More On Tax Planningfrom The Advisor's Professional Library
- IRAs: In General Individual Retirement Accounts are highly popular tools for contributing funds that grow on a tax deferred basis. Depending on the type of IRA, the accumulation can be tax free.
- Health Insurance: Health and Medical Savings Accounts A Health Savings Account is a trust created exclusively for the purpose of paying qualified medical expenses of an account beneficiary. Although they are popular, they are not without their pitfalls and the regulations can be complicated. Learn more about how to avoid federal taxation on the accumulation and distributions of HSA.
When the Supreme Court ruled last June that same-sex couples vowing “I do” would have their unions recognized by the federal government, jubilant partners may have been unaware: Tying the knot also means saying “I do” to paying steeper income tax bills.
Complicating an already-complex scenario, in which most states don’t recognize same-sex marriage, are changes — chiefly increases — to the massive U.S. tax code effective with 2013 returns.
For last year, the federal tax rate was raised by 4.6% to 39.6% on ordinary income above $400,000 ($450,000 for couples filing jointly). Investments-wise, rates on long-term capital gains and qualified dividend rates went up to 20% from 15%. And there are also new taxes related to the Affordable Care Act: a 0.9% Medicare surtax and a 3.8% tax on net investment income (both starting at the $200,000 income threshold; the 0.9% tax is applicable to neither estates nor trusts).
Janis Cowhey McDonagh, a partner at Marcum LLC and co-leader of its LGBT and Non-Traditional Family Practice Group, talked with ThinkAdvisor about the tax situation for wedded same-sex couples and filers in general. Here are highlights of that chat with the New York City-based accountant and attorney:
What’s the main difference about 2013 income tax that filers will discover?
All of a sudden, people are getting hit with a higher tax bill. Therefore, they need to have a conversation with their accountant and financial advisor to discuss priorities. Planning is always important; but this year, with so many new taxes, it’s more important than ever.
Will affluent taxpayers have a rude awakening when they get their tax bills?
Many will. A lot of people heard that taxes were going up, but now they’re finding out how much they have to make the check out for. Everybody is going to call their financial planners about their portfolios and tax bill. That’s why advisors need to work with accountants when creating a financial plan and ask: “Here’s what I’m recommending the client invest in. What do these investments mean in terms of taxes?”
Do the changes in the tax code provide opportunities for advisors to rebalance portfolios?
Yes. We have the new 3.8% Medicare tax on investment income. If clients change their investments, they may be able to bring down their tax bill. You could get out of some current taxes if you invest in, say, long-term growth. Eventually you’ll have to pay capital gains tax, but for now, you can get out of the Medicare tax. This makes it even more important than ever that the accountant and advisor are on the same page.
What can be done to reduce 2013 tax bills?
It’s too late. Last year is done, other than maybe opening an IRA. We’re in the reporting phase now, not the planning phase anymore. But there should be a meeting with clients to understand how the higher taxes impacted them in 2013, how they will affect them in 2014 and whether they want to change their investment portfolio. If you wait till December 2014, it’s too late.
How would you characterize the tax increases married same-sex couples will encounter?
Dramatic. They’re going from filing single to filing married; so they’re getting hit with a bigger bill. They don’t have a choice now: If you’re legally married, you absolutely have to file a married tax return at the federal level – either joint or separate. They’ve lost a couple of opportunities. Most will file jointly. Separate never really helps; generally, it only hurts you.
The IRS says that same-sex married couples can get retroactive refunds on federal taxes paid in prior years. How does that play out?
Previously, if you were LGBT and married, you were unable to file jointly. But now you have the ability to amend your tax returns up to three years back provided you’re married. It’s not a requirement, though. And you can pick and choose years. You have to see what works best. With a couple I saw last week, one of the years worked out to be a refund; the next year would cost them money in taxes. You need to run the numbers to make those decisions.
What’s the so-called marriage penalty?
Two high-wage earners paid a lot less in taxes when they filed as single than they will when filing as married. One same-sex married couple who came in last week told me, “We’re getting divorced!”
They were kidding, right?
No. I truly believed them. The marriage meant nothing to them other than as a political statement. It was something they fought for and now have the ability to do — but they didn’t necessarily have to do it personally. But another couple said, “Well, this is the price we’re paying: We wanted equality across the board.” So there’s good and bad that comes with that.
What are some specific changes to the tax code that impact married same-sex couples?
For all taxpayers, many deductions now have limitations on them. For example, medical expenses are going to be harder to deduct because they have to exceed 10% a year of adjusted gross income vs. 7 1/2% previously. Married LGBT couples are now combining their income. So when you combine two adjusted gross incomes, the total is a higher number to get past.
Suppose a married couple doesn’t mingle their assets. How does that affect income taxes?
