Tax Planning to Avoid ATRA-phy
The American Taxpayer Relief Act. Brought to you by the same people who ushered in Super PACs guised as “campaign finance reform” and unleashed the Orwellian flood by calling it “The Patriot Act”. The relief is comes in the form of 20% top tax rate on dividends and long-term capital gains, and 39.6% top tax rate on ordinary income and short-term capital gains. Throw in net investment income tax (NIIT), and the top rates could be as high as 23.8% and 43.4%, respectively.
Now, more than ever, tax bracket utilization strategies have become key planning issues with my clients. Bracket utilization is a term to describe flying under the radar of higher tax brackets. You start by calculating your long-term tax rate (out to 15 years), assuming it’s below the 39.6% threshold, and use strategies to keep it below the higher brackets. In addition, you look for ways to fill up the current year tax bracket right up to the last dollar. Why? Suppose your income moves your tax bracket up 10% next year, then you will need to beat 10% to make it a good deal for deferring that income.
This wasn’t always the case. In the past, I would focus on harvesting losses and deferring income and gains where possible in order to reduce the current year’s tax liability. Today, I focus on ways to help clients avoid having to pay taxes at those higher marginal rates and phase-outs in the future by harvesting gains today and filling up tax brackets in the current year.
Using Roth Conversions for Bracket Management – If you have traditional IRAs and your tax brackets will be higher in the future, you may want to convert some of those funds into Roth IRAs. This is often referred to as “filling-up” the 10% and 15% tax brackets. As an example, Ms. Jones will make $220,000 this year, so she has a $30,000 gap before jumping into the surtax. Next year it looks like her income might reach $270,000. If she does a Roth conversion now and picks up that income, she will smooth out some of the surtax.
15 Impactful Bracket Management Ideas
As part of my quest to increase my knowledge of bracket management, I’ve become a student of Robert S. Keebler, CPA. I read as many of his articles as I can, as well as purchased his fantastic tax charts. Keebler shares these 15 good tax strategies than you can use to keep out of higher tax brackets and reduce or eliminate NIIT.
Strategies for Staying Out of Higher Tax Brackets and Avoiding NIIT
Harvesting Capital Losses. The taxpayer sells assets at a loss and uses these losses to offset capital gains realized on other assets. This strategy might be particularly useful if capital gains realized for the tax year would otherwise push the taxpayer into a higher tax bracket or cause the NIIT to apply.
Harvesting Capital Gains. If the taxpayer has a lower capital gains bracket now than he expects to have in the future, the taxpayer may wish to recognize gain now instead of later. Note, however, that selling early introduces a trade-off between paying less tax and losing tax deferral. Thus, a quantitative analysis should be performed to see if gain harvesting is advisable. Note also that if the taxpayer is currently in the 10% or 15% ordinary income tax bracket, the loss of tax deferral is not a factor. Long-term capital gains for these taxpayers are taxed at 0%, so there is no trade-off for the lower rate.
Roth IRA Conversions. There have always been important advantages to Roth IRA conversions, but now they can also be used to smooth income. Traditional IRA distributions are not NII, but they are included in MAGI and this could increase exposure to the NIIT. To illustrate, suppose that Tina is a single taxpayer with $150,000 of salary income and $50,000 of interest income. Although Tina has $50,000 of NII, she is not subject to the NIIT because her income does not exceed her ATA of $200,000. If she receives a $60,000 distribution from a traditional IRA, her MAGI increases to $260,000. The full $50,000 of NII becomes subject to tax and Tina pays NIIT of $1,900 (.038 x $50,000). By contrast, if the distribution was from a Roth IRA, Tina’s MAGI would stay at $200,000 and there would be no NIIT payable. Tina could eliminate all future NIIT on IRA distributions by converting the traditional IRA to a Roth IRA, assuming a conversion otherwise made sense. This strategy would also have an income smoothing effect if the taxpayer expected to be in a higher tax bracket when distributions were received than when the conversion (or series of conversions) was done.
Substantial Sale Charitable Remainder Trust (Charitable Remainder Annuity Trust or Charitable Remainder Unitrust). This strategy is very favorable for a taxpayer who expects to recognize a large capital gain during the tax year that would push him into a higher tax bracket or cause the NIIT to apply. The taxpayer transfers the appreciated asset to the charitable remainder trust (CRT) and the CRT sells it. Because the CRT is a tax-exempt entity, no gain is recognized. Gain on the annuity or unitrust payments are subject to tax only as annual distributions are received by the donor, spreading the income out over a period of time.
Charitable Lead Annuity Trust (CLAT). Direct charitable contributions do not reduce MAGI because they are taken below the line. When a CLAT makes its annual annuity or unitrust payments to charity, however, the charitable deduction reduces the trust’s MAGI, possibly also reducing the NIIT payable and leaving more in the CLAT to pass to the donor’s heirs at the end of the trust term.
Oil & Gas Investments. These investments can create a large deduction in a tax year. Therefore, they can be used in a high-income year to keep a taxpayer out of higher brackets or to avoid the NIIT. Two-Year Installment Sales. Installment sales from parents to children or children’s trust can spread out a gain over a period of time, thereby smoothing income. The children or the trust must wait more than two years to resell the assets to avoid having the sale proceeds included in the parents’ income at the time of the second sale under IRC Section 453(e).
Retirement CRT. A net income with make-up charitable remainder unitrust (NIMCRUT) can be used as a supplement to a qualified retirement plan. The NIMCRUT minimizes trust distributions during a taxpayer’s high earning work years while investing for tax-deferred growth. After the taxpayer retires and has lower annual income, the appreciated assets are invested to generate the maximum amount of income possible, producing an income smoothing effect.
Income shifting CRT. This is a CRT in which the donor’s children receive the lead annuity or unitrust payments. By transferring income-producing assets to the trust, the parents can reduce or eliminate their exposure to high tax brackets and/or the NIIT during high earning years.
Deferred Annuities. During higher tax bracket years, the taxpayer invests income- producing assets in deferred annuities to reduce taxable income. Annuity payments begin when the taxpayer is in a lower tax bracket, thereby smoothing income. Borrowing From Permanent Life Insurance Policies. The taxpayer pays into a permanent life insurance policy in high income years, reducing taxable income. If the taxpayer needs additional income in later years, she can borrow from the policy on a tax- free basis instead of selling assets and perhaps pushing income into a higher tax bracket or creating NIIT exposure.
Incomplete Gift, Non-Grantor Trusts. Taxpayers in high tax states may be able to reduce or eliminate state tax by creating a trust in a state that does not tax 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.
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, as a result, is not subject to the NIIT. Choice of Filing Status. For married couples, the amount of NIIT payable may vary depending on whether they file jointly or file single returns. Such taxpayers should run the numbers to see which filing status would be preferable.
Tax-Efficient Investing. Tax-aware investing can substantially reduce taxable income and increase after-tax returns, perhaps keeping a taxpayer in a lower tax bracket. Tax-aware investing includes the following components: (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.