Big changes ahead for how you save, invest, draw down
By Robert Powell, MarketWatch
Last Update: 7:03 AM ET Mar 5, 2013
The new tax lawthe American Tax Payer Relief Act of 2012is forcing retirees to take a closer look at their tax strategies in retirement and, for some, it means big changes in how they save, invest and draw down their resources.
First, there is a new top income tax bracket and a new top rate for capital gains and dividend income for individuals, estates and trusts.
Next, itemized deductions and personal exemptions are phased out for high-income taxpayers. (Theres a broader definition of who falls into that category than applies to the new tax rates.) And finally, everyone who earns wages or has self-employment income will contribute more to Social Security through their payroll taxes.
According to ATRA, theres a new 39.6% tax bracket for single taxpayers with taxable income over $400,000 and married taxpayers filing jointly with taxable income over $450,000. Plus, for taxpayers in the new 39.6% tax bracket, capital gains and qualified dividends might be taxed at 20%, up from 15% in 2012. Itemized deductions are phased out for single taxpayers with adjusted gross income of more than $250,000 and married couples with adjusted gross income of more than $300,000. And the deduction for personal exemptions was reduced or eliminated for certain high-income taxpayers.
Given the new top tax rates for capital gains, dividends and other income, what are the best strategies now for saving for retirement and drawing down assets in retirement? In this edition of Retirement Adviser, MarketWatchs Robert Powell spoke with three tax experts about retirement planning in the wake of the new tax law.
First, Frank Par, an instructor in the personal financial planning program at the University of California at Berkeley and the founder of PF Wealth Management, said most taxpayers can breathe a sigh of relief in the wake of ATRA. The vast majority of taxpayers, retired or not, will be largely unaffected by ATRA.
Most pre-retirees, for example, who are contributing to retirement accounts such as an IRA, 401(k) or a Roth IRA have little about which to worry. Their money is still going to be tax deferred, or tax free if the Roth conditions are met, he said. And so theyre not going to have to worry about the recent changes.
High-income taxpayers who are in or nearing retirement, however, ought to examine how the new tax law will affect their retirement-income plans. What will the tax changes mean for them in terms of their distributions, the amounts and so forth? Par asked.
In the wake of ATRA, high-income taxpayers have to consider whether distributions from their retirement accounts will put them into the highest income tax bracket. A taxpayer might think they are in a lower tax bracket, but the distribution from a retirement account could potentially put them in the highest bracket, he said.
For instance, if youre single and your income is around $380,000 by the end of the year, it might not be worth taking a distribution of more than $20,000 from your IRA if you can avoid it. Income over $400,000 will be taxed at the 39.6% rate rather than the 35% rate.
Now would be the time for retirees and would-be retirees to talk with their tax professionals and financial planners to see how all of these different moving parts are going to impact their distributions going forward, said Par.
And Mary Kay Foss, a director at Sweeney Kovar and an instructor for the CalCPA Education Foundation, added: Generally retirees are in the same tax bracket as when they were working, but now they have the risk of perhaps being in a higher tax bracket, she said.
Michael Jackson, a partner with Grant Thornton, and a leader of the firms private wealth services team, agreed that retirees and would-be retirees have to do what some describe as income-tax bracket planning, but they also have to worry about losing the value of some of their deductions.
A lot of retirees are going to have to do a lot more planning for what income they want to have at each given year, Jackson said. By managing their distributions the can avoid having their deduction be worth less or paying taxes at a higher rate, he said.
To be fair, Jackson said retirees and would-be need to coordinate their distributions so that they are tax efficient but not so much that youre letting the tax tail lead the dog.
Par also said most investors need not worry about paying the 20% tax on capital gains and dividends. But high income tax payers can use certain strategies and tactics to avoid being taxed at the highest rate. In some regards it depends on the asset that theyre holding, Par said.
Owners of real estate, for instance, might consider a 1031 Exchange or Like-kind property exchange in order to defer capital gains. And owners of stock might consider offsetting their capital gains with capital losses.
Taking some losses to offset the gains is always a very good idea, said Foss. (Some investors) tend to forget that they still have some (loss carry-overs) available to offset their gains. So, one good thing is to make sure that people are aware of what they have carrying over.
Taxpayers might also consider deferring their capital gains and/or creating tax-efficient portfolios.
I think looking at your overall investment portfolio and making sure you understand that the asset mix you have is whats key here, said Jackson. We havent had a major shift in the tax law like this for some time. So, people made decisions on asset allocation based on the tax rates that were in existence prior to 2013. Now, that we have higher tax rates the efficiency of the portfolio needs to be redetermined.
