Tax Update. Before the Year Ends What to Know About Investment Income and Taxes. Stephen A. Baxley, Director of Tax & Financial Planning

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1 November 2013 Tax Update Before the Year Ends What to Know About Investment Income and Taxes Stephen A. Baxley, Director of Tax & Financial Planning Many higher-income taxpayers earn a large portion of their annual income through their investments, much of this in the form of long-term capital gains and qualified dividends. Starting this year, three important changes to the tax code higher tax rates, limits on itemized deductions, and a new tax on net investment income may cause a significant increase in the overall tax liability for these taxpayers. The following summary offers a closer look at what those changes may mean to Bessemer clients. Top Tax Rates on Investment Income and Capital Gains Have Increased As shown in Exhibit 1, the combined top tax rate on long-term capital gains and qualified dividends has jumped from 15% to 25%, which represents a 67% increase. The combined tax-rate increase on ordinary investment income of 27% (from 35% to 44.6%) is also significant. Exhibit 1: Top Tax Rates on Investment Income Increased in 2013 Top Tax Rate Stealth Tax New 3.8% Tax Long-Term Capital Gains/ Qualified Dividends 25% 67% increase 15% 2012 For taxpayers subject to the Alternative Minimum Tax, the top tax rate on ordinary investment income increases from 28% to 31.8%, and the top tax rate on long-term capital gains and qualified dividends increases from 15% to 23.8%. Significant 2013 Tax Changes Income Tax Rates 2013 Ordinary Investment Income 27% increase 35% % 2013 Ordinary income. The top tax rate on ordinary income such as wages, taxable interest, and short-term gains has increased from 35% to 39.6% for higher-income taxpayers, defined as individuals with taxable income above $400,000 and married couples filing jointly with taxable income above $450,000. Long-term capital gains. The top rate jumped from 15% to 20%, restoring the rate in effect prior to the Bush-era tax cuts. Qualified dividends. A preferential tax rate on qualified dividends was retained for all taxpayers, although it has risen. The prior rate of 15% had been scheduled to increase to 39.6% with the expiration of the Bush-era tax cuts, but instead increased to 20%, the same level as long-term capital gains. Return of the Stealth Tax The return of the Pease provision, which limits the amount of itemized deductions taxpayers can claim, has been called a stealth tax, as it increases tax liability without an increase in rates. The 2013 adjusted gross income threshold at which this provision sets in is $250,000 for individual taxpayers and $300,000 for married couples filing jointly. This is how it works. In 2013, itemized deductions are now reduced by 3% of income above these thresholds, with a maximum reduction of 80%. With a top rate of 39.6% on ordinary income, this equates to an increase of approximately 1.2% in the top tax rate.

2 The math behind the 1.2% rate increase is relatively simple, as shown in the following example. Highincome Taxpayer A receives $100 in income over the threshold amount. Under the Pease provision, she has a reduction in otherwise allowable itemized deductions equal to 3% of this amount. This loss of $3 in deductions creates an additional tax liability of approximately $1.20 ($3 at the top tax rate of 39.6%). $1.20 of additional tax on $100 in taxable income equates to a marginal tax rate increase of 1.2%. Net Investment Income Tax An additional 3.8% tax now applies to the net investment income of individuals with adjusted gross income above $200,000 and married couples with income above $250,000. This tax was included as a funding measure in the Affordable Care Act. Preferential Tax Treatment? Does the combined effect of these higher tax rates and new taxes mean that long-term capital gains and qualified dividends no longer receive preferential tax treatment? The short answer is no. If we rearrange the bars from Exhibit 1, as shown below in Exhibit 2, we can see there was a 20 percentage-point differential in the tax treatment of long-term capital gains and qualified dividends as compared to ordinary investment income in The differential in 2013 is nearly the same a 19.6 percentage-point spread. Clearly, long-term capital gains and qualified dividends still enjoy a significant benefit in the form of lower tax rates. Different Thresholds and Bases To further complicate matters, these three new tax changes apply at varying income thresholds and on different measures of income. As illustrated in Exhibit 3, the 3.8% net investment income tax applies for married taxpayers filing jointly at a threshold of $250,000 of adjusted gross income. The Pease provision applies at a slightly higher adjusted gross income level of $300,000 for married taxpayers. The higher tax rates that took effect as a result of the fiscal cliff deal in January 2013 apply at a much higher level of $450,000 for married taxpayers, and this threshold is taxable income, a much different measure than adjusted gross income. The net result is that taxpayers with very high incomes will be subject to all three of these new tax changes. Many more will be subject only to the Pease provision and net investment income tax. Exhibit 3: Income Thresholds for 2013 Tax Changes Single Taxable Income Married $450k $400k Adjusted Gross Income Exhibit 2: Long-Term Gains, Qualified Dividends Still Receive Preferential Treatment $250k $200k $300k $250k Long-Term Capital Gains/Qualified Dividends Ordinary Investment Income 19.6-point spread 35% 44.6% 20-point spread 25% 3.8% Net Investment Income Tax Pease Provision Top Tax Rate for Income/ Long-Term Gains/Qual. Dividends 15% Net Investment Income Tax A Closer Look The new net investment income tax is a 3.8% tax on the lesser of a taxpayer s net investment income or the excess over a threshold amount in this case, $250,000 for married taxpayers filing jointly 2

