The election is over—now what? More than any other election in the past few decades, this one may have the most significant tax impact on high-income taxpayers, including physicians. Here, we will lay out the impending tax increases and some ideas on what you can do to alleviate their impact.
As most physicians know, the 2001 Bush tax cuts are set to expire on December 31, 2012. We have found that there is unease from many clients surrounding when Congress will act and what they will do. Republicans control the House, and Democrats control the Senate—Republicans seemingly refuse to endorse an extension of the Bush tax cuts that does not include all taxpayers. Meanwhile, Democrats—including the President—claim they will not extend the cuts for the wealthiest Americans. With congressional gridlock on the horizon, uncertainty could extend into the first quarter of 2013.
The election was one piece of the puzzle, but it is going to take putting together a few more pieces to get a clear picture of what 2013 will look like. What we do know is that there is still time to take advantage of the lower 2012 rates and mitigate the possible ramifications of the new 2013 tax laws, but you need act now. If you do nothing else, you should at minimum understand what your potential tax exposure may be if you do nothing and what options you have to reduce taxes in 2012 and beyond.
Impending tax increases
If Congress fails to reach an agreement in the next seven weeks, everyone will pay more taxes in 2013. The impending changes provide wholesale restructuring of income tax brackets—meaning higher tax brackets for just about every taxpayer. The rates for ordinary income will change from six income tax brackets, back to five:
2012 2013
35% 39.6%
33% 36%
28% 31%
25% 28%
15% 15%
10% 15%
Certainly, without a deal made shortly, all physicians will see a tax increase despite their income level remaining flat. There will also be an additional 3.8% Medicare surtax on specific types of net investment income stemming from the Affordable Care Act (ACA) for all single taxpayers with a modified adjusted gross income (MAGI) of $200,000 per year, or higher; and married taxpayers with a MAGI of $250,000 or higher. Net investment income affected includes interest, dividends, net capital gains, rents, royalties and passive income from a partnership or an S corporation. In addition, these high income taxpayers will pay an additional 0.9% tax on compensation income and self-employment income, bringing their total Medicare tax on these items to 3.8%. This can be a significant additional payment, beyond income tax rate increases, for most physicians, who will qualify for this new tax—as single individuals earning above $200,000 per year or married couples earning more than $250,000 per year.
Many other deductions and exemptions are also set to expire, including the following partial list:
- There is currently no alternative minimum tax (AMT) patch in effect for 2012
- Payroll tax relief expires on 12/31/12
- Phase-out’s of itemized deductions and personal exemptions will be reinstated for high-income individuals
- Marriage penalty relief will expire
- Child tax credit will decline from $1,000 to $500
What can you do?
- Accelerate income into 2012. In the past, it has generally been advantageous to defer income and accelerate deductions. However, in late 2012, high-income taxpayers should give consideration to doing the opposite and accelerating income into the current tax year. If you reside in the highest tax bracket, accelerating a year-end bonus from January 2013 into December 2012 may save you up to 5.5% in federal tax.
Now is also the time to realize large capital gains. Any decision to sell assets should be made based on the specific economics of the situation, but if you have assets you have been thinking about selling, the tax consequences will be much less severe in 2012 versus 2013. Cash basis taxpayers should also delay major expenses to 2013 in order to offset the impending tax increases. Finally, if you are considering selling your practice or another large asset, consider utilizing an installment sales contract to spread the income generated from the sale rather than recognizing all of it in 2013.
Capital gain harvesting can be utilized for investments that you are not yet ready to sell. Selling stock at a gain and recognizing the gain in 2012 then subsequently purchasing the same or similar stock at the higher price allows you to pay tax on the gain to date at the lower 2012 rates. It also increases your basis in the stock going forward in order to reduce future capital gains. Consult your investment advisor to determine if this makes sense for you and your investment portfolio.
- Figure out now what to do about investment income. The lower long-term capital gains tax rates are set to increase to 20%. Today, the top long-term capital gains tax rate is 15%, but it will increase by 5% after the Bush tax cuts expire—tack on an additional 1.2% after the itemized deduction tax break is reversed, and don’t forget the aforementioned ACA surtax of 3.8%; and long-term capital gains tax could reach 25% for some taxpayers.
