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Year-end tax planning should be easier this year than last. Thanks to the new law enacted in January, you won't have to wait to see whether Congress will reinstate popular breaks that have expired. But don't break out the bubbly just yet. If you're a high-income taxpayer, there's a good chance your taxes will go up in 2013, and that makes year-end planning more important than ever.
The law resurrected a top rate of 39.6% for taxable income over $400,000 ($450,000 for married couples), and it revived phaseouts of itemized deductions and personal exemptions for taxpayers with adjusted gross income of $250,000 or more ($300,000 for married couples). In addition, the Affordable Care Act imposes a new surtax on investment income earned by high-income investors. Taxpayers in this bracket will also pay 23.8% on dividends and long-term capital gains, not the 15% rate that applies to most investors.
Although taxes won't go up for most taxpayers, "if you're at one of those higher income levels, you may be in for a rude awakening this year," says Tim Steffen, director of financial planning for Robert W. Baird & Co., a wealth-management firm.
Starting this year, single taxpayers with modified adjusted gross income of $200,000 or more (and married joint filers with MAGI of $250,000 or more), will pay a 3.8% surtax on unearned income, including interest, dividends, royalties, rents and capital gains. The surtax will be based on your investment income or the amount by which your MAGI (which includes investment income) exceeds the threshold, whichever is less. (In this case, MAGI is basically AGI plus any tax-free income earned while living outside the U.S.)
One way to reduce your exposure to the surtax is to take full advantage of tax-advantaged retirement plans. For 2013, you can contribute up to $17,500 to your 401(k); if you're 50 or older, you can stash up to $23,000. Contributing the max to retirement plans is one of the smartest ways to reduce your taxable income even if you aren't snagged by the surtax.
If you own stocks or funds that have declined in value since you purchased them, selling them by year-end will generate losses you can use to offset investment gains. Higher tax rates on capital gains and investment income make such losses even more valuable.
It's risky, though, to sell securities that you really want to keep in an effort to manufacture tax-saving losses. The IRS bars you from claiming a loss if you repurchase the same or a "substantially identical" investment within 30 days of a sale. And depending on what happens in the market during that period, a tax-motivated sale could wind up hurting rather than helping your financial situation. Harvesting losses is easier with index or exchange-traded funds because there are many other funds you could turn around and purchase that are similar but not substantially identical.
Even if you didn't sell anything this year, you could owe tax on capital gains distributions from mutual funds in a taxable account. Gains from stocks are triggered only when you sell shares, but mutual funds are required to distribute all gains from the sale of their investments, along with the dividends and interest they earn each year. Unless you own the fund in a tax-advantaged account, a distribution is taxable, even if you reinvest it.
Because it has been a good year for the stock market, distributions could be larger than in recent years, says Stephen DeFilippis, an enrolled agent in Wheaton, Ill. Check your fund's Web site for estimates of this year's payouts. If you plan to buy fund shares before year-end for a taxable account, check the fund's site to find out whether it plans to make a large distribution. You can avoid the tax hit by waiting until after the distribution to purchase shares.
When you donate appreciated securities to charity, you escape taxes on capital gains, and the charity doesn't have to pay them, either. Plus, you can deduct the market value of the securities, which will reduce your taxable income. If your favorite charity is not set up to accept noncash donations, consider a donor-advised fund, which allows you to make a charitable contribution now, claim the deduction on your 2013 tax return and distribute the money later. If you donate appreciated stocks or funds, the fund will sell the securities and add the proceeds to your account.
In 2013, you can give up to $14,000 to as many individuals as you like without filing a gift-tax return. If you're married, you may give $28,000 per recipient, as long as your spouse agrees not to give anything to that person. (In that case, a gift-tax return must be filed.)
At first blush, the case for using the annual gift-tax exclusion for transferring wealth to adult children (or other lucky recipients) isn't as strong this year as it has been in the past. The estate-tax exemption is now $5.25 million (and twice that for married couples), indexed to inflation. Only a handful of ultra-wealthy families need to worry about the estate tax at that level.
Still, there's no guarantee the threshold will remain so high. "You never know, especially when they're entertaining tax reform in the House and the Senate," DeFilippis says. In addition, 21 states and the District of Columbia impose some type of estate or inheritance tax, and most come with much lower exemptions. Rhode Island, for example, taxes estates valued at more than $910,725 at a maximum rate of 16%.
Giving appreciated securities is another way to reduce the size of your taxable estate, and it could also eliminate the capital gains tax that would be due if you were to sell the securities. If your adult children or parents are in the 10% or 15% tax bracket (taxable income of up to $36,250 for singles, $72,500 for married couples), they qualify for the 0% tax rate on long-term capital gains. When they sell the securities, profit that would have been taxed at a rate as high as 23.8% on your return will be tax-free on theirs. Children under 18 and full-time students under age 24 are subject to the "kiddie" tax. Investment income that exceeds $2,000 will be taxed at the parent's higher rate.
To qualify for the special rate for capital gains, the securities must have been held for at least 12 months. For securities given as gifts, though, the holding period includes the time you owned them.
Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.