Strategies for Minimizing Clients' Tax Exposure All Year Long

Posted by Rose Watson, JD, MSEL

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January 21, 2015 at 1:30 PM

strategies for minimizing clients' tax exposureAlthough your financial planning clients tend to focus on tax strategies as the year comes to a close, you know tax planning should be a yearlong process. The New Year is a good time for financial advisors to review the prior year's tax results and consider new strategies for minimizing clients' tax exposure.

This high-level overview offers strategies you should consider—especially in light of recent tax reform.

Net Investment Income and Medicare Contribution Taxes

Passed in 2013, the Patient Protection and Affordable Care Act added a 3.8-percent net investment income tax to taxpayers with qualifying income levels. The tax is applied to the lesser of net investment income or the excess of modified adjusted gross income (MAGI) over the applicable threshold: $200,000 for single filers, $250,000 for married taxpayers filing jointly, and $125,000 for married taxpayers filing separately.

For example:

Brian and Patty earned $175,000 in wages and $100,000 in investment income. The couple's total wages and investment earnings (MAGI) equal $275,000. According to the act, the 3.8-percent tax will be applied to the lesser of net investment income ($100,000) or the excess of MAGI over the applicable threshold ($275,000 – $250,000 = $25,000). In Brian and Patty's case, only $25,000 will be subject to the 3.8-percent tax.

Net investment income includes taxable interest, capital gains, dividends, nonqualified annuity distributions, royalties, and rental income. It also includes business income if the taxpayer is a passive participant, as well as rental income not earned by a real estate professional.

Be sure to examine the impact of this tax on the prior year's return and continue to monitor net investment income for future exposure each year.

The Medicare contribution tax, also brought into effect in 2013, increases the employee share of the Medicare tax by an additional 0.9 percent of covered wages in excess of $200,000 for single filers, $250,000 for married taxpayers filing jointly, and $125,000 for married taxpayers filing separately. The tax is also applied to self-employment income in excess of the same threshold amounts.

The Medicare tax adds one more factor to the review of your client's current withholdings or estimated payment amounts.

Pease Limitation Phase-Out

The American Taxpayer Relief Act restored the Pease limitation phase-out for itemized deductions. The threshold amounts are adjusted gross income of $250,000 for single taxpayers and $300,000 for married taxpayers filing jointly. Taxpayers' allowable itemized deductions will be reduced by 3 percent of the amount exceeding these thresholds, though the reduction will be capped at 80 percent.

The most common federal itemized deductions include:

  • Mortgage interest
  • State income tax and property tax
  • Charitable donations
  • Medical expenses (10-percent floor)
  • Miscellaneous itemized deductions (2-percent floor)
  • Unreimbursed business expenses
  • Home office deductions
  • Investment management fees

Individual Income and Capital Gain Tax Rates

In 2015, individual income tax rates remain at 10, 15, 25, 33, 35, and 39.6 percent, and the top rate for capital gains is 20 percent. Planning for each tax year should include looking for ways to avoid spikes in income and determining the best method to spread the recognition of income over future years.

One way to do this is to help your clients with a marginal tax rate analysis. A marginal tax rate analysis involves understanding the difference between your client's marginal tax rate and his or her effective tax rate. By knowing the rate at which your client's next dollar of income will be taxed, you may be able to identify a strategy that will prevent him or her from being pushed into a higher tax bracket unnecessarily. If a higher tax bracket seems likely, certain strategies, such as deferring income and accelerating deductions, may allow your client to lower his or her federal income tax burden.

The Alternative Minimum Tax (AMT)

Now "permanently" patched, the AMT remains a liability for many high-net-worth clients. Be sure to review your client's situation to determine if there's a benefit in shifting AMT-triggering items from an AMT year to a year in which the client is not expected to be subject to AMT liability.

Tax Loss Harvesting

This traditional tax planning strategy should always be an area you review. Carefully consider the value of tax loss harvesting strategies to offset current gains or to accumulate losses to offset future gains (which may potentially be taxed at a higher rate). Evaluate whether the investment qualifies for long- or short-term capital gain, and be sure to offset short-term gains with short-term losses and long-term gains with long-term losses.

Also keep the wash sale rule in mind, as this prohibits a tax-deductible loss on a security if the client repurchases the same or substantially identical assets within 30 days of the sale.

Estate and Gift Taxes

In 2015, the federal gift tax annual exclusion allows individual taxpayers to give up to $14,000 ($28,000 per married couple) to any individual gift tax-free. For taxpayers making noncharitable gifts, there is no limit to the number of individuals who can benefit from a gift under the annual exclusion. In addition, the federal estate tax exemption has increased to $5,430,000 in 2015.

State gift and estate tax laws may vary from the federal provisions and are playing a more important role in gift and estate tax planning for many taxpayers. Be sure that you understand how the state provisions may affect your clients' planning—and consult with a qualified tax advisor for guidance.

Charitable Giving from IRAs

In case you missed it, at the 11th hour Congress passed the Tax Increase Prevention Act of 2014, which extended taxpayers' ability to make qualified charitable distributions (QCDs) from IRAs through December 31, 2014. The QCD legislation has been extended several times since its introduction in 2006, so keep an eye out for future legislation that may provide a more permanent solution or simply continue to extend this legislation for 2015 and upcoming tax years.

Life Events

Changes in personal circumstances should be reviewed to determine the impact on your client's tax return. These may include:

  • Birth of a child
  • Change in marital or filing status
  • Change in dependent status
  • Support payments such as alimony or child support
  • Employment changes
  • Retirement
  • Bankruptcy
  • Inheritances
  • Changes to medical expenses

Always Be on the Lookout for Tax Reform

The November 2014 elections changed the makeup of Congress, and comprehensive tax reform may be on the horizon as a result. It's hard to say what may change, but the focus seems to be on modifying or repealing certain provisions of the Patient Protection and Affordable Care Act.

Regardless of what Congress eventually does, organization, awareness, and a proactive approach will always be key factors in finding strategies for minimizing clients' tax exposure. Encourage your clients to conduct an annual review of their personal and business taxes with you and their tax advisor to stay ahead of the game.

Do you have any other strategies for minimizing clients' tax exposure? Have you found the newer tax code to be challenging? Share your thoughts below!

This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.

Uncover Value-Added Planning Through Your Clients' Tax Returns 

Topics: Financial Planning

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