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Making Your Money Last

Reduce the Risks of the New Tax Scenario


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.

See Also: Beware States With Their Own Estate Taxes

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 opportunities—and pitfalls.

We take a look at each development and suggest ways to minimize the risks.

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 live overseas.


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 bill.

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 says.

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 income.

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.

Estate-planning strategies. 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 estates.

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