Income & Estate At The Edge Of The Fiscal Cliff By: Michael E. Kitces, MSFS, MTAX, CFP, CLU, ChFC, RHU, REBC, CASL Partner, Director of Research, Pinnacle Advisory Group Publisher, The Kitces Report, www.kitces.com Blogger, Nerd s Eye View, www.kitces.com/blog Twitterer, @MichaelKitces, www.twitter.com/michaelkitces Income & Estate Tax Planning 1
The Sunset of EGTRRA Economic Growth & Tax Relief Reconciliation Act of 2001 ( the Bush tax cuts ) Sunset provisions scheduled to take effect after December 31, 2010 Effective January 1, 2011, numerous laws would revert back to pre-egtrra status for both income and estate tax purposes EGTRRA provisions enhanced, accelerated, and modified by numerous additional pieces of legislation throughout the decade, but underlying sunset not altered for most provisions The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 Compromise legislation to address the sunset of EGTRRA (and unemployment insurance) Direction of compromise shifted several times through the fall and election season Temporary versus permanent; wealthy versus lower/middle income Ultimate compromise: 2 year extension with a number of caveats 2
Medicare Earned Income Tax starting in 2013 Established under Patient Protection Act Additional Hospital Insurance tax of 0.9% on earned income in excess of applicable thresholds Increase from the normal 1.45% hospital insurance tax amount for high income taxpayers Results in total tax of 2.35% for excess income Threshold amounts are $200,000 for individuals; $250,000 for married filing jointly Unlike regular hospital insurance tax, is applied to joint income for a married couple Amounts are not indexed for inflation Medicare Unearned Income Tax starting in 2013 Also established under Patient Protection Act Additional unearned income Medicare contributions tax of 3.8% (for individuals and trusts) on lesser of: Net investment income Excess of modified AGI over threshold amounts Applies in addition to any other income taxes that may apply Included when determining estimated tax payments 3
Individual Income Taxes Tax brackets extended for two years, through 2012 Scheduled to lapse to pre-egtrra after 2012 Marriage penalty relief extended too 15% bracket + standard deduction 2011-12 Tax Brackets 2013 New Tax Brackets 10% 15% 15% 25% 28% 28% 31% 33% 36% 35% 39.6% Individual Income Taxes Planning Implications Planning in a rising tax bracket environment Upper brackets versus lower/mid brackets? Accelerating income and deferring deductions Roth conversions in 2012 and beyond if tax rates are rising Risk of tax reform and lower tax brackets in the future? 4
Long-Term Capital Gains Current maximum tax rate of 15% Tax rate of 0% for those who fall into the bottom two tax brackets Example: $20,000 of Ordinary Income $60,000 of L/T Capital Gains Maximum 15% Bracket for Married Couple - $68,000 $60,000 of Long-Term Capital Gains $20,000 of Ordinary Income 15% Gains / 25% Bracket 0% Gains / 15% Bracket 15% Bracket 10% Bracket Long-Term Capital Gains in 2013 Long-term capital gains reverts back to 20% 10% for those in the bottom tax bracket 18% and 8% rates apply for ultra-long-term (5- year) holding periods started after January 1 st, 2001 5
Long-Term Capital Gains Planning Implications Harvesting Gains 0% versus 15% harvesting Watch out for installment sales NOT Harvesting Losses Benefit is only the time value of money, because cost basis is reset; higher rates can destroy value Dealing with Loss Carryforwards Intra-family transfers & income shifting Qualified Dividends Eligible qualified dividends receive long-term capital gains treatment Must satisfy corporation and holding period requirements Eligible for 15% and 0% rates Was scheduled to sunset at the end of 2010 and revert to ordinary income treatment Extended for two years through the end of 2012 Tax rates remain the same, given no change in long-term capital gains rates 6
Qualified Dividends Planning Implications Possible portfolio shifts Taxation of dividend versus bond income after 2012 Planning for closely-held businesses Harvesting dividends at current rates versus retaining cash for business needs Multi-year workout plans for significant retained earnings Alternative Minimum Tax AMT patch under Tax Relief Act of 2010 lapsed at end of 2011 Was $74,450 for married couples, $48,450 for individuals in 2011 Reverts to $45,000 for married couples, $33,750 for individuals in 2012 AMT exemption phaseout still applies for higher income Will thrust almost 25 million taxpayers into the AMT for 2012 if not patched retroactively later this year 7
