It's not business as usual when it comes to taxes in 2013. The
New Year rang in several changes that will require your careful
consideration--and perhaps a bit of maneuvering.
The health care law imposes a 3.8% surtax on net investment
income of higher-income investors--a development likely to lead to
a taxpayer scramble to trim taxable gains. Meanwhile, higher
estate-tax exemptions could still leave smaller estates exposed to
estate tax if owners are not careful. And a provision allowing more
workers to convert a traditional 401(k) to a Roth 401(k) comes with
We take a look at each development and suggest ways to minimize
Surtax on investments.
The 3.8% surtax applies to taxpayers whose modified adjusted gross
income exceeds $250,000 for joint filers and $200,000 for singles.
Modified AGI is AGI plus any foreign earned income exclusion if you
Net investment income includes interest, dividends, capital
gains, the taxable portion of annuity payments, rents and
royalties. It does not include tax-exempt interest from municipal
bonds, pension payouts, Social Security benefits or life-insurance
proceeds. Withdrawals from a traditional IRA or 401(k) don't count
toward net investment income, but they do count as part of your AGI
and could potentially push you above the thresholds.
The surtax applies to the smaller of net investment income or
the amount by which the modified AGI exceeds the thresholds. The
surtax will have its biggest impact on taxpayers between ages 50
and 70 who are in their peak earning years, says Robert Keebler, a
certified public accountant in Green Bay, Wis. He offers this
example of how the surtax works: Jane, a single taxpayer, has
$190,000 in salary and $75,000 in capital gains, for a total
modified AGI of $265,000. Because the amount above the $200,000
threshold is less than the $75,000 in net investment income, she'll
owe the surtax on $65,000. That will add $2,470 to her tax
You can avoid or reduce the new tax by holding down your net
investment income. For example, if Jane had capital losses of
$30,000, she'd reduce her net investment income to $45,000, and
she'd also reduce her AGI to $235,000. She'd owe the surtax on the
$35,000 that exceeds the threshold--for a hit of $1,330.
To reduce net investment income, Keebler is advising some highly
paid clients--say a 55-year-old dentist and a spouse--to invest in
deferred annuities rather than taxable investments. "Any gains in
the annuity will be tax-deferred and won't show up on a tax return
in the form of capital gains and interest," he says. When payouts
begin in retirement, your AGI might be below the threshold.
Because interest from municipal bonds doesn't count as net
investment income, you could consider switching part of your
corporate bond portfolio to munis. "If someone is in the top tax
bracket, the tax-exempt bond looks better," says Mary McGrath, a
certified public accountant with Cozad Asset Management, in
Champaign, Ill. Munis avoid the surtax as well as the hike in the
top rate from 35% to 39.6%.
A taxpayer can limit the impact of the surtax by placing various
asset classes in tax-efficient locations, says James Ciprich, a
certified financial planner at RegentAtlantic Capital, in
Morristown, N.J. For example, hold real estate investment trusts,
which throw off a lot of taxable income, in an IRA. Meanwhile,
place stocks in a taxable account, where "gains and losses can
offset each other," he says. Also, index funds and exchange-traded
funds tend to generate less in annual capital-gains distributions
than actively managed funds.
Another potential route around the surtax is to reduce your AGI
by boosting contributions to a traditional IRA, 401(k) or 403(b).
If you're 50 or older, you can contribute up to $23,000 to a
401(k). "If you're a married working couple, you can get $46,000
off of your income, and perhaps get below the threshold," Ciprich
Charitable giving can play a role, too. Donating appreciated
stocks will avoid capital gains, thus reducing net investment
income. Plus, the charitable deduction will reduce taxable
Consider a charitable remainder trust. You can place appreciated
stock in the trust with a charity as the beneficiary. You get an
immediate deduction as well as annual income from the trust, says
McGrath, that "you hope would keep you under the $200,000"
threshold. When you die, the charity keeps the trust balance.
