PERSONAL TAX PLANNING

PERSONAL TAX PLANNING after the new tax law American Taxpayer Relief Act 2606 116 th Avenue N.E., Suite 200 Bellevue, Washington 98004 Tel 425-629-1990, Fax 425-629-1999 www.sweeneyconrad.com

PERSONAL TAX PLANNING AFTER THE NEW TAX LAW After a dramatic year-end debate over the so-called fiscal cliff, lawmakers in Washington enacted the American Taxpayer Relief Act of 2012. Many of the law s provisions are aimed at preventing widespread federal tax increases for the majority of Americans. However, higher income investors, business owners, and those with accumulated wealth are also affected and not all the news is good. Now that the flurry of reports about the new law has subsided, it s time to take a closer look at how the new tax changes will affect your personal situation. Here, we summarize several important provisions and their potential impact. We also suggest planning strategies that might be advantageous under the new law. But use caution. No publication can cover all of the law s nuances or take your specific circumstances into account. Before applying any strategy to your personal situation, be sure to discuss the matter with your professional advisor. INCOME TAXES Top Rate on Individuals What Has Changed: Before the new tax law, individual income-tax rates had been scheduled to revert to the higher rates in effect before the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). Now the rates will remain the same as they have been for several years, except for the addition of a 39.6% rate bracket beginning in 2013. TAX RATES Pre-EGTRRA 15% 28% 31% 36% 39.6% 2012 10% 15% 25% 28% 33% 35% 2013 and After (old law) 15% 28% 31% 36% 39.6% 2013 and After (new law) 10% 15% 25% 28% 33% 35% 39.6% 1

The 39.6% rate is applicable to taxable income over a specified threshold, which varies depending on filing status. 39.6% RATE THRESHOLDS FOR 2013 Filing Status Taxable Income Over Single $400,000 Married Filing Jointly (and Surviving Spouse) $450,000 Head of Household $425,000 Married Filing Separately $225,000 The Impact: Most taxpayers can breathe a sigh of relief that their income-tax rates won t increase. However, the jump in the top income-tax rate almost five percentage points amounts to a substantial tax increase for high earners. (Note: They still benefit from the lower graduated rates on a portion of their taxable income.) Small business owners and professionals are among the taxpayers most likely to be affected, since many of them pay taxes on business income individually. Example: Bill is a shareholder in a small firm that has been an S corporation since its inception. As a 50% owner of the company, Bill reports half the firm s taxable income on his individual return. For 2013, the company passes through $400,000 of taxable income to Bill. When combined with his and his wife s other income, the S corporation income passed through to Bill easily pushes the couple into the 39.6% tax bracket. Strategies To Consider: Fund Retirement Plans. Taking full advantage of the deferral features a tax-favored retirement plan offers can make more sense than ever. Pretax salary deferrals to a 401(k) or similar retirement savings plan lower your currently taxable income. Consider contributing the maximum amount your plan allows, and don t overlook the opportunity to make catch-up contributions if you are eligible for them. If you are self-employed or a small business owner, establish a retirement plan or reconsider whether the plan you already have puts you in the best position to maximize tax-deductible contributions. Defer Compensation. You may have additional opportunities to defer compensation in a nonqualified plan. Although the 39.6% tax bracket could be a feature of the tax system for some time, deferring taxes is generally more advantageous than paying them currently. And it s always possible you ll be in a lower tax bracket when you eventually take the money (in retirement, for example). Review Investments. Now is a good time to meet with your advisors to review your investments and potential opportunities to sidestep or defer income taxes. For now at least, the interest on most municipal bonds is exempt from federal income taxes. (Private activity bond interest subject to alternative minimum tax, discussed later, is an exception.) Permanent life insurance offers potential tax benefits, such as the income-tax-free buildup of cash value in a whole life insurance policy. Contributions to a Section 529 college savings plan* are not tax deductible, but plan earnings accumulate tax deferred and may be withdrawn income-tax free for the account beneficiary s qualified higher education expenses. * Certain benefits may not be available unless specific requirements (e.g., residency) are met. There also may be restrictions on the timing of distributions and how they may be used. Before investing, consider the investment objectives, risks, and charges and expenses associated with municipal fund securities. The issuer s official statement contains more information about municipal fund securities, and you should read it carefully before investing. 2 3

