business, up to 300 square feet.

Remember – You must regularly use part of your home exclusively for business and you must show that you utilize your home as your principal place of business. See IRS Publication 587 for details.

5). Tax-loss harvesting can be effective. If you’re subject to the 3.8% Medicare tax, which is applied to the lesser of net investment income or modified adjusted gross income above $200,000 (single filers) or $250,000 (married filing jointly), tax-loss harvesting is worth the effort. Selling capital losses to offset capital gains should be examined throughout the year to minimize your tax bill.

6). Consider a “surgical” Roth conversion process.  If you’re currently in the 25% marginal tax bracket and expecting to be at 28-39.6% marginal tax rates in the future, it’s worth formulating a schedule where a targeted amount of dollars is converted from a traditional IRA to a Roth conversion IRA every year. This process can minimize the eventual impact of adding to modified adjusted gross income, which may trigger the 3.8% surtax on net investment income as withdrawals from Roth IRAs are tax free. Also, having the option to tap tax free accounts can allow for flexible, tax-effective distribution strategies through retirement.  Best to work closely with your tax advisor to determine how much to carve from an IRA to convert each year. You don’t want taxable IRA distribution to push you into a higher tax bracket or increase your chances of phasing out of itemized deductions.

7). Consider “retire-smart” distribution strategies. If you hold IRAs, company retirement accounts, annuities, stock options or brokerage accounts, planning a tax-effective strategy to re-create the paycheck in retirement can be extremely challenging, especially in the face of ATRA.

Waiting to withdraw money from tax-deferred accounts until 70 ½ (required minimum distribution age) and exhausting taxable accounts first can be a costly mistake. Working closely with a qualified financial planner and tax strategist, before and during retirement, to create a flexible distribution method will provide you the most tax-efficient bottom line results.