By Robert S. Keebler, CPA, MST, AEP (Distinguished)
As we near the end of 2013, year-end tax planning again takes center stage. In the last two newsletters we covered two of the most important year-end planning strategies in detail—loss harvesting and Roth IRA conversions.
In this newsletter we summarize a number of other strategies that may produce substantial tax savings.
Making Trust Distributions
The tax brackets for trusts are much more compressed than the tax brackets for individuals. Trusts begin being taxed at the top rate of 39.6% when income rises above $11,950. By contrast, individuals filing joint returns don’t reach the 39.6% tax bracket until taxable income exceeds $400,000 and single filers don’t reach it until taxable income exceeds $450,000. Such income is also subject to the 3.8% net investment income tax (NIIT) if it is net investment income (e.g., interest, dividends, or non-business capital gains). Since most trust income would fall into this category, it would be taxed at 43.4% (39.6% + 3.8%) if retained by the trust.
This suggests that, if the governing instrument allows it, trustees should consider making discretionary distributions of income to beneficiaries at the end of 2013 to reduce tax rates, particularly if the income is NII. The trust will receive a DNI deduction and the income will be taxed to the beneficiary, often at a much lower tax rate.
Suppose, for example, that a trust had net investment income (NII) of $41,500. The last $30,000 would be taxed at 43.4%. If the income was distributed to a married beneficiary filing jointly with other income of $40,000, however, the tax rate would drop to 15% for ordinary income and 0% for long-term capital gains. Before making such distributions, however, trustees should make sure that the distribution provides an overall benefit, not just a reduction in taxes. Thus, the trustee should also consider estate planning goals, creditor problems, divorce problems, etc. before making a decision.
Harvesting Capital Gains
If a taxpayer has a lower long-term capital gain bracket in 2013 than he expects to have in later years and owns appreciated assets that he planned to sell in 2014 or a later year, it might make sense to make the sale in 2013 to take advantage of the lower tax rate. Assume, for example, that the taxpayer has an asset with a $100,000 long-term capital gain and would be in a 15% capital gain bracket this year but an 18.8% bracket in 2014. By selling at the end of 2013, the taxpayer saves $3,800. A word of caution is in order, however. Recognizing gain early introduces a trade-off between paying less tax and losing tax deferral. Before making the 2013 sale, the taxpayer should compare the tax savings with the opportunity cost of paying the tax early. Note that if the taxpayer is currently in the 0% long-term capital gain bracket, however, there is no opportunity cost. Taxpayers who expect to be in a lower tax bracket in the future might use the opposite strategy, deferring gain into 2014. (Also see Robert Keebler’s Capital Gains Harvesting Calculator)
Taxpayers may have a spike in income in 2013 that pushes them into a higher tax bracket than they expect to have in the future. Suppose, for example that a single taxpayer, who is ordinarily in the 35% tax bracket, recognized a large capital gain earlier in the year that pushed her 2013 income up to $435,000, $250,000 of which is NII. The last $35,000 of income is taxed in the 39.6% bracket. This income is also subject to the 3.8% NIIT (The NIIT applies to the lesser of (1) NII ($250,000) or (2) AGI – $200,000, or $235,000).
One way to reduce the tax would be to make a $35,000 contribution to charity. The charitable deduction would eliminate the income in the 39.6% tax bracket, but it wouldn’t help with the NII. Because the charitable deduction is taken below the line, the taxpayer would still have AGI of $435,000 and be subject to the NIIT on $235,000 of income.
Another possibility is an investment in oil and gas. Investors can deduct 100% of their share of intangible drilling costs (IDCs) and certain other expenses in the year they are incurred. These costs typically represent 65% to 80% of the taxpayer’s investment, producing a large deduction that can be used to offset AGI from wages, interest, business profits or capital gains. In the fact pattern outlined above, if the taxpayer invested $50,000 in an oil and gas venture, he might expect a deduction of approximately $35,000 that could be used to offset the last $35,000 of income and keep him out of the 39.6% bracket. The deduction would be taken on Schedule C and flow through to Form 1040 at line 12, reducing AGI and the amount subject to the NIIT. When the well started producing income in later years it would be taxed at the taxpayer’s usual rate of 35%.
Charitable Remainder Trusts for Large Sales
Taxpayers who plan to make large sales at the end of the year should consider creating a CRAT or CRUT to smooth income. The taxpayer transfers the appreciated asset to the CRT and the CRT sells it. Because the trust is a tax-exempt entity, no gain is recognized. Gain on the annuity or unitrust payments are subject to tax only as annual distributions are received by the donor, spreading the income out over a period of time. This prevents a spike in income in 2013 and may help the taxpayer to stay out of the higher tax brackets and reduce or eliminate exposure to the NIIT. The annuity or unitrust payments are received in later years when the taxpayer is in a lower tax bracket.
Avoiding Estimated Tax Penalties
Favorable stock market returns and higher tax brackets may have caused underpayments of estimated tax for many taxpayers. Penalties can be avoided on the shortfall by having employers increase withholding.
With the end of 2013 fast approaching, now is the time to find out if one or more of these strategies might help you save on your income tax this year.
RELATED PRODUCTS & EDUCATION:
- BRAND NEW: Robert Keebler’s Capital Gains Harvesting Calculator
- 2013 Year-End Tax Planning Chart
- Using Charitable Trusts to Avoid Capital Gains Taxes & the 3.8% Surtax
- The Top 10 Hottest Estate Planning Ideas for 2013 – – Updated and Expanded
ABOUT THE AUTHOR
Robert S. Keebler is a partner with Keebler & Associates, LLP. He has received the prestigious Accredited Estate Planners (Distinguished) award from the National Association of Estate Planning Counsels and has been named by CPA Magazine as one of the Top 100 Most Influential Practitioners in the United States. Mr. Keebler is the past Editor-in-Chief of CCH’s magazine, Journal of Retirement Planning, and a member of CCH’s Financial and Estate Planning Advisory Board. Mr. Keebler frequently represents clients before the National Office of the Internal Revenue Service (IRS) in the private letter ruling process and has received over 150 favorable private letter rulings. Mr. Keebler is nationally recognized as an expert in family wealth transfer and preservation planning, charitable giving, retirement distribution planning and estate administration and works collaboratively with other professionals on academic reviews and papers, as well as client matters. He can be reached at (920)593-1701 or at firstname.lastname@example.org.