Deduction Limits for High Earners What Has Changed: Two previously expired provisions that effectively increase tax rates for higher income taxpayers one phasing out the deduction for personal exemptions and another placing an overall limitation on itemized deductions return for 2013 and subsequent tax years, as was scheduled to happen under prior law. The new income thresholds for both the personal exemption phaseout (PEP) and the itemized deduction limitation (sometimes called the Pease limitation, after the lawmaker who originally championed it) are significantly lower than the thresholds for the 39.6% rate bracket, although they are somewhat higher than they would have been absent the new law. PEP/PEASE LIMITATION INCOME THRESHOLDS Filing Status Adjusted Gross Income (AGI) Over Single $250,000 Married Filing Jointly (and Surviving Spouse) $300,000 Head of Household $275,000 Married Filing Separately $150,000 The Impact: Because of these less obvious tax hikes, many affluent taxpayers will see their deductions for both personal exemptions and itemized deductions reduced, boosting their tax liabilities. The limitation on itemized deductions may be particularly onerous since taxpayers can lose up to 80% of their itemized deductions (except for those not affected by the limitation, such as medical expenses and casualty losses). Basically, itemized deductions are reduced by 3% of the amount by which AGI exceeds the relevant threshold for a taxpayer s filing status. Strategy To Consider: Because above-the-line deductions reduce AGI (rather than being subtracted from AGI), they can limit your exposure to the personal exemption phaseout and the itemized deduction limitation, as well as potentially help you qualify for other tax breaks limited by AGI. The deductions for alimony, self-employed health insurance premiums, self-employed retirement plan contributions, and contributions to a traditional individual retirement account (IRA) are examples of above-the-line deductions. (Limits apply.) Capital Gains and Dividends What Has Changed: The American Taxpayer Relief Act permanently sets the top tax rate on individual investors net capital gains and qualified dividend income at 20% starting in 2013, but only for those with income over the same levels ($400,000 for single filers, $450,000 for joint filers, etc.) discussed earlier regarding the 39.6% income-tax rate. The capital gains/dividend rate for most other investors is capped at 15% (0% for income that would otherwise be taxable in a below-25% ordinary tax bracket). These changes prevent more sweeping increases in the capital gains rates that were to have taken place in 2013 and retain the preferential tax treatment of qualified dividends that investors have enjoyed for several years. The new law also allows noncorporate taxpayers to exclude 100% of capital gain realized on the sale of qualified small business stock acquired after September 27, 2010, and before January 1, 2014, and held for more than five years. The acquisition deadline under prior law was December 31, 2011. To the extent capital gains on qualified small business stock are taxable, a maximum 28% rate applies. CAPITAL GAINS RATES AFTER 2012 Holding Period Ordinary Bracket More Than One Year (long term) One Year or Less (short term) 39.6% 20% 39.6% 25%-35% 15% 25%-35% 10%-15% 0% 10%-15% Long-term capital gains from the sale of certain types of assets are taxed at different rates. Real estate gains are taxed at a maximum rate of 25% to the extent of prior allowable depreciation. The top rate on collectibles gain and taxable qualified small business stock gain is 28%. 4 5

