If your clients are anywhere near the cutoff line for the upper tax brackets, laws enacted in 2013 make it more important than ever that they take advantage of strategies to reduce taxable income.
The good news for most Americans is that the tax increases included in the American Taxpayer Relief Act of 2012, which President Obama signed into law on Jan. 2, 2013, largely affect only the country's highest earners, individuals making $400,000 or more a year or $450,000 for a married couple filing jointly.
But the law does reinstate the Pease limitation on itemized deductions, which, starting with 2013, applies to individuals making $250,000 or more ($300,000 for married couples).
Based on a percentage formula, this feature limits common itemized deductions such as mortgage interest, charitable contributions and property taxes (medical expenses are exempt).
Moreover, the lesser known 3.8% Medicare tax on net investment income-part of the Affordable Care Act, which also went into effect in January 2013-applies to single people making $200,000, and married folks making $250,000.
Even if many of your mass-affluent clients have salaries below these thresholds, a hefty bonus or a significant gain on a stock sale could bump them up, making regular re-evaluation that much more important.
"So much is driven by modified adjusted gross income-even more than in previous years," says Gary Fox, a managing partner at Crowe Tax Services. "Strategies to reduce modified adjusted gross income are critical."
Max Out, in a Good Way
The easiest way for a client to reduce taxable income is through tax-free retirement accounts like 401(k)s, IRAs and SEPs. These plans reduce income now, lowering current taxes, and holders pay at retirement, when most people are at a lower tax level.
This may seem a simple, commonsense piece of advice, but only 28% of workers making over $100,000 per year max out their 401(k), according to 2010 data from the Center for Retirement Research at Boston College. So if your mass-affluent clients still haven't maxed out their plans, it may be time to start pushing them to do so for 2014.
In fact, for many taxpayers it may not be too late to take advantage of tax-deferred contributions for 2013. With certain types of IRAs, the individual can make a contribution for the prior year up to April 15.
The same is true for SEP (Simplified Employee Pension) plans, used by doctors and other self-employed professionals. The account must be opened by Dec. 31, but contributions up to the maximum-usually 15% to 25% of income-can be made until the day the return is filed.
"Taking full advantage of tax-deferred qualified plans makes sense, particularly for investors in high tax brackets," says Peter Wall, investment strategist for Chase Private Client. "In most cases it's preferable to defer taxes now, when investors are at higher marginal tax rates, and pay them at retirement, when marginal rates are presumably lower."
Of course, there are situations where the opposite is true. For example, a young professional who expects to have a higher modified adjusted gross income at retirement might want to go with a Roth IRA and pay the taxes now, at a lower rate.
"You should just time it to whatever is going on in your life," says Michael Kitces, partner and director of research at Pinnacle Advisory Group in Columbia, Md. "The tax code allows you to time this."
So the key is regular evaluation of each situation. "They have to sit down with their financial advisor at least every six months," says James Suh, a regional sales manager at Merrill Edge, serving the Los Angeles coast region.
While the current focus is on 2013 taxes, the recent tax increases should now be part of long-term planning because they aren't going away anytime soon.
Consider the 3.8% Medicare tax on net investment income, which is calculated on the lesser of either net investment income or the amount by which modified adjusted gross income exceeds the appropriate threshold.
For example, let's say a single woman earns $190,000 in compensation and $35,000 of dividend and interest income during 2013, for a total of $225,000. She will be required to pay the 3.8% Medicare tax on the lesser of $35,000 (her net investment income) or $25,000 (her modified adjusted gross income minus the applicable threshold, or $225,000 minus $200,000).
So even though she has both net investment income and a modified adjusted gross income above her applicable threshold, she owes the 3.8% tax on only the lesser of these two, or $25,000.
One natural question is: What counts as investment income? The following are some examples.
Gains from selling investment assets, like stocks and securities, held in taxable brokerage accounts, and real estate gains, including the taxable portion of a big gain from selling a principal residence.
Capital gain distributions from mutual funds.
Gross income from dividends, annuities, royalties and interest (not including tax-free interest such as municipal bond interest).
Gross income and gains from passive business activities (business activities in which you don't spend a significant amount of time) and gross income from rents.
Gains from selling passive partnership interests and S-corporation stock.
Gross income and gains from trading in financial instruments or commodities.
"It's quite an onerous provision," says Diane Giordano, a tax partner at the Long Island office of the accounting and advisory firm Marcum LLP. "I don't think individuals [in this tax bracket] necessarily understand the staggering amount of increases they'll see to their taxes."
Whether it's a one-time sale of stock or a regular income from rental properties, if it pushes your clients into a new tax bracket, now's the time to help them prepare.
Another key element of long-term tax planning is tax-exempt investing, which means investing in municipal bonds. Unfortunately, in the fixed income world, finding returns of any kind isn't easy, given persistently low interest rates.
Chase's Wall promotes tax-exempt investing but adds that a tax benefit should be only part of the equation. "Our general advice is that the potential tax impact should not be the sole consideration when making an investment decision," Wall says. "Investors should focus on developing a portfolio that provides a risk/return scenario that best allows them to achieve their financial goals. We advocate making full use of tax advantaged strategies but not to the exclusion of other considerations such as volatility, liquidity and return expectations."
Proceed with Caution
All of this said, while deference can be an efficient strategy for reducing the tax bite, there is a danger of getting carried away.
Kitces notes that when looking long term, pushing too much income indefinitely into the future can actually result in overall losses. "It's very risky to bunch it all up at the end," he says.
In today's environment, he says, it may be more effective to consider strategies like Roth conversions or capital gains harvesting that aim to accelerate income into the current year, rather than defer it into the future.
This form of "tax bracket arbitrage" can actually result in greater lifetime wealth, even though it triggers a tax liability sooner rather than later.