Recent legislation, coupled with the arrival of health-care-reform taxes, has pushed tax rates north for well-to-do clients. Those earning at least $200,000 a year, or $250,000 if married, could see a jump in their federal income tax rate of nearly 4 percentage points from last year. The rise could be two to three times as great for singles making more than $400,000 and joint filers earning $450,000.
Tax considerations should never solely dictate investment decisions, of course. But for high-income clients, tax-efficient investing is more important than ever. It’s now also more complex.
Mitchell Drossman, U.S. Trust’s national director of wealth planning strategies in New York, compares tax-aware advising today to “peeling back the layers of an onion. You peel one and there’s still more to come,” he says. “Asset allocation is a very good start, but it can be improved upon by understanding the taxes on investments, alternative investment choices and the accounts—taxable, tax-deferred and tax-free—that clients have available to them.”
The first step is ascertaining the client’s true marginal rate on various types of investment income, which is easier said than done in some cases.
As the accompanying table reveals, the American Taxpayer Relief Act, signed into law January 2, gave clients at the top end a 39.6% ordinary rate and paired it with a 20% tax on long-term capital gains and qualified dividends. Last year, these folks paid 35% on the ordinary income and 15% on the capital gains.
A quirk for single clients is that their 35% bracket is now a mere sliver. Less than $2,000 of taxable income separates the 33% and 39.6% brackets for singles. You’ll need careful income projections to get a good grip on the marginal rate of unmarried clients earning close to $400,000, says Mark Luscombe, the principal federal tax analyst at CCH, an information and software provider in Riverwoods, Ill.
The published brackets aren’t the whole story, however. The January 2 legislation reinstated phase-outs for personal exemptions and certain itemized deductions. As these breaks shrink, the effective marginal rate can jump significantly, Drossman says.
For example, the personal exemption phase-out increases the marginal rate by about 1% per personal exemption claimed when the client is mired in the phase-out range. In other words, a married couple with two children—a total of four dependents—pays approximately 4% more than the bracket rate while their exemptions are phasing out. For joint filers for 2013, the phase-out range starts at $300,000 of adjusted gross income and ends at $422,500. For singles, the phase-out range is $250,000 to $372,500. Above these figures, the effective marginal rate returns to the bracket rate, as long as there are no other stealth taxes.
But that’s not all.
Beyond the changes in the taxpayer relief act is the new 3.8% Medicare surtax on net investment income, courtesy of 2010’s health-care reform legislation. This will hit more clients than the other changes we’ve mentioned because it kicks in at a lower income threshold.
The 3.8% surtax is on the smaller of (1) net investment income, or (2) the amount by which modified adjusted gross income exceeds $250,000 for a married couple or $200,000 for a single person. As a practical matter, the “smaller of” math means that some of the client’s investment earnings may escape the surtax.
For example, suppose a married couple has $200,000 in salaries and $75,000 from a combination of interest, dividends and capital gains. This hypothetical couple would pay an additional 3.8% tax on $25,000: the $275,000 in income minus the $250,000 threshold for joint filers. This amount is less than the couple’s $75,000 of investment income.
“The 3.8% surtax is calculated completely separately from the regular income tax and from the alternative minimum tax,” says CPA Mike Robbins, a principal and director of tax at Rehmann, an accounting, consulting and wealth management firm in the Midwest and Florida. “Nor is the surtax on top of either the ordinary or capital gains rates in terms of how it’s applied. Advisors need to understand whether, and to what extent, the client is subject to this tax.”
Surtax Strategies For Investors
Because clients pay surtax on their net capital gain for the year—that is, after subtracting their capital losses, including those carried forward from previous years—aggressive tax-loss harvesting is essential for surtax clients, according to Drossman. “However, a net capital loss doesn’t offset interest income or dividends for the surtax like it does for regular tax purposes,” he says.
Income from a business that is a passive activity is included in net investment income and therefore subject to the surtax. One approach for avoiding it is for the client to satisfy the IRS’s material participation test, which can be accomplished in several ways. Perhaps the simplest way is for the client to work 500 hours in the business during the year. This must be documented with detailed time logs.
“We are talking to all of our clients about material participation,” Robbins says. “This is a big issue.”
Certain real estate investors may be able to sidestep the surtax by qualifying as real estate professionals. This requires 750 hours of work per year, among other things.
