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.

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.

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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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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 tax free.

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, Ga.

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 IRA.

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 future.

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