The Impact: Despite the five-percentage-point hike in the top capital gains rate, assets that have the potential to produce long-term capital gains are still more attractive tax-wise than those that produce ordinary income. For higher income investors, the differential between the 20% capital gains rate and the 39.6% highest marginal rate on ordinary income means a tax savings of $196 per $1,000 of affected income. The fact that qualified dividends will continue to be taxed at the long-term capital gains rates is another major plus for investors. Before the new law, qualified dividends were to be taxed at ordinary tax rates beginning in 2013. (But keep in mind that both capital gains and dividends are also potentially subject to the new 3.8% investment income surtax that takes effect in 2013 under the 2010 health care reform legislation. This could raise the potential federal tax rate on long-term gains and qualified dividends to a high of 23.8%.) Strategies To Consider: Here are some possible ways to reap the most from the still favorable rates on capital gains and qualified dividends or to sidestep current taxes on capital gains: Review Your Portfolio. Where otherwise appropriate, put more of your portfolio into investments with the potential to generate capital gains and qualified dividends. But make sure the potential tax savings are worth the added risk. Watch Holding Periods. The 20%/15%/0% rates on capital gains apply to investments held for the long-term holding period (more than one year) and to inherited assets. (Gain on a subsequent sale of inherited assets is automatically considered long term.) Similarly, dividend income is taxed at the favorable rates only when shares have been held for a minimum period: generally, for more than 60 days during the 121-day period beginning 60 days before the stock s ex-dividend date. (Other requirements apply.) Qualified small business stock must be held for more than five years to be eligible for the gain exclusion. Keep these holding periods in mind when planning your investment transactions, but don t let tax considerations cloud your investment judgment. Consider Net Unrealized Appreciation (NUA) Rules. If your retirement benefits will consist in part of highly appreciated employer stock held in a qualified retirement plan, consider receiving a lump-sum distribution to take advantage of the tax law s NUA rules. Very generally, only the plan s basis in the employer stock (basically, its value at the time it was purchased) will be currently taxable to you as ordinary income. The difference between this basis and the stock s fair market value won t be subject to tax until you sell the stock. And then, your gain will be taxable at the applicable long-term capital gains rate. Otherwise, if you roll over the stock (say, to an IRA), the entire value will be taxed as ordinary income when the stock is liquidated and the proceeds are paid out of the rollover account. Give Appreciated Investments to a Charitable Remainder Trust (CRT). Consider this strategy if you own a highly appreciated investment (shares of stock, for example) and would like to diversify your holdings while deferring the tax impact. A CRT can provide you (or another noncharitable beneficiary) with a lifetime income stream. At the end of the trust term, the remaining trust assets pass to the qualified charity (or charities) you designated. The value of your charitable gift is tax deductible in the year you establish the CRT, subject to the usual tax law limits. Your trustee is free to sell the shares you donated and reinvest all the proceeds without incurring a capital gains tax liability (since the trust is tax exempt). If desired, you can arrange to replace the value of the trust assets that will eventually pass to the charity by purchasing a life insurance policy on your life and naming your children or other heirs as the policy beneficiaries. Alternative Minimum Tax What Has Changed: The new law provides alternative minimum tax (AMT) relief by permanently raising the AMT exemptions and indexing them for inflation. In the past, lawmakers have temporarily patched the AMT rules each year to limit the number of taxpayers it affects. The new law also permanently allows individual taxpayers to use nonrefundable personal credits to offset both regular tax and AMT. These changes were made retroactively effective for 2012 and later tax years. 6 7

