Editor: Theodore J. Sarenski, CPA/PFS, CFP, AEP
With the introduction of the 3.8% net investment income tax (Sec. 1411), and the return of the 20% capital gains rate (Sec. 1(h)) and the 39.6% income tax rate (Sec. 1(i)), America shifted overnight at the start of 2013 from a two-dimensional tax system to a four-dimensional system.
There are now seven income tax brackets (10%, 15%, 25%, 28%, 33%, 35%, and 39.6%) and three capital gains brackets (0%, 15%, and 20%) (Sec. 1). There is also a maximum 25% capital gains rate for depreciation recapture and a maximum 28% capital gains rate for gain on collectibles (Sec. 1(h)).
Virtually every financial decision for higher-income taxpayers now needs to be analyzed through the lens of the regular income tax, the alternative minimum tax (AMT), the net investment income tax, and the new additional brackets.
The complexity of going from a two-dimensional system to a four-dimensional system is exponential, not linear, and requires a quantum leap in tax analysis methodology, tax strategy, and tax planning software tools.
PEP and Pease Limitations
Also new for 2013 are the reinstatement of the personal exemption phaseout (PEP) (Sec. 151(d)(3)) and limitation on itemized deductions (Pease limitation) (Sec. 68), both applicable when adjusted gross income (AGI) exceeds $250,000 for singles, $275,000 for heads of households, $300,000 for married taxpayers filing jointly and surviving spouses, and $150,000 for married taxpayers filing separately.
The PEP reduces personal exemptions by 2% for every $2,500 of income above the threshold amount for single taxpayers or married taxpayers filing jointly or by 2% for every $1,250 of income above the threshold amount for married taxpayers filing separately (Sec. 151(d)(3)). The Pease limitation cuts itemized deductions by the lesser of 3% of AGI above the threshold amounts or 80% of the itemized deductions otherwise allowable for the tax year (Sec. 68). Deductions not included in the Pease calculation are investment interest, medical expenses, nonbusiness casualty and theft losses, and wagering losses (Sec. 68(c)).
Net Investment Income Tax
The net investment income tax for individuals applies to the lesser of net investment income or the excess of modified adjusted gross income (MAGI) over the applicable threshold amount (Sec. 1411(a)). The thresholds are $250,000 for married taxpayers filing jointly, $125,000 for married taxpayers filing separately, and $200,000 for all others (Sec. 1411(b)).
Gross investment income includes interest, dividends, annuity distributions, rents, royalties, income from passive activities, and net capital gain from the disposition of property other than the disposition of property held in a trade or business that is not a passive activity with respect to the taxpayer or a trade or business of trading in financial instruments or commodities (Sec. 1411(c)). It does not include salary, wages, bonuses, distributions from IRAs or qualified plans, any income taken into account for self-employment tax purposes, gain on the sale of certain active interests in a partnership or S corporation, or items that are otherwise excluded or exempt from income, such as interest from tax-exempt bonds, excluded gain on the sale of a principal residence (Sec. 121), tax-free gain on like-kind exchanges (Sec. 1031), excluded gain on the sale of small business stock (Sec. 1202), and gain on tax-free exchanges of life insurance policies (Sec. 1035).
Gross investment income is reduced by deductions properly allocable to such income or net gain (Sec. 1411(c)(1)(B)). Some examples of allowable deductions are investment interest expense, investment advisory fees, and brokerage fees. Nondeductible items include net operating losses, charitable deductions under Sec. 170, and personal exemptions. MAGI is defined as AGI plus the net foreign earned income exclusion (Sec. 1411(d)).
Analysis Methodology and Perspective
For more than 20 years the vast majority of income tax planning has focused on short-term tactics, looking at a period of two or perhaps three years. However, with the return of the 39.6% and 20% income tax and capital gains rates, respectively, plus other changes mentioned above, many retired clients or taxpayers nearing retirement need to project their income and deductions over a five- to 10-year period.
