The American Taxpayer Relief Act of 2012 (ATRA), enacted to avoid the fiscal cliff, includes two provisions that may be important to certain IRA owners and retirement plan participants. The first extends tax-free charitable contributions from IRAs through 2013, and the second liberalizes the rules for 401(k), 403(b), and 457(b) in-plan Roth conversions.
Background
The Pension Protection Act of 2006 first allowed taxpayers age 70½ or older to exclude from gross income otherwise taxable distributions from their IRA ("qualified charitable distributions," or QCDs), up to $100,000, that were paid directly to a qualified charity. The law was originally scheduled to expire in 2007, but was extended through 2011 by subsequent legislation. The law has just been extended yet again, retroactively to 2012 and through 2013, by ATRA.
How QCDs work for 2012 and 2013
You must be 70½ or older in order to make QCDs. You direct your IRA trustee to make a distribution directly from your IRA (other than SEP and SIMPLE IRAs) to a qualified charity.* The distribution must be one that would otherwise be taxable to you. You can exclude up to $100,000 of QCDs from your gross income in each of 2012 and 2013. If you file a joint return, your spouse can exclude an additional $100,000 of QCDs in 2012 and 2013. Note: You don't get to deduct QCDs as a charitable contribution on your federal income tax return--that would be double-dipping.
QCDs count toward satisfying any required minimum distributions (RMDs) that you would otherwise have to receive from your IRA, just as if you had received an actual distribution from the plan. However, distributions that you actually receive from your IRA (including RMDs) that you subsequently transfer to a charity cannot qualify as QCDs.*
Example: Assume that your RMD for 2013, which you're required to take no later than December 31, 2013, is $25,000. You receive a $5,000 cash distribution from your IRA in February 2013, which you then contribute to Charity A. In June 2013, you also make a $15,000 QCD to Charity A. You must include the $5,000 cash distribution in your 2013 gross income (but you may be entitled to a charitable deduction if you itemize your deductions). You exclude the $15,000 of QCDs from your 2013 gross income. Your $5,000 cash distribution plus your $15,000 QCD satisfy $20,000 of your $25,000 RMD for 2013. You'll need to withdraw another $5,000 no later than December 31, 2013, to avoid a penalty.
Example: Assume you turned 70½ in 2012. You must take your first RMD (for 2012) no later than April 1, 2013. You must take your second RMD (for 2013) no later than December 31, 2013. Assume each RMD is $25,000. You don't take any cash distributions from your IRA in 2012 or 2013. On March 31, 2013, you make a $25,000 QCD to Charity B. Because the QCD is made prior to April 1, it satisfies your $25,000 RMD for 2012. On December 31, 2013, you make a $75,000 QCD to Charity C. Because the QCD is made by December 31, it satisfies your $25,000 RMD for 2013. You can exclude the $100,000 of QCDs from your 2013 gross income.
As indicated above, a QCD must be an otherwise taxable distribution from your IRA. If you've made nondeductible contributions, then normally each distribution carries with it a pro-rata amount of taxable and nontaxable dollars. However, a special rule applies to QCDs--the pro-rata rule is ignored and your taxable dollars are treated as distributed first. (If you have multiple IRAs, they are aggregated when calculating the taxable and nontaxable portion of a distribution from any one IRA. RMDs are calculated separately for each IRA you own, but may be taken from any of your IRAs.)
Why are QCDs important?
Without this special rule, taking a distribution from your IRA and donating the proceeds to a charity would be a bit more cumbersome, and possibly more expensive. You would need to request a distribution from the IRA, and then make the contribution to the charity. You'd receive a corresponding income tax deduction for the charitable contribution. But the additional tax from the distribution may be more than the charitable deduction, due to the limits that apply to charitable contributions under Internal Revenue Code Section 170. QCDs avoid all this, by providing an exclusion from income for the amount paid directly from your IRA to the charity--you don't report the IRA distribution in your gross income, and you don't take a deduction for the QCD. The exclusion from gross income for QCDs also provides a tax-effective way for taxpayers who don't itemize deductions to make charitable contributions.
*Special rules for 2012
Because the QCD rules were extended retroactively to 2012, two special rules apply:
It's expected that the IRS will issue guidance in the near future describing how and when your election must be made.
ATRA also makes it easier to make Roth conversions inside your 401(k) plan (if your plan permits).
A 401(k) in-plan Roth conversion (also called an "in-plan Roth rollover") allows you to transfer the non-Roth portion of your 401(k) plan account (for example, your pretax contributions and company match) into a designated Roth account within the same plan. You'll have to pay federal income tax now on the amount you convert, but qualified distributions from your Roth account in the future will be entirely income tax free. Also, the 10% early distribution penalty generally doesn't apply to amounts you convert.
While in-plan conversions have been around since 2010, they haven't been widely used, because they were available only if you were otherwise entitled to a distribution from your plan--for example, upon terminating employment, turning 59½, becoming disabled, or in other limited circumstances.