AMT EXEMPTIONS Filing Status New Law* Prior Law Single $50,600 $33,750 Married Filing Jointly (and Surviving Spouse) $78,750 $45,000 Head of Household $50,600 $33,750 Married Filing Separately $39,375 $22,500 * To be indexed for inflation for tax years beginning after 2012. The AMT exemption amounts are phased out at higher levels of AMT income. The Impact: The increased AMT exemptions provide welcome relief to middle-income taxpayers. Nonetheless, the AMT will continue to be a headache for high earners. Taxpayers and their advisors should continue to plan transactions with an eye toward their potential AMT consequences. Incentive stock options, used by many companies to reward executives and other key employees, remain a potential AMT trap since their exercise generally results in gain that must be included in alternative minimum taxable income. Other items that can trigger AMT include: An unusually large deduction for state income taxes Tax-exempt interest from certain private activity bonds Interest on home equity debt not used to buy, build, or improve your home A higher-than-average number of dependency exemptions A large deduction for unreimbursed employee business expenses Strategies To Consider: Defer Expenses. If you expect an AMT liability for a particular tax year, consider deferring any late-year expenses that are not deductible for AMT purposes to the following year when the AMT may not apply to you. Accelerate Income. Although it may seem counterintuitive, accelerating taxable income into a year you will be subject to the AMT could be a tax saver if your regular marginal tax rate for that year will be higher than the 28% maximum AMT rate. Before accelerating income, however, be sure to consider the time value of money since you will have to pay taxes on the additional income sooner. Claim a Credit. If you pay the AMT, you may be entitled to a credit in future tax years that can offset your regular income-tax liability, in effect returning some of the AMT you paid to you. Check with your tax advisor for details about the credit. ESTATE AND GIFT TAXES Basic Exclusion Amount and Highest Rate What Has Changed: Instead of falling to $1 million in 2013 as previously scheduled, the cumulative amount exempted from estate and gift taxes technically referred to as the basic exclusion amount is permanently fixed at $5 million, indexed for inflation after 2011. With inflation indexing, the basic exclusion amount was $5.12 million for 2012, and it rises to $5.25 million for 2013. The exclusion amount is provided in the form of a unified credit against gift and estate taxes. The new law also brings a measure of certainty to federal estate- and gift-tax rates. After 2012, the top gift- and estate-tax rate is permanently increased from 35% to 40%. Under prior law, the top rate had been scheduled to increase after 2012 to its pre-egtrra level of 55%, with a 5% surtax on transfers over $10 million designed to phase out the benefits of the graduated unified tax rates. The Impact: The $5 million (indexed) basic exclusion amount and the 40% top rate are better than many observers expected. Many taxpayers can opt for simpler estate plans as a result. And, although there are still advocates for estate-tax repeal, the new law ends years of uncertainty concerning the direction of the federal transfer-tax system and provides taxpayers and their advisors with a more solid framework for planning. State estate taxes will continue to be a planning concern for some taxpayers, particularly residents of states that have lower exemptions than the federal exclusion amount. 8 9

ESTATE TAXES IN TRANSITION Highest Tax Rate 55% $5.5 mm 50% $4.5 mm 45% $3.5 mm 40% $2.5 mm Exclusion Amount up, your capital gain on the sale is just $25,000 ($75,000 sale proceeds less $50,000 basis). The $40,000 increase in the value of the shares during your Uncle Charles s lifetime is not subject to capital gains tax. Recipients of lifetime gifts generally assume a carryover basis in the property they receive (so your recipient s basis would be the same as yours). When the property is later sold, the calculation of capital gain for tax purposes typically would include appreciation that accrued during the time you owned the property. 35% 30% 2001 2003 2005 2007 2009 2011 2013 Year $1.5 mm $0.5 mm No estate tax applied in 2010 if an estate s executor elected to opt out of the estate tax in exchange for limited step-ups in income-tax basis on property passing to beneficiaries. Strategies To Consider: Capture Basis Step-up. A beneficiary s basis in inherited property is generally its fair market value on the date of death (or an alternate valuation date elected by the estate s executor, generally six months after the date of death). The ability to substitute a stepped up basis for the cost of appreciated property included in an estate can save income taxes for heirs because any increase in the property s value that occurred before the date of death won t be subject to capital gains tax upon a subsequent sale of the property. Example. Assume you own stock you inherited from your Uncle Charles that he originally bought for $10,000. At the time of his death, the shares were worth $50,000, and you recently sold them for $75,000. Your basis for purposes of calculating your capital gain on the sale is stepped up to the $50,000 estate value. Because of this step- Don t Hesitate To Plan. If you anticipate having an estate large enough to be subject to estate tax, a variety of effective strategies ranging from simple lifetime gifts to valuation discounts for closely held business interests and the use of tax-saving trusts remain available after the new law. Exclusion Portability Between Spouses What Has Changed: Prior law introduced a provision allowing estates of married individuals to make an election to transfer any exclusion amount not used by the estate to the decedent s surviving spouse. This deceased spousal unused exclusion (DSUE) amount can then be used in conjunction with the surviving spouse s own basic exclusion amount to protect future lifetime and death-time transfers from gift and estate taxes. This portability provision was effective for 2011 and 2012 only. However, the American Taxpayer Relief Act makes it permanent. The Impact: This development simplifies estate-tax planning for married couples. But it does not negate the need for planning, nor does it mean that traditional bypass trusts are no longer useful for planning purposes. For surviving spouses who wish to take advantage of the portability provision, it will be very important to follow all the tax law requirements for making a valid election. 10 11