A clear example is the effect of required minimum distributions (RMDs) from an IRA at age 70½. Exhibit 1 projects the future tax consequences of RMDs over 15 years at 2% inflation for a hypothetical married 65-year-old with an IRA with $5 million in principal and other taxable income totaling $192,200 in 2013, who starts taking RMDs in 2018. He gets pushed into the 35% bracket in 2018 and eventually into the 39.6% bracket. Additional illustrations of some of the effects for this hypothetical client and scenario of applicable marginal income and capital gains tax rates and the PEP and Pease limitation are available online.
Three Leading Tax Strategies
Three leading tax strategies for eliminating or reducing taxable income in the higher tax brackets or net investment income subject to the net investment income tax are harvesting income and gains, Roth IRA conversions, and tax-efficient investing.
Harvesting Income and Gains
Harvesting losses has been a key part of financial planning for years, and with the advent of a four-dimensional tax system and seven individual brackets, advisers must also gain a finer understanding of when it is prudent to harvest income or capital gains.
Example 1: G and B, a married couple, have projected 2013 income of $150,000 and expect their 2014 income to be $500,000. They also expect to have $100,000 in long-term capital gain in 2014 (stock with a basis of $10,000 and a fair market value of $110,000).
If they choose to harvest the gain in 2013, the cost (or tax) would be $15,000 (15% × $100,000). If instead they wait until 2014, the cost will be $23,800 (20% capital gain plus 3.8% net investment income tax). Exhibit 2 on p. 848 shows the return on investment (ROI) achieved by harvesting the gain on Dec. 31, 2013, vs. Jan. 1, 2014.
In effect, the taxpayer invests the tax payable on the 2013 gain ($15,000) to produce a return of $8,800. Thus, the ROI is 58.67% ($8,800 ÷ $15,000).
Roth IRA Conversions
Roth IRA conversions have always offered advantages, but now they may also help facilitate planning and income smoothing to avoid the 3.8% net investment income tax. Distributions from a traditional IRA are not considered net investment income, but they do increase MAGI and therefore could create or increase a taxpayer’s net investment income tax. By contrast, a Roth IRA distribution is neither net investment income nor MAGI, and therefore it does not create or increase a taxpayer’s net investment income tax. Thus, a taxpayer can use a Roth IRA conversion to keep future income out of higher brackets and eliminate all future net investment income tax on IRA distributions.
Example 2: F, a single taxpayer, has salary income of $100,000 and dividend income of $100,000. F is not subject to net investment income tax despite having $100,000 of net investment income (from the dividend income) because his MAGI does not exceed the applicable threshold ($200,000 for a single taxpayer). If F also receives a $50,000 RMD from his traditional IRA, the net investment income tax applies to the lesser of net investment income ($100,000) or the excess of MAGI over applicable threshold ($250,000 – $200,000). Thus, the traditional IRA distribution subjects F to net investment income tax on $50,000 of his net investment income.
Example 3: Suppose instead that F previously had converted a traditional IRA to a Roth IRA. If F receives a distribution of $50,000 from his Roth IRA, he is not subject to any net investment income tax. His MAGI would not exceed his applicable threshold because, unlike a distribution from a traditional IRA, a distribution from a Roth IRA does not count toward MAGI. Thus, F’s MAGI does not exceed his applicable threshold ($200,000), and F saves $1,900 in net investment income tax ($50,000 × 3.8%).
Another important factor to consider before converting is the taxpayer’s current and expected future income tax brackets. If the taxpayer is currently in a lower tax bracket than he or she expects in later years, the taxpayer will usually want to do a Roth IRA conversion. Also note that the conversion can be done in stages so that it does not push the taxpayer into a higher tax bracket, the net investment income tax, or the PEP/Pease limitation.
