By this time, most taxpayers have filed their 2013 tax return. While it may seem to be a perfect time to relax and enjoy the summer, tax planning has become more critical than ever. There are several significant changes that may adversely affect many taxpayers. Given the far reaching impact these changes may have on your taxes, it would be wise to analyze your current tax situation now while viable strategies remain open.

There are three major changes in income tax rates that begin in 2014. The most significant increase is the 3.8% surtax that applies to net investment income for single taxpayers with a modified adjusted gross income (MAGI) of $200,000 or $250,000 for married taxpayers.

The second change involves the tax rates for long term capital gains and dividends. This tax rate is 15% for single taxpayers who earn up to $ 406,750 of taxable income and $ 457,600 for married taxpayers. Dividends and capital gains that catapult taxpayers over these income thresholds is taxed at 20%.

Finally, the Medicare payroll tax has been increased .9%, from 1.45% to 2.35% for earned income greater than $ 200,000 and $ 250,000 for single and married taxpayers respectively.

Any approach that can alleviate these higher taxes may involve a synergy to simultaneously reduce income and add tax advantaged investments to a portfolio. Of course, every taxpayer’s situation is unique and an in-depth analysis of available tools is required to develop the optimal solution.

Strategies that can reduce income and, possibly, prevent taxpayers from exceeding these income thresholds include the following: becoming more active in a business activity to “convert” income from passive to active and avoid the 3.8% surtax on investment income, deferring gains on the sale of an asset through an installment sale or implementing a tax free Section 1031 exchange for like kind property used most often in real estate transactions, maximizing retirement plan contributions to reduce MAGI, and gifting appreciated assets rather than cash to charities in order to reduce MAGI by deducting a charitable contribution and avoiding capital gains on the sale of the asset.

There are several tax preferred investments where gains from these assets may avoid the surtax, partially shelter or defer income from taxes, minimize realized capital gains, and create tax deductions. Interest from tax exempt municipal bonds is not subject to the surtax. As a result, their tax equivalent yield becomes even more attractive to high tax bracket investors who are subject to the surtax. The cash value in life insurance and annuities accrues tax deferred and does not exacerbate current income taxes while providing a mechanism to control future tax liability. Direct real estate investments provide income tax benefits through the deductibility of depreciation. Oil and gas drilling partnerships generate income that may not be subject to the surtax as well as being partially tax sheltered by the oil depletion allowance. Additionally, these investments provide a tax write off derived from deductible Intangible Drilling Costs (IDC). Potential investors need to carefully consider the suitability of real estate and oil and gas for their portfolios due to the inherent risks that include leverage, adverse market forces, regulatory changes and the lack of liquidity. Finally, direct investments in growth stocks or mutual funds, whose primary objective is to manage and avoid capital gains, may represent an attractive means of controlling long term capital gains since gains are not realized until the securities are sold.

This new era of higher taxes requires a more pro-active approach to income tax planning. And with the dual function of managing both income and investments to minimize these new taxes, the role of a well versed and seasoned financial planner in coordinating these activities is more imperative than ever.


Clifford L. Caplan, CFP®, AIF®

Commonwealth Financial Network® does not provide tax advice. You should consult a tax professional regarding your individual situation.

Municipal bonds are federally tax-free but may be subject to state and local taxes, and interest income may be subject to federal alternative minimum tax (AMT).