Year-end tax considerations, 2013 edition

by James B. Gust, Esq., Senior Tax and Trust Editor

Merrill Anderson Co. Inc.

In contrast to recent years, when clouds of uncertain and various expiration dates hung over the tax code, this year taxpayers know what the rules are.  For those with higher incomes, taxes will be higher. Period.  Top tax rates are higher; itemized deductions are phased out for some taxpayers; new Medicare taxes apply.

            Even so, there are steps to consider, as we approach the end of the year, that could make a difference next April 15.

AMT

Upper-income taxpayers have to calculate their income tax liability, in two ways. The regular way has a top marginal rate in 2013 of 39.6% and lots of allowable deductions.  The Alternative Minimum Tax (AMT) has two brackets, 26% and 28%, and it provides for far fewer deductions.  Taxpayers pay the higher of the two tax figures.

            Just as taxpayers’ circumstances vary from year to year, so does their exposure to the AMT.  Their deductions and exemptions may trigger the AMT one year, but not in another.  This fact can lead to some counterintuitive tax strategies.

            If a tax review projects that you will be paying the AMT in 2013, but there is a chance you won’t in 2014, then you might want to accelerate ordinary income into 2013 to take advantage of the 28% top tax rate, instead of having that income taxed at 39.6% next year.  For example, if you own nonqualified stock options, they could be candidates for a 2013 exercise. However, take care not to exercise so many options that the AMT no longer applies.

            In this situation you also may want to defer actions that generate ordinary tax deductions until 2014, when the deductions will be worth more. For example, you might defer payment of state taxes into the new year or delay some charitable gifts.

            On the other hand, if you know that you will not pay the AMT this year, but you might in 2014, you would reverse these strategies.

Portfolio moves

Tax consequences shouldn’t drive portfolio management decisions, but they do need to be taken into account.  Tax efficiency matters.

            Capital gains and losses for the entire tax year are netted against each other, according to these rules:

            1. Short-term losses are netted against short-term gains.

            2. Long-term losses are netted against long-term gains.

            3. If one of these is a gain and the other is a loss, they are netted.

            4. Any resulting short-term gains are taxed as ordinary income. Any resulting long-term gains from securities sales are taxed at 15%.  At some income levels, the rate is boosted to 20%, and at still higher levels a 3.8% surtax applies, for a maximum capital gains tax rate of 23.8%.

            5. Up to $3,000 of net capital losses may be deducted from ordinary income.  Short-term losses are used up first, then long-term losses.

            6. Unused capital losses may be carried to future years until death.

            The conventional wisdom resulting from these rules is that long-term gains are better than short-term, because they have a lower tax rate. Short-term losses are better than long-term losses, because they shelter income at a higher tax rate.  However true this may be in general, it shouldn’t be applied to the next transaction until the full range of gains and losses for the year is understood.

            Example.  Wes needs to sell $100,000 of securities to raise cash.  He can choose lot A, which will generate a $20,000 long-term gain, or lot B, which brings with it a $20,000 short-term gain.

            In the absence of any other trading, Wes would prefer lot A, because the long-term gain brings less taxation. But if we add one fact the picture changes. Wes already has incurred $20,000 in capital losses this year, and they will offset his $20,000 gain fully. In that case he may prefer to realize the short-term gain, and save the long-term gain for another day.

            Wash sales. When harvesting capital losses, beware of the “wash sale” rule.  If you sell a stock at a loss and reacquire substantially identical securities within 30 days of the sale (either before or after the sale), the loss will be disallowed.  Instead, the loss will be added to your basis.  Note that the rule applies even if the loss is incurred in a taxable account and the securities are reacquired in your IRA (traditional or Roth).

            No one ever suggested that tax planning is easy.  If you find these ideas of interest see your tax advisors soon to learn more.

© 2013 M.A. Co.  All rights reserved.