They could keep their bank accounts completely separate and choose to file married-separate, but it probably would hurt them tax-wise. For instance, one person is a stay-at-home parent who inherited the house they live in, and the other partner makes the money and pays the real estate taxes and mortgage interest. Now — unlike before they married — they can deduct those expenses on a joint return. If unmarried you have to own the property and pay the bill to deduct it. So they completely lost the real estate deduction of mortgage interest before getting married. When you’re married, it doesn’t matter how things are titled.
If one party earns much more than the other, how does that reflect on their tax bill?
If one makes a good deal of money and the other is, say, a stay-at-home parent not making a salary, they will pay less under married rates.
How does having a child before or after marriage affect income taxes?
There was no change to the tax code about children as dependents. Whether same-sex or heterosexual, if you’re married, children are taken as dependents on your return. If you’re not married, you have to decide which party is entitled to take the deduction based on whose child it is. You’ve got to provide more than half of someone’s support to [claim] them as a dependent.
What other financial ramifications can same-sex married couples expect?
When you marry, there’s a whole different set of rules. There are downsides to getting married. For example, if one spouse goes into a nursing home, the other is required to support them. If you’re unrelated, you’re not. The rule is you can’t throw your spouse out on the street. Each state is different in how they enforce that rule, but there’s always a version of support for a spouse.
What’s the story about Social Security for same-sex unions?
In order for one spouse to get the other’s Social Security benefits [upon death], the [Social Security Administration] looks to whether the marriage is recognized in the state they reside. That’s the first step you have to get past.
What are the complexities involving state tax returns for LGBT married couples?
Before, the federal government didn’t recognize their marriage, but certain states would. So, for example, in New York, my married couples filed federal single returns but were required to file married returns in New York City. Now, if you live in New York, you need to file married at the federal level and at the state level.
What if you live in a state that doesn’t recognize same-sex marriage?
If you reside, for example, in Pennsylvania, you’re required to file a married tax return at the federal level but file single at the state level. You may be paying more, or you may be paying less. But you will be paying more to your accountant to prepare your returns! It’s very complicated.
There’s obviously much more work involved.
Yes. You need to have an advisor who’s well versed in the rules because it’s 50 states with 50 different rules. There are even a couple of states that don’t recognize same-sex marriages but at the same time, will allow you to file a joint return.
What can be done to reduce 2014 investment taxes for filers in general? Is it smart to domicile investments according to tax deferred, taxable and tax-free?
Many people will consider that. It all goes back to having a lot more opportunities for the final advisor and accountant to sit down with the client. You have to work with the numbers. I have certain clients who believe in investing everything in tax-free municipal bonds. They don’t care if they get a lower rate of return; they just don’t want a big tax bill. One very high-net-worth widow doesn’t want to worry about instability of her portfolio and has all her investments in municipals. She sleeps at night.
Is tax-loss harvesting to offset gains a good idea?
Sure. Most of my high-net-worth clients who do year-end plans where we project what their taxes are going to be speak with their final advisor to find out what their year-to-date gains and losses are. Then we have a conversation and sometimes take a few losses. It could be stock they’ve inherited that’s been sitting around a while. There are always plenty of opportunities at the end of the year.
Is there anything special for married same-sex couples to consider with regard to tax-loss harvesting?
Before their marriage was recognized, if they wanted to keep a stock in the family, one of the partners could sell it to the other to realize a loss and didn’t have to worry about the wash-sale rule. That goes away when you’re married.
Some itemized deductions aren’t allowed now as a result of tax-code changes. Are there ways to get around that?
Yes, but planning needs to be more efficient. For example, do you really need your mortgage if you don’t get the tax benefit anymore? People that can afford to pay off their mortgages in this low-interest-rate environment can get the tax benefit. It becomes worth paying off your mortgage.
What about itemized deductions for a home office?
When you reach certain income levels, there are all sorts of limitations on those. Instead of getting 100% of an itemized deduction, you’ll get, say, 90%.
What’s the alternative minimum tax?
A nightmare! It’s to prevent people from getting away with paying too little in taxes. This is for higher-net-worth people with a lot of deductions they don’t want to lose. It’s very complicated but something that should be taken into account because once you hit certain levels, you do start to lose the benefits of itemized deductions. It’s all part of year-end planning.
If you’re a U.S. citizen living elsewhere, you’re subject to U.S. income taxes on worldwide income. You could live in France and not have set foot here in 30 years, but whatever your income is worldwide, it’s subject to taxes in the U.S.
Do many Americans give up their U.S. citizenship just to get out of paying U.S. income tax?
Yes. Last year expatriation went up [substantially]. People gave up their citizenship for that reason. They were already living abroad but were still citizens of the United States.
What’s your opinion of the U.S. tax code?
A necessary evil! We’re highly taxed right now. This is a year that’s costing people a lot of money. But the government has all these programs it wants to fund; and this is how they pay for them. Obamacare is being paid for with the 3.8% Medicare tax. There’s a cost to everything.
For more tax planning advice check out ThinkAdvisor’s 21 Days of Tax Planning Advice for 2014 home page.