Perhaps most important, opportunistic conversions by asset classes must be considered. The ability to recharacterize an opportunistic Roth IRA conversion back to a traditional IRA if the assets drop in value eliminates much of the risk of the conversion. A taxpayer can recharacterize the conversion any time before the filing date of the current year’s tax return, i.e., as late as Oct. 15 of the year following the year of the conversion. If the taxpayer chooses to recharacterize, he or she must recharacterize the entire IRA, even if some asset classes have increased in value; thus, a separate IRA should be set up for each asset class, allowing the taxpayer to recharacterize only those IRAs that decline in value.
Until recently, proactive tax planning was not a major part of the investment process. However, with the new higher tax brackets for both income taxes and capital gains, and the net investment income tax, investors have increasingly realized that it is not what they earn that counts, but what they keep after taxes. The following example illustrates the dramatic impact of taxes on wealth accumulation over time.
Example 4: A young married couple plan to invest $10,000 each year for 40 years, at which time they will retire. Assume that their investments grow at a pretax rate of 8%. Exhibit 3 compares how much they will accumulate after 40 years, assuming different effective income tax rates.
Tax-efficient investing includes: (1) increasing investments in tax-favored assets; (2) deferring gain recognition; (3) changing portfolio construction; (4) after-tax asset allocation; (5) tax-sensitive asset location; (6) managing income, gains, losses, and tax brackets from year to year; and (7) managing capital asset holding periods. The following example illustrates planning with tax-favored assets.
Example 5: M, a single taxpayer in the 39.6% marginal income tax bracket, owns $1 million worth of corporate bonds that pay 4% interest ($40,000) per year. M could switch to tax-exempt bonds paying 2.5% interest and avoid both income tax and the net investment income tax. But is this a good idea?
M’s after-tax return on the corporate bonds is $22,640 ($40,000 [0.434 × $40,000]). This makes the after-tax return 2.264%. Her after-tax return on the tax-exempt bonds would be $25,000, or 2.5%. Thus, switching to the tax-exempt bonds would produce a better economic result. However, if the tax-exempt bonds instead produced only 2% interest, M would be better off keeping the taxable corporate bonds.
Overview of Other Tax Planning Strategies
- Bracket management: This strategy uses income smoothing techniques to obtain the maximum benefit of tax rate arbitrage. This basically involves (1) reducing income in high-income years by maximizing deductions and shifting income to low-income years and (2) increasing income in low-income years by deferring deductions and increasing taxable income to fill up the lower tax brackets.
- Harvesting capital losses: The taxpayer sells assets at a loss to offset capital gains realized on other assets.
- Charitable lead annuity trusts (CLATs): An inter vivos CLAT is a split-interest trust created by a donor during the donor’s life that pays an annuity to a charity for a term of years or for the life of the donor or another individual. At the end of the term, any assets remaining in the trust pass to noncharitable remaindermen. CLATs for a term of years can be zeroed out and produce tax-free transfers in the same way as zeroed-out GRATs. The only difference is that a charity receives the lead annuity interest instead of the grantor. Lifetime CLATS always produce a taxable gift because of the exhausting corpus rule, but they can still produce very favorable gift tax results.
- Substantial sale charitable remainder trusts (CRTs): An inter vivos CRT is an irrevocable trust created by a donor during life with a lead annuity interest (CRAT) or a lead unitrust interest (CRUT) and a charitable remainder interest. CRTs can be useful for a taxpayer who has a large capital gain that pushes income for a tax year up into higher tax brackets and/or subjects the taxpayer to the net investment income tax. Because CRTs are tax-exempt entities, they can sell assets without recognizing gain. Instead, the gain realized by the trust is taxed to the grantor, but only as the annuity or unitrust payments are received, thus allowing the gain to be spread out over many years, subjecting it to lower tax brackets.