3 and $200,000 for individuals. The tax also applies to the undistributed net investment income held in estates and trusts, but a much lower threshold applies for 2013, it is $11,950. Although it may seem that net investment income should be a relatively easy calculation, it is, in fact, unnecessarily complex. A quick overview is illustrative. We start by determining gross investment income, which consists of three categories: 1. Interest, dividends, annuities, royalties, and rents unless they are earned in the ordinary course of a trade or business in which the taxpayer plays an active role. An important exception applies: A trade or business of trading in financial instruments or commodities will always be subject to the tax; 2. Passive income from a trade or business; and 3. Net gain from the disposition of property, other than property held in a trade or business in which the taxpayer is active. The next step is to calculate the deductions allowable to determine net investment income. Allowable deductions include the following: Deductions attributable to rent and royalty income; Trade or business deductions; Investment interest; Investment expenses; and State income taxes. The result of this calculation is the taxpayer s net investment income. A Startling Outcome The combined application of the 2013 tax law changes can have an unexpected effect on the tax liability of higher-income taxpayers. Perhaps the best way to illustrate this is to calculate 2012 and 2013 tax liabilities using the same figures for taxable income and itemized deductions, as shown in Exhibit 4. Exhibit 4: The Difference a Year Makes Married Taxpayers, Filing Jointly Income Itemized Deductions Wages $450,000 Taxes $30,000 Qualified Dividends $300,000 Mortgage Interest $15,000 Long-Term Capital Gains $1,000,000 Charitable Contributions $75,000 Total Income $1,750,000 Total Deductions $120, Adjusted Gross Income $1,750,000 $1,750,000 Itemized Deductions 120, ,000 Less: Pease disallowance ,500 Allowable Deductions - 120,000-76,500 Taxable Income 1,630,000 1,673,500 Tax 293, ,000 Net Investment Income Tax ,400 Total Tax 293, ,400 Effective Tax Rate 16.7% 23.3% Increase in Tax 114,400 Percentage Increase over % 3

