In 2013, there is a new, harsher tax landscape for high-income taxpayers. The top rates on ordinary income, capital gains, and qualified dividends are higher than in 2012. There are new phase-outs for itemized deductions and personal exemptions that limit write-offs for these taxpayers. And there are additional Medicare taxes on earned income and net investment income. All of these changes combine to make tax planning more challenging than ever. One of the ways to sidestep some or all of these changes, at least temporarily, is to defer income. Here are some ways to do it.
Deferred compensation
Executives, top management, and other key personnel may be permitted to defer compensation (e.g., year-end bonuses) to a future year. As long as the deferral arrangement is a nonqualified deferred compensation (NQDC) plan that satisfies tax rules (Code Sec. 409A), the deferred compensation is not subject to income tax in the year in which it is earned; it is taxed when received. Usually this is not until retirement or some later event.
However, deferred compensation continues to be subject to Social Security and Medicare (FICA) taxes in the year it is earned. Usually, this proves advantageous because high earners likely have already received compensation in excess of the Social Security wage base ($113,700 in 2013), so there is no additional Social Security tax on the deferred compensation—in the year earned or in the year received.
All compensation is subject to the Medicare portion of FICA; there is no wage limit. For purposes of the additional 0.9% Medicare tax on earnings over a threshold amount, which starts in 2013, the deferred compensation is taken into account in the same way as the basic Medicare tax (IRS Q&As (#24) at www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Questions-and-Answers-for-the-Additional-Medicare-Taxrefer to Reg. §31.3121(v)(2)-1(a)(2)). This means that there will be no additional Medicare tax when the deferred compensation is received. Bottom line for deferred compensation under an NQDC plan: income tax is postponed; FICA and the additional Medicare tax (if applicable) is not.
Savings in qualified retirement plans
Savings in qualified retirement plans and IRAs produce automatic deferral of income. All of the earnings on these savings plans are not immediately taxable. Instead, taxes result only when distributions are taken from the account. At that time, all of the earnings are treated as ordinary income.
Distributions from these plans are not treated as investment income for purposes of the 3.8% additional Medicare tax on net investment income, called the NII tax (Code Sec. 1411 (c)(5)). More specifically, this tax applies to the lesser of net investment income or modified adjusted gross income (MAGI) over a threshold amount ($250,000 for married filing jointly; $200,000 for singles; and $125,000 for married filing separately). However, while the distributions are not treated as net investment income, they do count toward MAGI and can, therefore, produce or increase the NII tax.
Roth IRAs. Even better than tax-deferred income is tax-free income. This can be achieved with Roth IRAs, which are savings accounts for those with earned income (with some exceptions). Earnings on contributions become tax-free after the account has been open for five years. The five-year period starts on January 1 of the year to which the contributions relate. Thus, a 2012 Roth IRA contribution made on April 15, 2013, starts the five-year period on January 1, 2012.
However, income limits apply for making Roth IRA contributions. The limits for making a full contribution for 2013 are modified adjusted gross income (MAGI) of $178,000 for taxpayers filing a joint return and qualifying widow(er)s and MAGI of $112,000 for all other taxpayers other than those who are married filing separately (IR-2012-77, 10/18/12). Married persons filing a separate return with any MAGI cannot make a full contribution. The Roth IRA contribution limits for 2013 are $5,500 (plus an additional $1,000 for those 50 or older by the end of the year).
Conversions from traditional IRAs and qualified plans can be made to create tax-free income. There are no income limits on individuals making conversions. However, there is an immediate tax cost for the conversion: the income resulting from the conversion is taxable, so only future earnings on converted amounts become tax-free. Again, while the income is not investment income for the 3.8% additional Medicare tax, the income will increase modified adjusted gross income, which could impact the applicability of this tax. Weigh the current tax cost against the future tax benefit in deciding whether and to what extent to make a conversion.
Like-kind exchanges
Gain on the disposition of business or investment property can be deferred if “like kind” property is acquired within a set time period (Code Sec. 1031). Like-kind property is property of the same nature, character, or class; the quality or grade of the property does not matter. Most real estate will be like-kind to other real estate (e.g., a vacant lot for rental residential property), as long as the realty is located within the United States.
Gain is postponed because the basis of the replacement property is reduced by the amount of gain not recognized. The basis reduction means that the gain will ultimately be recognized on the future sale of the replacement property. The basis reduction has a negative impact: It limits the amount of depreciation that can be claimed on the replacement property.
The exchange can be simultaneous (e.g., a swap of properties of similar value) or it can be more complicated. A qualified intermediary or other exchange facilitator can be used to hold the proceeds from the original disposition. If the owner is directly paid on the disposition of his or her property, the opportunity for a like-exchange exchange is lost. If the owner receives cash in the course of making a like-kind exchange, gain is recognized to the extent of this cash.
Time limits. Potential replacement property must be identified in writing within 45 days of the disposition of the original property (called relinquished property). The exchange must be completed within 180 days of relinquishing the original property.
Tax-wise investments
In view of the new top tax rate on ordinary income of 39.6% on joint filers with taxable income over $450,000 ($425,000 for heads of households; $400,000 for singles; and $225,000 for married persons filing separately), the new 20% rate on capital gains and qualified dividends for those in the 39.6% bracket, and the 3.8% NII tax explained earlier, high-income taxpayers should review their portfolios to see which investments are still desirable. Investment classes that are particularly attractive in the new tax landscape include:
- Tax-exempt bonds. The interest on these bonds is tax free for federal income tax purposes (although the interest can affect the extent to which Social Security benefits are includible in gross income) (Code Sec. 103).
- Growth stocks. Annual appreciation is not taxed; the tax applies only when gain is actualized. Thus, income is deferred until a future sale. Even better, investors who plan to hold these investments indefinitely may never report gains. Instead, their heirs will receive a stepped-up basis to the value of the stock at the time of their death; all appreciation is permanently disregarded.
- Annuities. Commercial annuities allow the earnings on premiums to be deferred until distribution. When a policy is annuitized, only a portion of each payment represents gain. In other words, gain is spread over the period in which payments are received.
- U.S. savings bonds. Interest on Series EE and I bonds can be deferred until the bonds are redeemed or mature (there is a 30-year maturity date). Currently the rates are very low, so they may not be attractive investments. However, because of their absolute safety (backed by the full faith and credit of the United States), they may still have some place in an investment portfolio. There is an annual purchase limit on bonds of $10,000 ($5,000 if purchased with federal tax refunds).
Caution: Taxes are only one factor in investment planning and should not be the determining one to govern investment decisions.
Conclusion
No one knows for sure what the tax rules will be in the future. Depending on political winds and other factors, there could be major tax reform and more tax-friendly treatment for high-income individuals in the future. If things change for the better, deferral is a way to escape some or all of the new tax burdens for high-income clients. If nothing changes, then deferral has at least postponed the tax bill for these individuals.
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