Strategy To Consider: The assistance of a professional executor (or personal representative) can be very helpful in handling tax-related (and other) matters for an estate and settling the estate in a timely manner. Consider naming a professional as your estate s executor or as co-executor to serve with your spouse or other loved one. If you are a surviving spouse charged with settling your spouse s estate, enlisting professional help early in the process can help ensure you meet all requirements for the DSUE election. Generation-skipping Transfer Tax What Has Changed: Along with potential gift or estate taxes, a third type of transfer tax may be imposed on transfers to grandchildren and others more than a generation younger than the person making the transfer. The generation-skipping transfer (GST) tax applies only when cumulative transfers exceed an exemption amount. The GST tax is calculated at a flat rate equal to the top estatetax rate. The new law permanently sets the GST-tax exemption at $5 million, as indexed for inflation the same as the basic exclusion amount that applies for giftand estate-tax purposes. It also fixes the GST-tax rate at 40%, somewhat higher than the 35% rate for transfers made in 2011 and 2012 but far lower than the 55% rate that would have applied without the new law. The Impact: As it does with the estate tax, the new law limits the number of taxpayers for whom GST tax may be a concern. But where GST tax does apply, it still packs a powerful punch and can severely diminish family wealth. Keep in mind that GST tax is assessed at a flat rate (rather than graduated rates) and it applies in addition to gift and estate tax. Strategy To Consider: A dynasty trust is commonly used for GST-tax planning. This type of trust can allow wealth to pass from generation to generation while keeping transfer taxes in check. Your advisor can brief you on the details. RETIREMENT SAVINGS IRA Charitable Rollovers What Has Changed: Through the end of 2013, individuals age 70½ or older who want to contribute to eligible charitable organizations may opt to transfer money tax free from their IRAs, up to a total of $100,000 a year. This charitable rollover provision had expired after 2011. Special rules allow certain distributions taken in December 2012 to qualify if contributed to charities before February 1, 2013. Also, certain distributions directly transferred to charities in January 2013 may be treated as being made at the end of 2012. The Impact: The charitable rollover provision has proved popular with charitably minded IRA owners. Such contributions are not tax deductible, but the contributed IRA funds are not taxable. When compared to making a taxable withdrawal from an IRA and then contributing the withdrawn funds, the charitable rollover option may be more advantageous since charitable contribution deductions are subject to AGI limits and the newly reinstated limitation on itemized deductions. Strategy To Consider: If you own a traditional IRA from which you must take required minimum distributions (RMDs), you can avoid the related income-tax liability by making a qualified charitable rollover contribution at least equal to your RMD for the year (up to the $100,000 annual limit). Such contributions count toward your RMD, even though you are not taxed on the contributed funds. In-plan Roth Conversions What Has Changed: Under the new law, a 401(k), 403(b), or governmental 457 plan offering designated Roth accounts may permit participants to roll over money to an in-plan Roth account without meeting the usual rollover qualification requirements. Previously, participants had to be qualified to receive a plan distribution eligible for rollover to make an in-plan Roth transfer. As before, participants will have to pay income taxes on taxable amounts transferred from their traditional plan accounts to a designated Roth account. However, when their Roth 12 13