- Retirement CRTs: A retirement CRT is set up using a special kind of CRUT called a net income with makeup CRUT, or NIMCRUT. The NIMCRUT pays the settlor the lesser of a fixed percentage of the trust assets or the net trust income. It also includes a makeup provision. The CRT retirement strategy works by minimizing trust distributions before retirement and maximizing trust distributions after retirement. In the years before retirement, the NIMCRUT invests in assets that produce very low income. This activates the makeup provision. Thus, in these years, the NIMCRUT makes few or no distributions and accumulates gains tax free. Then when the donor retires, the NIMCRUT invests in assets that will maximize trust income. This will create trust income that exceeds the fixed percentage and will allow not only for the full amount of the fixed percentage to be paid out but also the amounts in the makeup account.
- Income-shifting CRTs: In an income-shifting CRT, the donor’s children or grandchildren are the lead beneficiaries instead of the donor. It eliminates or reduces the donor’s 3.8% net investment income tax and 5% incremental capital gains tax rate by shifting ordinary income and capital gains to the donor’s children or grandchildren while also benefiting a charity.
- Oil and gas investments: Oil and gas investments can create a large deduction in a tax year. Therefore, they can be used to lower a taxpayer’s taxable income for the year, thereby avoiding the higher tax brackets and the net investment income tax.
- Two-year installment sales: A taxpayer sells a highly appreciated asset to a trust for the benefit of his or her children and takes back an installment note. The trust receives a stepped-up basis in the asset. After two years and one day, the trust sells the asset to an unrelated buyer. By waiting more than two years to make the second sale, the trust avoids application of Sec. 453(e), which would otherwise attribute the gain on the second sale to the original taxpayer. This enables the trust to cash in the full appreciated value of the assets before most of the tax has been paid on the gain.
- Intra-family loans: Parents loan money to their children at a low interest rate, and the children invest the borrowed money for a higher rate of return. The difference represents a tax-free increase in wealth for the children.
- Grantor retained annuity trusts (GRATs): A GRAT is a split-interest trust in which the grantor retains an annuity interest for a term of years. At the end of the annuity term, any assets remaining in the trust pass to the remainder beneficiaries. The amount of the taxable gift is the value of the property transferred to the trust minus the present value of the lead annuity interest retained by the grantor. The value of the lead interest can be set equal to the full value of the property transferred, creating a “zeroed-out GRAT” with no taxable gift. Then if the GRAT produces a total return exceeding the Sec. 7520 rate (which was used to determine the present value of the lead annuity interest), property will remain in the GRAT at the end of the term to pass tax free to the remainder beneficiaries.
- Dynasty trusts: A dynasty trust takes advantage of how the generation-skipping transfer tax (GSTT) is applied by passing assets down through successive generations of a family for as long as the trust is permitted to last under applicable state law. A taxpayer uses the gift and GSTT exclusion amount to avoid tax on the initial transfer to the trust. No transfer tax is payable at any generation of beneficiaries thereafter because the beneficiaries have only discretionary interests that are not includible in their estates when they die. Thus, in some states, a one-time use of the gift and GSTT exemption eliminates transfer tax for a family forever.
- Sales to an intentionally defective grantor trust (IDGT): Sales to an IDGT are completed transfers for gift and estate tax purposes, but they are ignored for income tax purposes. As a result, the grantor is taxed on all trust income, but the transferred assets are removed from the grantor’s estate. This produces important gift and income tax benefits for very large estates.
- Domestic asset protection trusts (DAPTs): While the primary goal of a DAPT is to provide asset protection, it may also afford estate planning benefits. DAPTs enable a taxpayer to give away assets and remove future appreciation from his or her gross estate while retaining the benefit of the assets if needed.
- Incomplete gift, nongrantor trusts: Taxpayers in high-tax states should consider transferring assets to a trust in a state that does not tax trust income. Over time, such a trust could produce impressive state tax savings. At present, Nevada appears to be the most favorable state for creating such trusts.
- Trusts as S corporation shareholders: A number of trusts may be eligible S corporation shareholders; however, the choice is usually between a qualified subchapter S trust (QSST) or an electing small business trust (ESBT). An ESBT provides more flexibility, while a QSST generally provides better tax consequences.