Also, retirees who are 70 1/2 and older can reduce AGI by making
a direct donation of up to $100,000 from an IRA to charity, says
Kevin Dorwin, a certified financial planner at Bingham, Osborn
& Scarborough, in San Francisco. The donation can count toward
your required minimum distribution. This maneuver "will keep your
AGI down because it avoids your RMD counting toward income on your
tax return," he says.
Moving money into a Roth IRA could reduce both AGI and net
investment income in your later years. Tax-free withdrawals from a
Roth don't count toward the thresholds. If you are converting from
a traditional IRA, you will need to pay income tax on the
distribution. Keebler warns it may not be wise to convert if your
tax rate at the time you convert is higher than your expected rate
when you take distributions.
The estate tax's roller coaster ride has finally come to an end.
After years of gyrating exemption levels and tax rates--plus a year
when the estate tax disappeared altogether--Congress permanently
set the exemption level at $5.25 million (double for a couple),
indexed for inflation, with a tax rate of 40% for larger
Lawmakers also made permanent a nice option for widows and
widowers that was set to expire after a two-year experiment. This
tax break, known as portability, allows the surviving spouse to add
the unused portion of the late spouse's estate-tax exemption to her
own. This will enable her to transfer up to $10.5 million (in 2013)
to heirs free of estate tax.
The higher exemption also applies to lifetime gifts, which means
a married couple can give away up to $10.5 million free of the
federal gift tax. Lifetime gifts (above the annual gift exclusion
of $14,000 for each spouse) protected by the exemption reduce the
estate-tax exemption dollar for dollar.
The portability feature and the higher exemption will eliminate
the need for many couples to set up complex trusts. Consider the
rules in place in 2009, when the exemption was $3.5 million and
there was no portability. A husband could leave an unlimited amount
to his wife thanks to the unlimited marital tax deduction, without
using a dime of his estate-tax exemption. If the wife's estate was
worth more than $3.5 million when she died, however, the heirs
would have owed tax on the excess. To avoid "wasting" the husband's
exemption, he could have left up to $3.5 million tax free to a
bypass trust to benefit his widow until she died. The trust would
then pass on to their children tax free. By using both parents'
exemptions, up to $7 million could have gone to the next generation
The portability rule makes this often expensive maneuvering
unnecessary. But people with estates that fall below the new
exemption levels should not assume that they have nothing to worry
about. Trusts can shelter appreciation--perhaps a couple's estate,
now $8 million, will grow to $12 million by the time the second
spouse dies. A trust can also shield assets from creditors.
Moreover, a trust may be needed to protect assets for children
from a first marriage while also providing for a new spouse, says
Robert Romanoff, an estate-planning lawyer with Levenfeld
Pearlstein, in Chicago. Say a widower has $6 million and two adult
children. He remarries and creates documents that would leave
one-third of his assets to his children and place the rest in a
trust for his wife. "The trust will provide that she gets income
and principal if she needs it, and upon her death the assets go to
the children," Romanoff says.
Also, portability does have its pitfalls if you're not aware of
the rules. If you want to preserve the right to portability, you
need to file a federal estate-tax return within nine months of the
death of your spouse. This means that folks whose net worth is far
below the exemption amounts need to file a return.
Portability also can be tricky if the surviving spouse
remarries. The surviving spouse who remarries gets to keep only the
estate-tax exemption from the most recent spouse to die.
Let's say David left $5 million to his wife, Jane, who has her
own $4 million. Then Jane marries Marvin, who used up his entire
exemption by giving money to his kids. Marvin dies. Jane's
inheritance from Marvin: She loses David's $5.25 million exemption
and assumes Marvin's $0 exemption. When she dies, her kids will pay
estate tax on the amount of the $9 million that exceeds Mom's
federal $5.25 million exemption.
In this case, a trust could have protected David's exemption and
eliminated the estate-tax tab. "Even if a couple has an estate that
is less than the exemption levels, they probably should be worried
about the impact of remarriage," Romanoff says.
