Over the next few months, millions of Americans will turn their attention to the annual ritual of income tax preparation—scouring for every opportunity to lower their tax bill. What's often overlooked amid the frenzy is the importance of thinking beyond the here-and-now to the value of long-term tax planning strategies. So this year, ask yourself: What are my goals for the short term? What are my goals for retirement? Is it important to leave a legacy to my children or to a charity? Then, take a look at how tax planning can be used to support those goals.
Of course, you'll need to begin with a clear understanding of the current income tax landscape. Each year brings new tax laws to consider, and 2013 was no exception. On January 2, 2013, the president signed into the law the American Taxpayer Relief Act (ATRA) of 2012. That law, and others, resulted in a number of changes that have the potential to significantly impact your tax liability. What follows are some of the major provisions new for 2013.
- Alternative Minimum Tax Changes
The majority of middle-income Americans now no longer have to worry about being hit with the Alternative Minimum Tax (AMT). AMT is an alternative to the traditional income tax and was designed to keep wealthy taxpayers from taking excessive advantage of deductions, credits, and exemptions to reduce their tax liability. But because it wasn't automatically updated for inflation, more middle-class taxpayers were in danger of getting hit with it every year, and Congress would respond with a temporary “patch.” In January of 2013, the AMT was permanently indexed for inflation, which means fewer middle-income taxpayers will be subject to the tax.
- New 3.8 Percent Net Investment Income Tax
Also referred to as the Medicare surtax, the Net Investment Income Tax is a new, additional tax on interest, dividends, royalties, annuities, and gains from the sale of certain property. The new tax generally applies to individuals whose income exceeds certain thresholds: $200,000 for an individual filer and $250,000 for those married and filing jointly. It also can apply to estates and trusts with income over a mere $11,950.
- Higher Unreimbursed Medical Expense Threshold
For taxpayers under the age of 65, the new Affordable Care Act makes it more difficult to deduct unreimbursed medical expenses on federal taxes. Prior to the Act, unreimbursed medical expenses could be deducted after they exceed 7.5 percent of adjusted gross income. The threshold is now 10 percent.
- Gift Tax Exemptions Raised
It's now easier to transfer wealth to children. Before a new law was passed in early 2013, the federal gift and estate tax exemption was scheduled to be $1 million in 2013, which meant that if you gave away more than $1 million dollars—or died with more than that—the excess would be subject to a gift or estate tax rate of up to 55 percent. But now, these federal exemptions have been increased and are inflation indexed, so in 2013 they are $5.25 million ($10.5 million per married couple).
- New Income Tax Bracket
Prior to 2013, the highest income tax bracket for ordinary income had been 35 percent. That bracket still exists but has a much smaller range. What's new in 2013 is a higher 39.6 percent tax bracket for taxable income above $400,000 if filing as single, or $450,000 if married filing jointly. In addition, for taxpayers in that highest bracket, the tax on long term capital gains has increased from 15 percent to 20 percent.
While it's obviously important to understand and consider the impact of annual changes in tax laws, it's equally important to think about tax planning as a tool that can help you get the most amount of money in your pocket and to your loved ones over your lifetime. By taking a longer-term view, you may find, for example, that it's not in your best interest to lower your tax burden each year. You may be better served by paying some taxes now rather than in the future. Here are a few examples:
- Education Funding
The 529 plans are designed to make it easier to save for college and other post-secondary training for a designated beneficiary, such as a child or grandchild. While contributions made to 529 education plans are not deductible for federal taxes, there are some states that do offer a small deduction for your state income tax. The biggest advantage for 529 plans is that they grow tax deferred, and distributions are tax free if used to pay for higher education.
- Retirement Accounts
Roth IRAs are savings vehicles that will not reduce your tax liability today but can have long-term tax advantages in retirement.
With a Roth IRA, you may contribute up to $5,500 each year (or $6,500 if you're over the age of 50). And although you contribute after-tax dollars, the investment grows tax free, and the withdrawals—after the age of 59.5—are generally free from income tax. There are, however, income level restrictions. Generally, you may not contribute to a Roth IRA for 2013 once your income exceeds $127,000 as an individual and $188,000 if you're married filing jointly, which leaves many Americans under the mistaken impression they can't take advantage of this powerful retirement planning tool. The fact is, regardless of how wealthy you are, you can convert a traditional IRA to a Roth IRA. You'll have to pay income tax on the amounts you convert—which may sting a little in the short term—but because qualified withdrawals are tax free, it might be worth it in the long run.
- Life Insurance
One other strategy that offers long-term tax benefits is the purchase of permanent life insurance. Premium payments are not tax deductible, but as long as your premiums are paid, your beneficiaries will generally receive the proceeds free from federal income tax. That makes life insurance a great tool to provide—at some point in the future—tax-free benefits to the people you care about the most.
Your hopes and dreams for the future are unique, and your financial plan should be designed to help you achieve them. This year, make sure tax planning is part of your strategy. You may be able to lower your short-term tax liability if that's a goal. But more importantly, effective tax planning can help you accomplish longer-term goals and live the life you envision today and into the future.
To hear more about tax planning strategies, watch our webcast, 2013 Tax Planning: Strategies That Can Save You Money.