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See why tax aware investing could help you keep more of what you earn.
The Affordable Care Act (ACA), aka Obamacare according to Title I of the act claims to be the “largest middle class tax cut for health care in history.” Despite a very messy and disappointing start, Obamacare is in motion and so are the new taxes that became effective January 1, of 2013. Higher income earners will be subject to increased capital gains tax rates in 2013 and the imbedded capital loss carry forwards from 2008-2009 that everyone has benefitted from are evaporating faster than a rain drop in the Sahara. It’s going to be a banner tax collection year for the Federal Government and it’s important you’re prepared.
The ACA created two new taxes. The first is an additional 3.8% NIIT (Net Investment Income Tax) and the second is the Additional Medicare tax of 0.9% on earned income. TITLE IX of ACA details REVENUE PROVISIONS and revised tax rates that became effective on January 1, 2013. If you’re Modified Adjusted Gross Income (MAGI) found on line 37 of 1040, is greater than the following amounts, $250,000 for Married Filing Jointly and Qualifying Widower, $200,000 for Single and Head of Household, and $125,000 for Married Filing Separately, you are at risk.
ACA taxes are in addition to the revised tax rates effective in 2013 which moves most people subject to NIIT and Additional Medicare into the 33% tax bracket with the highest rate of 39.6%. Earners making above $400,000 will be subject to the increased capital gains and dividend rates of 20%. ACA taxes are also added on top of the capital gains.
Let’s define investment income according to the IRS:
· Interest, dividends, capital gains, rental and royalty, and income from non qualified annuities.
· Income from trading activities that is passive to the taxpayer.
· Gains from the sale of stocks, bonds, and mutual funds and capital gains distributions from mutual funds.
· Gains from sale of investment real estate and second homes that are not your primary residence.
· A gain on the sale of interests in partnerships and S Corporations for passive owners is also subject to NIIT.
How to minimize NIIT Taxes.
If you plan year round for taxes you’ll develop a better understanding of how certain financial transactions and decisions impact you. Be sure to maximize all qualified plans such as 401(k), 403(b), including catch up provisions for people over 50 and take full advantage of all deferred compensation options and defined benefit if you are a highly compensated employee. The IRS limit for defined contribution plans in 2013 is $17,500 or $23,000 over age 50. Defined benefit plans allow you to defer up to $210,000 for 2014. If you had passive activity losses from past investments, they can be harvested to offset passive income. An easy way of remembering is “PAL’s can be used to offset PIG’s.” Loss carry forwards from “at risk” prior activities can also be used to offset new taxes. Be sure to take all your deductions from investment related activities. Some examples are expenses from investments, interest, advisory fees, tax prep fees, legal fees associated with profit seeking activities, and fiduciary expenses related to estates and trusts. If you are self employed, keep track of all business related expenses and if you are an employee keep track of non reimbursed expenses. Increasing your gifts to charitable organizations always helps. The 0.9% additional Medicare tax on wages that is not automatically held from payroll but you can request a modest adjustment using IRS forms W-4. Finally, be careful of tax schemes involving foreign trusts or international business corporations. If it doesn’t smell right, the milk is probably spoiled.
The Alternative Minimum Tax is a topic for another conversation could phase out some of your deductions if you claim a high number of personal exemptions, have incentive stock options, or have high state and local taxes. If you live in New York City, this means you. AMT and its impact are rarely discussed in national debates on tax fairness but it does impact your effective tax rate adversely.
If you own a large stake of highly appreciated assets that will create an estate tax liability, consider a Charitable Remainder Trust. Aside from the highly beneficial charitable deduction, assets sold inside a CRT are not subject to capital gains but you must take an annuity stream of income each year. The annuity income stream from a CRT is not subject to NIIT. I will cover more specifics in a future article. Incomes from Grantor Trusts are also typically exempt from NIIT but you pay them as income flows through to your personal tax return. However, Estates and Trusts which are normally subject to taxes on undistributed net investment income above $11,950 for 2013 threshold are subject to NIIT. In such cases your tax professional can spread out the distribution among multiple beneficiaries to reduce the tax impact.
Consider tax managed investments whose stated goals are after tax return versus absolute returns before capital gains. These funds limit taxes by continuously offsetting gains and losses and avoid managers who focus on short term trading. You should seek to shelter as much income as possible from taxable events unless it’s more economic to take a profit. At that point feel fortunate and keep good track of your cost basis.
In closing, managing your tax liabilities is an ongoing process and waiting until December of a given tax year with the hopes your advisor can tax harvest your brokerage accounts or simply handing everything to your accountant isn’t the most optimal approach. A more proactive approach is to manage your liabilities year round by working closely with your tax professional and financial advisors on a more regular basis to develop a strategy. If you treat tax liabilities as part of your overall financial plan and invest accordingly with tax efficiency and after tax returns as one of your objectives you will have a better chance of lowering the taxes you pay to Government and increase the amount of money to charitable causes you want to support. Tax year 2013 as it pertains to NIIT and The Additional Medicare Tax will be a learning experience.
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Proper planning can help you avoid the 3.8% tax on NII (Net Investment Income) and the additional 09% medicare tax on earned income.
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