The higher tax rates passed by Congress this year have some top earners seeking last-minute strategies to lower their tax bite as year-end calculations turn up unpleasant surprises.
“There are many, many high-income taxpayers now who are finding themselves facing tax rates in excess of 50 percent,” said Suzanne Shier, a tax strategist and director of wealth planning at Chicago-based Northern Trust. “That really gets their attention.”
High earners are seeing a combination of federal tax increases for 2013: a top marginal rate of 39.6 percent, up from 35 percent; a 20 percent tax on long-term capital gains and dividends, up from 15 percent; and a new 3.8 percent tax on investment income. Also, limits on exemptions and deductions are taking effect.
Some top earners are only now realizing they may owe much more by April 15 because they’ve been paying quarterly estimated taxes based on their liability for 2012, which the Internal Revenue Service allows in a “safe-harbor” rule, said Elda Di Re, a partner at Ernst & Young.
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Others are absorbing the effects as they rush to implement strategies before Dec. 31 to limit the tax bite on earnings, market gains and stakes in businesses.
Investors with significant portfolios are seeing some of the biggest increases this year, said Martin Kalb, co-chairman of the global tax group at Greenberg Traurig.
For wealthy taxpayers, the rate on long-term capital gains and qualified dividends can be as much as 25 percent, including the new surtax and limits on deductions, Kalb said. That’s a 67 percent increase from 2012. The rate on other investment income such as royalties, interest and rents can exceed 43 percent.
“Clients are a little startled at the amount of additional taxes they are paying,” said Maury Cartine, a partner at Marcum whose clients include private equity and hedge fund managers.
Congress set the top tax rate for income above $450,000 for married couples or $400,000 for individuals, after deductions. Those are the same thresholds for the top levy on long-term capital gains and dividends.
Additionally, two new taxes to help finance the 2010 health-care law — a 3.8 percent surtax on investment income and 0.9 percent added levy on wages — apply to income of more than $250,000 a year for married couples and $200,000 for individuals.
Lawmakers also reinstated phaseouts of personal exemptions and itemized deductions for adjusted gross income exceeding $250,000 for individuals and $300,000 for married couples.
“It’s going to be a big surprise when they find out they aren’t going to be able to take all of their itemized deductions,” said Tracy Green, a vice president in tax and financial planning in the advisory unit of Wells Fargo.
With less than a month left in the tax year, advisers and accountants are focusing on clients with closely held business stakes, mutual-fund holdings, charitable donations and retirement accounts to help maneuver around higher rates.
To minimize the effect of the 3.8 percent tax, high earners are reviewing their interests in S corporations and other flow-through entities to see if they can become active rather than passive participants, said William Zatorski, a partner in PricewaterhouseCoopers’s private company services practice.
Business income from active participation isn’t subject to the surtax and that shift in S corporations doesn’t trigger self- employment tax, he said.
Some high earners may have to shift their usual year-end strategies because the new top rate means they are no longer subject to the alternative minimum tax, or AMT, said Di Re of Ernst & Young. Taxpayers not subject to the minimum tax can prepay state income or real-state taxes before Dec. 31 to lower their taxable income, Zatorski of PwC said.
Bumping up charitable donations is another strategy, Kalb of Greenberg Traurig said.
Taxpayers with gains in publicly traded stocks can donate them to a public charity or their own private foundation. They’d be eligible for a charitable deduction equal to the fair value of the security, and would avoid the long-term capital gains rates, he said.
Also, high earners can maximize contributions to tax-advantaged retirement plans and realize some losses to offset capital gains, said Green of Wells Fargo.
Another recommended strategy is to defer income by investing in private-placement life insurance and private annuities.
Beyond 2013, high-income investors can add tax-exempt bonds or convert some retirement savings to Roth accounts, Green said. When savers put money into Roth IRAs and Roth 401(k)s, they pay taxes on the money upfront in exchange for tax-free withdrawals later.