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Surviving the new tax environment

May 13, 2013

Washington policymakers voted to extend the Bush-era tax cuts for most Americans earlier this year. In this interview, Sarah Hammer, a senior investment analyst in Vanguard Investment Strategy Group, explains the changes that took place, including increased rates for higher income taxpayers, revisions to the estate and gift tax, limitations to personal exemptions and itemized deductions, and a new Medicare investment surtax. She also discusses how these changes could affect your investment decisions.

What are the major changes that investors should be aware of?

Sarah HammerThere were a lot of changes that took place earlier this year, both under the fiscal cliff deal and under a new tax known as the Medicare investment surtax. There was a new higher-income tax bracket created, and for those in that higher-income tax bracket, there were changes to taxation of capital gains and dividends. There are changes to the gift and estate tax regime, which were made permanent, and two provisions, known as PEP and Pease, were reinstated. And then on top of that, there's a new tax known as the Medicare investment surtax,* which is the product of the Patient Protection Act. And these are all things for investors to be aware of as we go forward.

So this new higher-income tax bracket sounds like it will be a significant increase for some investors. Can you explain that in a little more detail?

Yes. There is a new higher-income tax bracket created this year. The bracket is 39.6%, up from last year's highest bracket, which was 35%, and the new higher tax rate will apply to those with more than $400,000 for single taxpayers or $450,000 for those who are married and filing jointly. But it's also important to keep in mind that for all other taxpayers, their brackets will be unaffected. Nevertheless, for those in the higher-income area, this is a significant increase.

Investors in this new higher-income tax bracket will also face steeper taxes on capital gains and dividends, as well as the Medicare surtax. What does this mean for those investors?

The capital gains and dividends tax was also raised for those in the highest income tax bracket. So for those who are paying that 39.6%, they will also pay 20% on their long-term capital gains and dividends. And that's up from 15% last year, in 2012. But it's also important to keep in mind that even with the new higher-income tax bracket and the higher long-term capital gains and dividends rate, the differential between your income tax bracket and your capital gains and dividends rate actually remains the same. So what that means is, there continues to be an incentive to save and invest for the long haul. Short-term capital gains will continue to be taxed at ordinary income tax rates—so gains on those investments held less than one year.

And then on the Medicare surtax front, this is a new net investment income tax, which is a product of the Patient Protection Act, and that will apply for those with net investment income above the threshold levels of $200,000 or $250,000. So this tax applies to investment income, which includes interest, dividends, capital gains, for example. And one thing that's very important for investors to realize is that municipal bond interest is not included in the Medicare investment surtax, so, again, the incentives to hold municipal bonds in your portfolio remain.

There are also changes to the estate and gift tax provisions. Unlike some of these other changes, this seems to be mostly good news for investors. Can you tell us a little bit more about these?

That's right. There was a little bit of good news in the changes that took place in January. The gift and estate tax regime applies to significant gifts that individuals or married couples might make to others. And there's what's known as an "exemption," which means you can make a fairly significant gift to your heirs and that amount will be exempt from the gift and estate tax. So the exemption amount was made permanent for 2013. It's $5.25 million, and that amount is inflation-indexed, so it should go up every year. And this is great news, because if the gift and estate tax regime sunset had been allowed to take place, that amount would have gone down to $1 million. And then any amount gifted above that $5.25 million will be subject to the estate tax, which has gone up to 40% from 35%. But, again, even that increase is relatively good news, because, if the sunset had been allowed to take place, the rate would've gone up to 55%.

And then some other, very useful provisions were maintained; so spousal portability is one. Portability means that one spouse can use the exemption of the other spouse upon their death, if it hasn't been used. So together, a married couple can gift up to $10.5 million for 2013.

And then some other good news is that unification remains, which means a gift can be made during life as well as at death. So if you make a gift during life, you actually enjoy the income tax benefits, as well as the estate tax benefits. So it's important for advisors to talk to their clients about what the opportunities might be there in terms of estate planning.

You mentioned earlier that the PEP and Pease provisions had been reinstated. Can you explain the difference between these two?

Yes. PEP stands for personal exemption phaseout. Now taxpayers may be eligible for an exemption amount on their taxes, but what the PEP provision does is, it will reduce the exemptions for taxpayers by 2% for each $2,500 that their income is above a certain threshold. And that threshold is $250,000 for single taxpayers and $300,000 for those who are married, filing jointly. And then the Pease provision is a limitation on your itemized deductions. So what the Pease limitation does is, it will reduce itemized deductions by 3% of the amount that adjusted gross income exceeds those threshold amounts.

Some philanthropic investors have expressed concern that the revival of the Pease limitation** could restrict their charitable deductions. Is this a legitimate concern?

The Pease provision can be very confusing. And some of the confusion arises because what Pease does is, it limits your itemized deductions, but the amount of the limit is actually based on adjusted gross income. So what does that mean? Well, that means that if you are a taxpayer that, for example, had state and local taxes or real estate taxes or you have a mortgage interest deduction, then the amount of your Pease limitation may actually already be satisfied by your existing itemized deductions. So if you are charitably inclined and you want to make that charitable gift at the end of the year, then your gift may still be fully deductible because your Pease limitation is satisfied by those other deductions that we mentioned.

We talked about a lot of changes. At the end of the day, should these recent changes affect the way clients invest?

You know, it's a great question, and it's one that a lot of people are thinking about in a rising-tax environment. We are empathetic for our clients who are affected by all of these changes. But it's important to keep in mind that our thinking on the way to tax-optimize has not changed. And, in fact, in the current environment, it's even more important.

So, for example, consider index funds and ETFs [exchange-traded funds]. They have a very high propensity for tax efficiency. Think about your asset location, placing your taxable investments in your tax-deferred accounts and your tax-efficient investments in your taxable accounts. Take advantage of tax diversification. You might want to have both a traditional and a Roth IRA, and that gives flexibility when it comes time to make withdrawals.

And utilize smart tax-loss harvesting. So if you are rebalancing a portfolio, you might want to use a tax-advantaged account to do that.

*The Medicare surtax will affect taxpayers whose income exceeds $200,000 (single)/$250,000 (married filing jointly)/$125,000 (married filing separately). It is levied on whichever is less, (a) modified adjusted gross income above the threshold, or (b) net investment income.

**Generally, the Pease limitation cannot reduce a taxpayer's total deductions by more than 80%. It does not apply to deductions for medical expenses, investment interest, casualty and theft losses, and gambling losses.


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  • We recommend that you consult a tax or financial advisor about your individual situation.
  • Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
  • Diversification does not ensure a profit or protect against a loss.
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