4 The 39% increase in year-over-year tax liability is caused by all three of the 2013 tax law changes discussed above. Taxpayers with high levels of investment income and itemized deductions are likely facing a much higher tax bill for What can be done to mitigate this additional cost? Year-End Tax Planning A small consolation to higher tax rates can be found in the corresponding increase in the value of deductions, losses, and other tax-planning tools. The Internal Revenue Code contains opportunities all taxpayers should consider, especially in a higher tax-rate environment. (For more on this topic, please see Bessemer s August 2013 Tax Commentary: Back to Basics Planning in a More Certain Tax Environment.) These tax-planning opportunities can be grouped into five general categories: Exclusions. Items that are excluded from federal taxable income are exempt from taxation. Notable items include gains on the sale of a principal residence (up to $250,000 for individuals and $500,000 for married couples filing jointly), municipal bond interest, and Roth IRA distributions. Deductions and losses. Itemized deductions can reduce taxable income and tax liability. Charitable contributions, state income tax, real estate tax, and mortgage interest provide significant tax benefits to taxpayers who itemize deductions. Business losses and capital losses can also reduce tax liability. Deferrals. Unless a taxpayer faces a sharp increase in tax rates, it is almost always preferable to pay taxes in the future rather than in the current year. The ability to defer income recognition and the associated tax payment provides a valuable economic benefit. Examples include qualified retirement plans in which assets are subject to taxation only when distributed in retirement (such as an IRA) and sales that are recognized on an installment basis. Reduced rates. Preferential tax rates on items such as long-term capital gains and qualified dividends can provide a major tax benefit. Although the rate has increased from 15% to a top combined rate of 25%, it is still significantly lower than the top combined rate on ordinary investment income, now more than 44%. Credits. Income tax credits are worth more than deductions since they provide a direct offset to tax liability, whereas deductions only reduce taxable income. Examples include the foreign tax credit, which is designed to prevent double taxation of foreign source income, and the energy credit, which can be claimed for 30% of the cost of certain solar and wind energy equipment. Specific Planning Moves to Consider Tax-planning moves that combine one or more of the categories noted above can be especially valuable. The following examples may provide a significant benefit if completed before year-end: Self-employed retirement plans. For individuals with self-employment income (e.g., consulting income, director fees, or professional services income), a self-employed retirement plan, such as an SEP-IRA, combines a current year s tax deduction with the benefits of long-term tax deferral. The amount of the deduction is usually calculated as a percentage of the income earned from the activity, and will vary depending on the type of plan chosen. Charitable contributions. Gifts of long-term appreciated property now provide a larger tax benefit because of higher tax rates and the increased level of tax liability attached to these assets. Private foundations, donor-advised funds, and charitable trusts are all effective techniques to consider. Charitable remainder trust. A 67% increase in the combined tax rate of long-term capital gains makes this type of trust especially valuable for taxpayers with low-basis, highly appreciated stock. This not only generates a current-year tax deduction, but also provides an income stream for a period of years. 4

5 Tax-loss harvesting. Although we do not believe there is significant value in selling all loss positions prior to year-end, we do believe that losses should be strongly considered to offset net short-term capital gains, which are now subject to tax at the highest combined top marginal tax rate of 44.6%. Roth IRA conversion. We believe wealthy taxpayers should consider this strategy at any point during the year. Our analysis has shown the initial cost of conversion is greatly outweighed by the long-term tax-deferred growth and full income exclusion connected to this powerful vehicle. Taxpayers who are subject to Alternative Minimum Tax (AMT) can convert at a lower tax cost. Review tax structure. It is often helpful to review the types of assets held in various investment accounts. For example, qualified retirement accounts should be considered for assets that generate high levels of ordinary investment income, such as taxable interest or short-term capital gains. Tax on the income earned is deferred until distributions are taken in retirement. Prepayment of state income taxes. This strategy is only beneficial for taxpayers who will not be subject to AMT in the current year. Careful tax projections should be prepared to determine the potential benefit prior to engaging in any of these strategies. If you have any questions, please contact your Client Advisor or one of Bessemer s Senior Tax Consultants. This material is for your general information. This material does not constitute legal or tax advice or take into account the particular investment objectives, financial situation, or needs of individual clients. It has been prepared based on information that Bessemer Trust believes to be reliable, but Bessemer makes no representation or warranty with respect to the accuracy or completeness of such information. Views expressed are current as of the date noted and are subject to change without notice. Forecasts may not be realized due to a variety of factors, including changes in economic growth, corporate profitability, geopolitical conditions, and inflation. Atlanta Boston Chicago Dallas Denver Greenwich Los Angeles Miami Naples New York Palm Beach San Francisco Washington, D.C. Wilmington Woodbridge Cayman Islands New Zealand United Kingdom Visit us at Copyright 2013 Bessemer Trust Company, N.A. All rights reserved.