Another reason for a trust: If you live in a state with its own
estate tax. The District of Columbia and 16 states impose their own
estate levies. "If a couple lives in a state with an estate tax and
the exemption is less than [the federal exemption], there could be
a hefty tax to pay," says Irene Steiner, a tax lawyer at Akin Gump
Strauss Hauer & Feld, in New York City. Portability does not
apply to state estate taxes.
Consider New York, which imposes a graduated levy of 5% to 16%
on estates worth more than $1 million. If an individual left her
entire $5.25 million estate to her sister, for example, the estate
would owe no federal estate taxes at her death but would owe more
than $420,000 in New York estate taxes, Steiner says.
If you're married, you can shelter the first spouse's exemption
from state estate tax by funding a bypass trust up to the state
exemption amount. Say each spouse has $3 million and they live in
Maryland, which also has a $1 million exemption. The husband dies
without a trust to preserve his state estate-tax exemption. When he
dies, his wife elects portability for the federal tax. When she
dies, her heirs won't pay federal estate tax because the $6 million
estate Mom leaves is less than $10.5 million. But they will pay
state tax on the $5 million that exceeds Mom's state exemption. If
Dad had funded a trust up to the state's $1 million exemption, the
kids would pay state tax on $4 million.
New Roth flexibility.
The tax law now gives workers of any age a chance to convert money
from a traditional 401(k) to a Roth 401(k), if the employer plan
allows such conversions. Before, only workers who were eligible to
withdraw money from a 401(k)--mainly workers 59 1/2 or older--could
make a 401(k) Roth conversion.
Before you take the plunge, remember that you will pay taxes on
any money you convert. As with Roth IRA conversions, 401(k)
conversions are "usually ideal for those who have a degree of
certainty that their tax rate will be higher in the future," says
Denise Appleby, of Appleby Retirement Consulting, in Grayson,
If you convert $40,000 at a 25% income-tax rate, you will owe
$10,000 in taxes. If you're in your peak earning years and think
your tax rate may jump to 39.6%, converting now would save you
$5,840 in taxes compared to what you'd owe if you withdrew the
$40,000 in the top tax bracket. To rein in the tax hit, you may
want to convert only an amount that will take you to the top of
your tax bracket each year.
But once you convert, you're stuck. Unlike with IRA Roth
conversions, you cannot recharacterize, or reverse, a 401(k)
conversion. The inability to recharacterize "increases the risks,"
says Paul Jacobs, a certified financial planner in the Atlanta
office of Palisades Hudson Financial Group.
One risk is that you will owe income tax even if you can't
afford to pay Uncle Sam when it comes time to file your return. In
the case of a market drop, you could end up owing tax on money you
no longer have. If a $100,000 conversion falls in value to $50,000,
you will still owe tax on $100,000. Consider such potential
scenarios as you decide how much to convert.
Another big difference between Roth 401(k)s and Roth IRAs:
Owners of Roth 401(k)s are still subject to required minimum
distributions starting at 70 1/2, while Roth IRA holders are not.
To avoid RMDs, Roth 401(k) owners can roll the money into a Roth
If you're already 59 1/2, there may be little reason to convert
to a Roth 401(k). If you're set on a Roth, you may be able to
convert your traditional 401(k) money to a Roth IRA. This way you
can avoid RMDs and have a full array of investment choices. And
money from a traditional 401(k) going into a Roth IRA can be
recharacterized, says Jeffrey Levine, technical consultant for Ed
Slott and Co., which provides IRA advice. You wouldn't be able to
return the money to the 401(k) plan, he says, but instead you can
put it into a traditional IRA and avoid the conversion tax bill if
you recharacterize by October 15 of the following year.
If you'd like some money in a Roth 401(k) but don't want to
convert your traditional 401(k), direct some or all of your future
contributions into the Roth 401(k) instead. You'll lose the benefit
of contributing money pretax into your 401(k), but in exchange,
you'll get tax-free withdrawals from the Roth 401(k) in the
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