For instance, Jackson noted that with municipal bonds the tax-equivalent yield went up for someone whos in the highest tax bracket. So, with 3% yielding municipal bond where the tax equivalent yield was somewhere in the 4s is now well over 5%, he said. So, it may mean a little bit of a shift in how they structure portfolios in order to maximize return after taxes.
Personal exemption phaseout
Each personal exemption youre entitled to fully deduct (for yourself, your spouse, and your dependents) will reduce your taxable income by as much as $3,900. However, a tax law provision phasing out higher income taxpayers exemptions has been reinstated for 2013. The exemption phaseout starts once adjusted gross income (AGI) exceeds $250,000 (single), $300,000 (married filing jointly), $275,000 (head of household), and $150,000 (married filing separately).
For each $2,500 of AGI over the threshold, personal exemptions are reduced by 2%. So, if youre subject to it, the exemption phaseout can increase your effective tax rate.
On the front page of your tax return there are some deductions that are not affected by these limits, Foss said. In fact, they may be more beneficial given these limits.
Foss said she doesnt want to encourage divorce, but the alimony deduction is a good one. Other deductions that you can take on the front page of your tax return, according to Foss, include contributions to a retirement plan, medical insurance premiums for somebody whos self-employed especially now that the IRS has said that if somebody is working past retirement age they can use their Medicare as a self-employed medical deduction. Plus self-employed taxpayers can deduct part of their Social Security tax on the front page of the return.
So, these are some nice little deductions to be aware of, said Foss.
Par also noted that self-employed workers might consider restructuring the ownership of their company from an S corporation to a C corporation if their company is profitable. An S corporation is a pass-through entity that might be creating a lot of income. By simply going to a C corporation they have some control with respect to their personal income, Par said. And that could be a huge benefit with respect to income and deductions on the front page of a tax return.
However, the decision to conduct business as a C corporation, S corporation, limited liability corporation or partnership should be made in consultation with experts who understand the intentions of and the impact on each of the business owners, Jackson said. There are many instances where continuing to operate in pass though form makes a lot of sense, he said after the roundtable.
Itemized deduction limitation
Along with any deduction for personal exemptions youre entitled to, you may claim either itemized deductions or a standard deduction, whichever is larger. As you plan for 2013, however, consider whether you will be subject to the newly reinstated limitation on itemized deductions. Like the personal exemption phaseout, this limitation essentially increases the effective tax rates paid by affected individuals, the experts noted.
The limitation applies to taxpayers with AGI over a threshold amount: $250,000 (single), $300,000 (married filing jointly), $275,000 (head of household), or $150,000 (married filing separately). Basically, deductions are reduced by 3% of the amount by which AGI exceeds the threshold. However, deductions for medical expenses, investment interest, casualty and theft losses, and gambling losses are not subject to the limitation. And you cant lose more than 80% of the itemized deductions that are affected.
Its basically a stealth tax, said Jackson. Its another tax over and above the 39.6% tax bracket that some of taxpayers may hit along with other taxes (such as the Medicare surtax) that are going to be coming into play for 2013.
So, are there ways to avoid this or plan around it?
Again, the biggest thing is planning for your income levels because its not a deduction-based limitation, said Jackson. Its based on your income. So, the more income you have the more susceptible you will be to losing some of those itemized deductions. The best strategy might be to restructure how you get your income.
Par agreed. The real point here I think is given the changes that have taken place now is the best time to start talking to a tax professional, he said. Oftentimes individuals get into this sort of automatic, it is what were going to do. Its every year we do it this way and theres no real reason to change, but I think now, if ever, is perhaps the best time for them to engage someone to say OK, lets look at how we can shift this income or shift the way were doing our business in order to take advantage of some of these changes.
2013 Tax Rates & Brackets
||2013 Taxable Income
||2013 Taxable Income
||Married Joint Filers
||$0 to $8,925
||$0 to $17,850
||$8,925 to $36,250
||$17,850 to $72,500
||$36,250 to $87,850
||$72,500 to $146,400
||$87,850 to $183,250
||$146,400 to $223,050
||$183,250 to $398,350
||$223,050 to $398,350
||$398,350 to $400,000
||$398,350 to $450,000
||$400,000 and up
||$450,000 and up
Robert Powell is editor of Retirement Weekly, published by MarketWatch. . Follow his tweets at RJPIII.
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