Robert Harwood, President of Harwood Financial
With the ever-growing debt crisis and our government representatives’ inability to work together, there is a high probability that the Bush tax cuts will expire in 2013 and we will see a significant increase in our personal and business tax rates.
Don’t be caught unprepared. You have limited time to get your financial house in order and minimize the potential effects on you and your family.
Successful people will suffer the most, although we will see higher taxes for most middle-class and above families. The good news is that there are several tools available to help prepare you for the challenges ahead.
These tax changes will most likely occur regardless of who wins the next election, so I would not recommend taking a wait-and-see approach. If you wait for the election results, you will be hard pressed to complete your plan by the end of the year, and regardless of the winner, the issues will still remain: an enormous deficit, spending that is out of control, and a Congress that can’t seem to work together.
A Historical View of Taxes
We have enjoyed historically low tax rates since the Reagan years, but the trend is now reversing.
Note on the chart above[H1] that we have had an income tax rate of 70 percent or more for half of the last 50 year period. You can also see that we have had an average tax rate of about 60 percent over the same period.
Historically, we have two periods where our government amassed a significant deficit, not unlike the one we are dealing with today: the first following the great depression and the second after World War II. Although those deficits were very different in many ways, we can see that tax rates rose significantly to help deal with the debt.
Many people I know do not think tax rates will rise significantly. But think about this for a moment: if we have an above average deficit, isn’t it reasonable to assume that we will have above average tax rates to pay it down?
Isn’t it also prudent to assume that if, historically, the top tax rates averaged around 60 percent, that rates may top that amount sometime in the near future?
Some Changes You Need To Prepare For
Taxing your Investments – Starting in 2013, a 0.9 percent Medicare surtax will apply to wages in excess of $200,000 for single taxpayers, or over $250,000 for married couples.
In addition, for the first time ever, a Medicare tax will apply to investment income of high earners. The 3.8 percent levy will hit the lesser of either
(1) their unearned income (defined as interest, dividends, capital gains, annuities, royalties and rents)
(2) the amount by which their adjusted gross income exceeds the $200,000 or $250,000 threshold amounts.
The good news here for retirees is that tax-exempt interest will not be included, nor will income from retirement accounts. They are also proposing to raise the amount of income that can be taxed for FICA. FICA, the Federal Insurance Contributions Act (FICA) tax, is a payroll tax imposed by the federal government on both employees and employers to fund Social Security and Medicare.
We can also expect to see an increase in the tax rate on long-term capital gains from the sale of securities. The current maximum tax on long-term capital gains from the sale of securities is 15 percent. The 3.8 percent investment tax, combined with the expected expiration of the Bush tax cuts, would produce a 2013 top federal income tax rate of 23.8 percent. The top rate on interest, rents, royalties and certain “passive income” would rise to 43.4 percent from 35 percent.
Consequently, this may be a good time to do a little “tax-harvesting” by locking in today’s lower rates.
Taxes on the Sale of your Home – If you’ve heard rumors about paying a tax on the sale of your home, be advised that the rumors are true. The good news is that it does not apply to everyone, only high earners. The bad news for anyone that owns a home is that this tax will negatively affect house prices and further slow an already anemic real estate market. The proposed tax is 3.8 percent according to Section 1402 of the Health Care and Education Reconciliation Act of 2010 and pertains to both residential and investment homes.
Reducing Your Medical Write-Offs – Workers at all income levels could be squeezed by new limits on medical flexible spending accounts (FSA) and medical deductions. Additionally, in 2013 we can expect it to become more difficult to write off out-of-pocket medical costs on your 1040. Taxpayers under 65 will be able to deduct such costs only to the extent they exceed 10 percent of adjusted gross income, up from 7.5 percent now. Older taxpayers can still use the 7.5 percent threshold through 2016.
One percent Transaction Tax is Proposed on Your Bank Accounts – President Obama’s finance team is recommending a transaction tax on your checking and savings accounts. This is a 1 percent tax on all transactions at any financial institution e.g. banks, credit unions, etc. The tax is proposed to be levied on any deposit you make. This means that when you deposit your paycheck or your Social Security, a 1 percent tax will be charged. This effectively increases your income tax without calling it an income tax.
The proposed reversion of 33 percent marginal income tax rates – We are expecting a reversion of the 33 percent marginal income tax rate to its pre-Bush 39.6 percent and possibly higher. If you have nonqualified stock options that you can exercise, or have been considering a Roth IRA conversion, consider doing it this year.
Taxing Your Trusts – The 3.8 percent surtax will also apply to trust income in excess of $11,200 that isn’t distributed to beneficiaries. This even applies to special needs trusts.
Get Your Financial House In Order
How you hold your investments affects your taxes – All these changes make tax-efficient investing more crucial than ever before. Consider holding corporate bonds and Treasuries in your tax-deferred accounts and buy tax-exempt municipal bonds for taxable accounts. Keep individual stocks in taxable accounts so you can harvest losses and benefit from the lower capital gains rate when you sell. If you still have unrealized losses from the market crash, harvest them and bank them for future use against the higher gains rate.
Evaluate a Roth Roll-Out – A Roth Roll-Out is a systematic approach that we utilize to move or convert funds from your IRA accounts into a Roth IRA. The key with any conversion is to minimize your tax obligations and the Roth Roll-Out is designed to do just this. This year will provide what may be a final opportunity for you to convert funds at today’s historically low rates. The looming 3.8 percent Medicare surcharge makes Roth IRA conversions even more attractive for some upper-income earners. Conversions aren’t right for everyone, but they are worth exploring. The Roth Roll-Out program makes it easier for most people to take advantage of today’s lower tax rates.
I believe that our government does not have an income problem — they have a spending problem! They should be able to provide necessary services at our current tax rates but unfortunately persistently poor spending habits have created a pretty dire situation. The reality is that we have an enormous deficit and unfunded liabilities that currently exceed seventy trillion dollars ($70,000,000,000.00).
The government has three viable options on the table:
(1) to inflate the debt away
(2) to raise taxes and pay down some of this debt
(3) to reduce spending on high-ticket items such as our entitlement programs.
I believe the “solution” will be a combination of all three of these options and all three of these can have a profound effect on you and your financial future. Take advantage of a very short window of opportunity to get your financial house in order. Your financial advisors should be helping you with this process. If they are not, then seek help elsewhere.
Soon the window of opportunity will close. A little planning will go a long way when it comes to preserving and protecting the assets that you have worked so hard to create.
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If you would like to schedule a complimentary review of your portfolio to see if there is any room for improvement, please call Celine at our office at (727) 524-1427. We will schedule you in one of our four convenience locations around the Tampa Bay area.
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