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Year-end tax planning important for upper income households

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A year ago, it was difficult for taxpayers to do last-minute tax planning because of uncertainty surrounding expiring tax breaks from the Bush era.

Lawmakers were at loggerheads on which, if any, deductions and credits to keep and whether to let tax rates rise.

This year, uncertainty isn't a problem. The American Taxpayer Relief Act, signed into law in January, has left taxes much the same for households with incomes less than $250,000. And for those with income above that, the tax landscape is clear, too: They will owe Uncle Sam more.

"High-income taxpayers have tax increases coming at them from multiple directions," said Tim Steffen, director of financial planning at Robert W. Baird in Milwaukee. "It's going to be some real sticker shock for them when they start looking at their tax returns a few months from now."

Congress raised tax rates on regular income and capital gains for the affluent. It also created a new tax for them on investment income as well as adding an extra Medicare tax on high wages. And the well-off will once more see their itemized deductions reduced as income goes up.

With Maryland having the nation's highest median income, these changes likely will affect residents here moreso than many in other states.

There still is one uncertainty, though, at this late stage about taxes — the start of the tax season. It had been scheduled for Jan. 21. But the government shutdown in October interrupted IRS preparations for the coming season, and the agency said the launch of the tax season will be no earlier than Jan. 28, but no later than Feb. 4.

For taxpayers, here are some changes to be aware of for the 2013 tax season, as well as some moves to consider that might reduce how much you owe:

The return of higher rates The lower tax rates on regular income introduced during the Bush administration remain intact. But the wealthy will see the return of the top tax rate of 39.6 percent, which had disappeared for years. This rate applies to taxable income above $400,000 for singles and $450,000 for married joint filers.

Most people don't fall into this category. But those who do might want to consider shifting more toward nontaxable income, such as tax-exempt bonds, said Mark Luscombe, principal analyst with CCH, an Illinois-based provider of tax information.

Or, if self-employed, taxpayers can try to get below those $400,000 and $450,000 limits by postponing income into next year, such as sending bills to customers early next year, Luscombe said.

Taxpayers in these income thresholds also will see the rate on long-term capital gains go up from 15 percent to 20 percent.

Those in the two bottom tax brackets — 10 and 15 percent — will continue not to be taxed on capital gains. Everyone else remains taxed at a rate of 15 percent.

Taxes to support health reform The well-to-do will be kicking in more under two new taxes that were part of the Affordable Care Act, better known as Obamacare.

Workers already pay 1.45 percent of wages for Medicare. But high-earners this year started paying an additional 0.9 percent on wages exceeding $200,000 for singles and $250,000 for joint filers.

Taxpayers at those income levels also will be subject to a new 3.8 percent tax on net investment income, which includes dividends, royalties, rents and capital gains.

This tax applies to whichever is less: the amount of net investment income or adjusted gross income over the $200,000 and $250,000 thresholds.

With this 3.8 percent tax plus regular capital gains tax, it's possible that some taxpayers will pay a rate of 18.8 percent or 23.8 percent on investment gains.

It gets complicated.

"At the end of the day, what's happened is it's become very difficult," said David Rosen, director of tax services at RS&F, an accounting and business consulting firm in Owings Mills. "Where I used to be able to go through a person's situation and figure out in my head what their next year tax will be, you can't do it without a computer these days."

Keep income low If possible, taxpayers should try to keep their income below the $200,000 or $250,000 threshold to lessen the tax impact of those taxes, Luscombe said.

For instance, they can contribute more pre-tax dollars to a retirement plan. Or, instead of converting an entire traditional IRA to a Roth IRA — in which the amount converted is considered income for tax purposes — taxpayers should convert smaller sums over a few years to keep below the threshold, Luscombe said.

Taxpayers age 701/2 and older with traditional IRAs can lower their adjusted gross income by making donations directly from the IRA to a charity, Luscombe said. They won't get a charitable deduction, but the distribution doesn't count as income on tax returns like regular required distributions older IRA owners must make annually.

And by lowering adjusted gross income, these taxpayers could avoid triggering the net income investment tax or find themselves eligible for other tax breaks with income limits, he said. This tax break, though, expires at the end of this year.

Harvesting losses If you sell securities, you can offset gains with losses on your tax return to minimize the capital gains tax bite. Given the new tax increases, this strategy of taking losses along with gains becomes even more attractive this year, Steffen said.

And when selling securities for a gain, Steffen added, high-income investors should look to jettison investments held for more than a year. Gains on investments held for less time will be taxed as regular income — or as much as 39.6 percent. Along with the 3.8 percent net investment income tax, wealthy investors could see gains taxed at a whopping rate of 43.4 percent.

Donate stock The typical tax advice is to make charitable donations before the end of the year to get a deduction. But with the stock market hitting new heights, consider donating appreciated shares. You can deduct the appreciated value of those shares without having to recognize the gain on your tax return.

Be aware, Steffen said, that if you sell shares held one year or less, the most you would be able to deduct is the cost basis — or the amount you paid for the shares.

Medical deductions In the past, you could deduct medical expenses that exceeded 7.5 percent of adjusted gross income. Now, that threshold is 10 percent for people under age 65.

If possible, plan elective medical procedures within the same year so you have a better chance of meeting that new limit, Luscombe said.

Health insurance The deadline to buy a health insurance policy on government exchanges has been extended to Dec. 23 for those who want coverage to start on Jan. 1.

Taxpayers without coverage next year will have to pay a penalty. The IRS has the ability to enforce it — offsetting the penalty against current or future refunds — but can't file a lien or levy to collect it, Luscombe said.

Expiration of tax cuts There are several tax breaks that are set to expire at the end of this year — although Congress in the past has extended them.

"If we ever get a serious proposal for serious tax reform," some of these tax breaks might go away in exchange for lower income tax rates, Luscombe said.

One of them, for instance, is the ability to deduct state and local sales taxes on the federal return instead of state and local income taxes, he said. Taxpayers who believe reform could happen next year should consider making major purchases, such as a car or boat, this year instead of next to get the sizable sales tax deduction, he said.

Luscombe, though, said Washington lawmakers are so polarized that it's doubtful they will reach a deal, especially in an election year.

Copyright © 2014, The Baltimore Sun
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