money is eventually distributed from the plan, no tax will be due if all applicable tax law requirements are met. The Impact: Roth accounts may hold the most appeal for younger participants who tend to be in lower tax brackets now and who have more time to benefit from the potential buildup of earnings that eventually can be distributed to them tax free. Despite the current tax hit, some older plan participants also may want to explore the possibility of transferring plan funds to a designated Roth account so they will have a potentially tax-free source of income after they retire. Still other individuals may be interested in a Roth account s potential estate planning benefits. But it s important to keep in mind that employer plans must make required minimum distributions from designated Roth accounts, while a Roth IRA is not subject to the lifetime RMD rules. So if leaving income-tax-free funds to beneficiaries is the objective, any funds accumulated in a designated Roth account eventually should be rolled over into a Roth IRA. Strategies To Consider: Spread Rollovers Over Multiple Years. If your employer s plan permits in-plan Roth rollovers and you want to take advantage of the opportunity, consider doing it incrementally over more than one tax year to avoid being pushed into a much higher tax bracket because of the additional income from the rollover. Generate an Offsetting Deduction. Making a deductible charitable contribution in the same tax year you complete an in-plan Roth rollover may help mitigate the tax impact of the rollover. OTHER PROVISIONS The American Taxpayer Relief Act contains several other changes that may affect your or your family s taxes. Here is a brief rundown. Qualified Conservation Contributions. More liberal deduction limits for charitable donations of qualifying interests in real property, including special rules for qualified conservation contributions by corporate farmers and ranchers, remain in place through 2013. State and Local Sales Tax Deduction. The election to deduct state and local general sales taxes as an itemized deduction in lieu of deducting state and local income taxes remains available through 2013. Credit for Energy-efficient Home Improvements. The credit for certain energy-efficient home improvement and equipment expenditures is extended through 2013. Education Incentives. Rules limiting the deduction for student loan interest after 2012 to the first 60 months of required interest payments and placing lower income limits on the deduction will not be reinstated as called for under prior law. The rules in effect for 2012 have been permanently extended. In addition: The annual limit on contributions to a Coverdell education savings account (ESA) remains $2,000 per beneficiary (instead of dropping to $500), and ESA funds may continue to be withdrawn tax free for qualified elementary and secondary school expenses, as well as for eligible higher education expenses. The American Opportunity Tax Credit and an above-theline deduction for qualified college tuition expenses are extended temporarily. The exclusion for up to $5,250 of employer-provided educational assistance is made permanent. Marriage Penalty Relief. Upward adjustments to the size of the two lowest individual income-tax brackets and the standard deduction applicable to married individuals filing jointly have been made permanent. Child Tax Credit. The maximum credit for each eligible child under age 17 was to have been reduced from $1,000 to $500 starting in 2013. The new law permanently retains the $1,000-per-child limit and makes the credit refundable for more households through 2017. Dependent Care Credit. The cap on the amount of workrelated child or dependent care expenses that can qualify for this tax credit ($3,000 for the care of one person; $6,000 for two or more) and the credit rate (a minimum of 20% of eligible expenses) remain at their current levels instead of being reduced after 2012 as prior law required. 14 15

Adoption Exclusion. The exclusion for employer-provided adoption assistance is made permanent. (Limits apply.) Business Provisions. Various tax breaks for businesses, including depreciation-related incentives and certain tax credits, are extended. CALL ON US The new tax law will have an impact on your investment, tax, and estate planning. It is important to sit down soon with your advisors to consider the planning steps you ll need to take. Our professionals are ready to help. Their knowledge and experience can be valuable assets when it comes to developing and implementing your planning strategies. We welcome the opportunity to assist you. This publication is an advertisement prepared by NPI for the use of the publication s provider. The provider and NPI are unrelated companies. The content is not written or produced by the provider. The general information in this publication is not intended to be nor should it be treated as tax, legal, or accounting advice. Additional issues could exist that would affect the tax treatment of a specific transaction and, therefore, taxpayers should seek advice from an independent tax advisor based on their particular circumstances before acting on any information presented. This information is not intended to be nor can it be used by any taxpayer for the purpose of avoiding tax penalties. Copyright 2013 by NPI FX2013-0115-1702/E HNW 01/13 16

2606 116 th Avenue N.E., Suite 200 Bellevue, Washington 98004 Tel 425-629-1990, Fax 425-629-1999 www.sweeneyconrad.com HNW