The dividend tax rate is also slated to increase from the current 15% to the higher ordinary income tax rate of 39.6%. Add in the planned phase-out of deductions and exemptions, and the rate hits 40.8%. Then go ahead and again tack on the ACA 3.8% surtax, and the new dividend tax rate in 2013 will be 44.6%—nearly three times today's 15% rate! The ACA surtax will also apply to many forms of passive investment income such as interest income, rental property income, annuities, royalties and flow-thru income from activities without material participation.
What else should you consider?
- Fringe Benefit Plans or Roth IRAs Rather than Qualified Plans
Every time future income tax rates rise, the value of qualified plans (QPs) like 401ks, pensions, profit-sharing plans and SEP IRAs is reduced. That is because all of the funds in these plans will be hit by income taxes before you can access them. Of course, we have no idea what tax rates will be in place in 5, 10, 20 years–but it may turn out that our present tax environment had the LOWEST marginal rates in decades. We do certainly KNOW that 35% as a highest marginal rate is the 3rd lowest we have ever had since the income tax was implemented in 1914.
Given this, many savvy clients are looking to plans beyond QPs that are not subject to future income taxes, such as fringe benefit plans, non-qualified plans and even Roth IRAs. This might make sense for many physicians to consider.
- 529s and MUNIs: With the upcoming tax changes, 529 Plans will be an attractive saving option since they are not included in determining the taxpayer’s adjusted gross income as long as the funds are used for qualified higher education expenses. Also, municipal interest becomes more attractive since it does not increase MAGI—which is used in determining whether the surtax applies.
- Cash Value Life Insurance: If you have not done so in the past, now is a good time to review Cash Value Life (CVL) insurance options. CVL policies are geared more toward investment growth (that is not subject to taxation and surtaxes) rather than term life products that only consider the ultimate death benefit. CVL products are also a great way to truly diversify your investment portfolio since they provide indexing strategies that offset market losses during economic down periods. Further, CVL policies’ cash value grow tax free can be accessed tax free, if managed properly. Thus, they would not be subject to any of the tax increases described above.
Gift/Estate Tax Increases
In addition to the income tax issues above, estate and gift taxes are also scheduled to be more burdensome after December 31st, In fact, the current $5,120,000 gifting and estate tax exemptions will drop to $1,000,000. That is an over 80% reduction.
What should you do? If you are comfortable surrendering control of some of your wealth, you can make gifts exceeding $1,000,000 in value in 2012 to make use of all or part of the $5,120,000 temporary gifting allowance. Regardless of congressional action, it is unlikely the exemption will be as high as $5,120,000 in the near future. If you’re on the fence, you should also keep in mind that the estate tax rate, which is now 35%, is scheduled to increase to 55%.
If you are concerned about gifting away too much, you may consider having a spouse as a beneficiary of your trust. Under this plan, as long as the spouse is alive, you as the donor can derive indirect benefit of support by the spouse while the spouse derives support via the trust. You may also consider creating a trust in an asset protection jurisdiction. The IRS has ruled in at least one case that a donor can be a discretionary beneficiary and receive the benefit of trust assets if needed.
Summary
Regardless of what happens by the end of the year, the future will likely include increasing taxes for high-income taxpayers including physicians. If you want the same ability to build wealth in this environment, pro-active tax planning is more crucial than ever before. For a chart outlining how the ACA could further affect you, see our chart at http://www.ojmgroup.com/obamacare.pdf.
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Jason M. O’Dell, MS, CWM is a consultant, author of a number of books for doctors, including FOR DOCTORS ONLY: A Guide to Working Less & Building More, and principal of the financial consulting firm OJM Group (www.ojmgroup.com), where Carole C. Foos, CPA works as a tax consultant. They can be reached at 877-656-4362 or This email address is being protected from spambots. You need JavaScript enabled to view it..
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This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized legal or tax advice. There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circumstances. Tax law changes frequently, accordingly information presented herein is subject to change without notice. You should seek professional tax and legal advice before implementing any strategy discussed herein.