AMT Potential Exposure Common AMT adjustments and tax preference items that cause AMT exposure: High state income tax rates (e.g., Montana, California, Oregon, Vermont, District of Columbia, Iowa, Hawaii, North Carolina) High property tax rates and/or substantial amount of property that will be taxable High number of dependents (e.g., children, dependent parents) High miscellaneous itemized deductions Investment management fees Tax preparation fees Variable annuity losses Unreimbursed employee business expenses AMT Potential Exposure Potential Exposure to AMT (2011) Amount of Adjustments & Preferences that may cause AMT to apply Regular Taxable Income Joint Single $50,000 $50,027 $31,623 $100,000 $40,796 $27,774 $150,000 $32,082 $20,851 $200,000 $25,159 $16,680 $300,000 $18,001 $12,132 $400,000 $13,479 $31,479 $500,000 $29,898 $56,479 8
AMT Potential Exposure Potential Exposure to AMT (2012) No Patch Amount of Adjustments & Preferences that may cause AMT to apply Regular Taxable Income Joint Single $50,000 $20,479 $16,476 $100,000 $10,452 $15,425 $150,000 $7,420 $8,502 $200,000 $497 $3,626 $300,000 $0 $10,514 $400,000 $1,670 $29,048 $500,000 $26,670 $54,048 Miscellaneous tax extensions No itemized deduction phaseouts through 2012 No personal exemption phaseouts through 2012 Deduction for state/local sales taxes paid lapsed in 2011 Above-the-line deduction for qualified tuition and related expenses up to $4,000 lapsed in 2011 American Opportunity Tax Credit extended through 2012 Expanded Coverdell Education Savings Account contributions and qualified distributions for elementary and secondary school expenses extended through 2012 Charitable contributions from IRAs lapsed in 2011 9
Payroll tax holiday Employee-portion of FICA taxes reduced by 2 percentage points for 2012 extended from 2011 Employee pays only 4.2% + 1.45% = 5.65% in 2011, up to $110,100 wage base Employee still pays 1.45% on excess above wage base Employers still owe 7.65% matching payroll tax amount Self-employed individuals also receive reduction; 12.4% for Social Security reduced to 10.4% for 2011 (plus 2.9% for Medicare tax) Tax savings of up to $2,202 when wage base is reached if extended for the year Adjusted withholding tables currently in effect Self-employed individuals may wish to adjust estimated tax payments for 2012 Miscellaneous Tax Provisions New cost basis reporting rules Brokers/custodians required to report cost basis Stocks acquired in 2011, mutual funds in 2012, all others in 2013 Brokers will use FIFO or average cost (for funds), unless taxpayers providing specific lot information Further coordination may be necessary to ensure custodian records match portfolio reporting software 10
Estate Taxes Estate tax exemption was set back at $5 million for 2011 (indexed for inflation in 2012), lapsing back to $1M in 2013 Top estate, gift, and generation-skipping tax rate at 35% through 2012 Gift tax exemption reunified with estate tax exemption at $5.12 million (for 2012) Legislation to prevent retroactive recapture via death if estate exemption is lowered? State decoupling version 2.0 state gifting Unused estate tax exemption amount at death now portable to surviving spouse Requires estate tax return to be filed! Summary Most major provisions under Tax Relief Act extended two years through 2012 Rules that lapsed at the end of 2009 only extended 2 years through 2011 (AMT, state/local sales tax deduction, charitable contributions from IRAs) and are now lapsed again Limited time window for some benefits and deductions still affords planning opportunities Delays some immediate urgency for planning around higher tax rates (accelerate income, defer deductions), but risk of rising tax rates still looms 11
Questions? Michael E. Kitces, MSFS, MTAX, CFP, CLU, ChFC, RHU, REBC, CASL Director of Research, Pinnacle Advisory Group Publisher, The Kitces Report, www.kitces.com Blogger, Nerd s Eye View, www.kitces.com/blog Twitterer, @MichaelKitces, www.twitter.com/michaelkitces michael@kitces.com 12