A strategy for both real estate investors and passive business owners involves using the IRS’s activity grouping rules. These can allow a client to move income out of the passive category and thus out of the surtax’s grasp. Under the rules, clients may be able to combine their activities and claim them together as active income, Robbins explains. Active income is typically not subject to the 3.8% surtax.
Proposed IRS regulations issued late last year allow clients a one-time regrouping of their activities in order to fold the new rules into their plans. Any regrouping applies for both surtax and regular tax purposes, so this strategy has a lot of moving parts to keep an eye on, and there are no off-the-shelf solutions. Each client’s unique circumstances demand a unique analysis, Robbins says.
Perhaps the most obvious solution to rising tax rates is municipal bonds. The income on these vehicles is free of both income tax and the 3.8% surtax. Munis can be examined once you’ve figured out a client’s true marginal rate and can accurately compute a bond’s taxable equivalent yield.
Roth accounts provide another venue for tax-free growth. The new tax law expanded the ability of 401(k) participants to convert their pretax accounts to Roths. Now workers can convert without leaving their employer or reaching age 59 and a half, among other things, as long as the sponsor amends the plan to permit these conversions. But the conversion, clients must remember, is a taxable event. It could expose more of their investment income to the 3.8% surtax. And the conversions cannot be recharacterized, Luscombe says.
Tax-deferred investing can be particularly helpful for clients who anticipate that their combined income and surtax rates will be lower in retirement. Workers can maximize their contributions. Business owners who put away the maximum in their defined contribution plans, which for 2013 is $51,000 ($56,500 for clients age 50 or older), can defer more income by adding a defined benefit plan, says consulting actuary James van Iwaarden, a principal at Van Iwaarden Associates in Minneapolis.
Tax-deferred annuities are being touted as a way for the high-bracket investor to defer investment income, and they certainly do that. However, when withdrawals are taken, a portion will be taxable and subject to the surtax if the client owes it at that time.
MLPs Are Gaining Popularity
For income-oriented clients seeking an investment with attractive fundamentals, publicly traded energy master limited partnerships (MLPs), with annual distribution rates currently in the 4% to 9% range, can provide tax-advantaged cash flow.
“Most of the income will be tax-deferred,” says Dave DeWitt, president of DeWitt Capital Management in Wayne, Pa. “On average, 85% of an energy MLP’s distribution might be a non-taxable return of capital, with only 15% subject to tax currently,” although the proportions can change over time, DeWitt adds.
The flip side is that return-of-capital distributions lower the client’s tax basis in the MLP, which increases the gain (or decreases the loss) whenever the MLP units are sold. The longer the client receives distributions from the MLP, the lower his basis in the MLP could fall, says Denver CPA Sarah Knight, managing partner at Knight Field Fabry LLP.
Although MLPs pay out cash, they typically report losses for tax purposes, which also reduces the client’s basis in the investment, Knight explains. In theory, the basis in the MLP units could fall to $0, which would render further distributions fully taxable to the client.
While many financial advisors take a dim view of MLPs because of these basis issues, DeWitt turns the lemons into lemonade. He sees MLPs as an ideal estate planning vehicle, because at the client’s death the heirs get a step-up in basis to current market value. They can therefore sell the MLP units for zero gain. “From an intergenerational standpoint, tax-deferred can become tax-free through step-up in cost basis,” DeWitt says.
But another turnoff for some advisors is that MLPs report their tax information to investors on the aggravating Schedule K-1, not the tidy Form 1099. “The K-1s are complicated for sure,” says Knight, whose clients have increasingly embraced MLPs in recent years. “Publicly traded partnerships have special rules that don’t apply to other passive partnership investments.”
Advisors willing to overlook these drawbacks should seek MLPs with a history of growth in their distributions and a promise of future increases, DeWitt says. He adds, “Also, make sure the partnership isn’t distributing out every last penny it receives so that there is a cushion for a rainy day.”
A warning: Some MLPs are thinly traded. Your transaction could move the market, DeWitt says. Tread lightly when necessary.
The sector’s positive fundamentals are examined in the story “Strong Outlook” in the October 2012 issue of Financial Advisor.
A final suggestion: Jettison investments that generate a lot of taxable income. Hedge funds engaged in short-term trading are one example.
If the client simply can’t bear to part with a tax-inefficient investment, perhaps it can be placed in a tax-efficient environment—put into a traditional retirement account or a Roth, Drossman suggests. But you have to watch out for anomalies such as unrelated business income, which can cause the IRA to owe tax and require it to file a return—if the investments are alternatives, for instance.