- Spousal limited access trusts (SLAT): A SLAT is an irrevocable trust established by one spouse for the benefit of the other spouse, with the remainder interest passing to the couple’s children and grandchildren when the donee spouse dies. With the 2013 individual gift and estate tax exemption amount at $5.25 million, creating a SLAT may be a good way to take advantage of the high exemption amount by transferring wealth tax free to future generations while indirectly retaining the ability to access the funds if necessary through distributions to the spouse.
- Family limited partnerships (FLPs): By transferring family assets to an FLP, the senior members of a family can share the value of the assets with the younger members while maintaining control over the assets. In addition, transferring the assets to an FLP takes them out of the senior family member’s estate, generally at a substantially reduced transfer tax value due to valuation discounts.
- Deferred annuities: The taxpayer, during higher-tax-bracket years, invests income-producing assets in deferred annuities, thereby reducing taxable income. The annuities produce no taxable income because the payments are deferred. Then later, when the taxpayer is in lower-tax-bracket years, payments from the deferred annuities begin, thus smoothing out income and subjecting the taxpayer to lower taxes.
- Borrowing from whole life insurance policies: This involves paying into a whole life insurance policy in high-income years, perhaps using other assets that would have produced taxable income, and avoiding the higher tax brackets and the net investment income tax. Then in later years, if taxpayers need additional income, they can increase their available funds without selling taxable assets and pushing themselves into a higher tax bracket, by borrowing funds from the life insurance policy instead.
- Captive insurance companies: By forming a Sec. 831(b) captive, a business could save a significant amount in income taxes, allowing those savings to be retained within the business and the family. This is because the Sec. 831(b) election allows the operating company to deduct premiums paid (up to $1.2 million per year) while also allowing the related-party captive to exclude premium income from federal income tax (up to $1.2 million per year), provided the Sec. 831(b) captive is designed properly. Furthermore, the captive’s asset reserves accumulate outside the business owner’s estate.
- Grouping business activities to create material participation: A taxpayer may want to group business activities to create material participation so that the income from those activities is not considered passive and thus is not subject to the net investment income tax.
- Choice of filing status: If one spouse has most of the net investment income and the other spouse has most of the non-net investment income, filing separate returns may save significant amounts on the 3.8% net investment income tax. However, it is also possible for net investment income tax to be owed if spouses file separate returns but not owed if they file jointly.
Practical Steps for 2013–2014 Tax Planning and Methods
- Develop a comprehensive 2013–2018 income projection.
- Test for the AMT, net investment income tax, PEP, Pease limitation, and income in the highest bracket.
- Look for opportunities to smooth out income or to harvest gains and losses.
- Implement opportunistic Roth IRA conversions in January 2014.
- Evaluate application of the remaining top 22 (and other) tax strategies.
With these tax strategies, most tax advisers are well-positioned to bring substantial value and insight to their clients. Comprehensive resources for planning for clients in the new tax environment are available on the AICPA’s Planning After ATRA and the Net Investment Income Tax Toolkit, which contains archived webcasts and related PowerPoint files, checklists, client communications, podcasts outlining planning ideas, and many other resources. See the sidebar, “PFP Resources,” for more products from the AICPA.
Theodore J. Sarenski is president and CEO of Blue Ocean Strategic Capital LLC in Syracuse, N.Y. Robert Keebler is a partner with Keebler & Associates LLP in Green Bay, Wis. Mr. Sarenski is chairman of the AICPA Personal Financial Planning Executive Committee’s Elder Planning Task Force and is a member of the AICPA Advanced Personal Financial Planning Conference Committee and Financial Literacy Commission. Mr. Keebler is chairman of the AICPA Advanced Estate Planning Conference Committee. For more information about this column, contact Mr. Keebler at firstname.lastname@example.org.