ATRA has eliminated the requirement that you be eligible for a distribution from the plan in order to make an in-plan conversion. Beginning in 2013, if your plan permits, you can convert any part of your traditional 401(k) plan account into a designated Roth account. The new law also applies to 403(b) and 457(b) plans that allow Roth contributions.
(c) Broadridge Communications 2013
Example(s):Assume you are considering making a charitable gift equal to the sum of $1,000 plus the income taxes you save with the charitable deduction. With a 28% tax rate, you might be able to give $1,389 to charity ($1,389 x 28% = $389 taxes saved). On the other hand, with a 35% tax rate, you might be able to give $1,538 to charity ($1,538 x 35% = $538 taxes saved).
The IRS cautions people wishing to make disaster-related charitable donations to be aware of possible scams relating to Hurricane Sandy. Be sure to deal with recognized charities, and be wary of charities with similar sounding names. It is common for scam artists to impersonate charities using bogus websites, and through contact involving e-mails, telephone, social media, and in-person solicitations. Check out the charity on the IRS website, www.irs.gov, using the search feature, Exempt Organizations Select Check. And don't give or send cash; contribute by check or credit card.
If you itemize deductions on your income tax return, you can generally deduct your gifts to qualified charities. However, the amount of your deduction may be limited to certain percentages of your adjusted gross income (AGI). For example, your deduction for gifts of cash to public charities are generally limited to 50 percent of your AGI for the year, and other gifts to charity may be limited to 30 percent or 20 percent of your AGI. Disallowed charitable deductions may generally be carried over and deducted over the next five years, subject to the income percentage limits in those years. And be sure to retain proper substantiation of your deduction for a charitable contribution.
When considering making charitable gifts at the end of a year, it is generally useful to include them as part of your year-end tax planning. In general, taxpayers have a certain amount of control over the timing of income and expenses. You generally want to time your recognition of income so that it will be taxed at a lower rate, and time your deductible expenses so that they can be claimed in years when you are in a higher tax bracket.
For example, if you expect that you will be in a higher tax bracket next year, it may make sense to wait and make the charitable contribution in January so that you can take the deduction in the next year when the deduction produces a greater tax benefit. Or you might push the charitable contribution, along with other deductions, into a year when your itemized deductions would be greater than the standard deduction. And, if the income percentage limits above are a concern in one year, you might move income into that year or move deductions out of that year, so that a larger charitable deduction is available for that year.
A financial or tax professional can help you evaluate how to make charitable gifts in a way that is beneficial to you.
(C) Broadridge Communications, 2012
In December 2010, Congress extended the so-called Bush-era tax cuts. However, for investors, the legislation may have been a stay of execution rather than a full pardon. As of January 1, 2013, federal tax rates on income, qualifying dividends, and capital gains (among other provisions) are scheduled to revert to previous levels.
Given recent partisan wrangling, no one can be completely sure about precisely what will happen. Even if all the scheduled changes don't ultimately go into effect, others likely will. In the meantime, as the clock ticks closer to some sort of decision point, it might make sense to review your portfolio and do some "what-if" planning for various scenarios. Taxes obviously are only one factor--and not necessarily the most important one--in decisions about your portfolio; think of this as a chance to fine-tune your planning efforts.
You'll want to pay attention to scheduled changes in tax rates, especially if your income is more than $200,000 a year ($250,000 for you and your spouse, $125,000 if married and filing separately). Absent further action, current tax rates will be replaced by five federal tax brackets rather than six (see table) and the top long-term capital gains rate will go up.
If you're considering selling an asset that has appreciated substantially, determine whether you should do so this year rather than next. Even if some current income tax rates are extended, individuals or households with incomes above the $200,000/$250,000 limits might still face higher rates. If you're above the threshold, you could be hit simultaneously with a higher capital gains rate on the proceeds of your sale and a higher income tax rate.
Don't forget the alternative minimum tax in your calculations. Although the AMT doesn't apply directly to long-term capital gains and qualifying dividends, they're included when calculating your taxable income under the AMT. If realizing a large capital gain indirectly increases your AMT exposure or might push you into the phaseout range for AMT exemptions, that could potentially wipe out any tax savings from selling this year.
If you think an investment will continue to be a sound one but feel you would benefit from selling prior to 2013 to take advantage of current low rates on existing gains, you could sell the investment and repurchase it later. That would give you a higher cost basis for any subsequent sale, potentially reducing your tax liability at that point. Also, even if you do decide to sell, you don't necessarily need to do so all at once. The tax cuts that produced the current rates have already been extended once, and it could happen again. Repositioning your portfolio gradually could moderate the risk of a single badly timed sale. There also are a variety of strategies for managing concentrated stock positions; get expert help before deciding that selling is your only choice.
There's another reason the scheduled tax bracket changes are important. As of 2013, qualifying dividends are scheduled to be taxed as ordinary income, as they were before 2003, rather than at the lower rate for long-term capital gains. The higher your tax bracket and the more you rely on dividends for income, the more you should be aware of the potential impact of that change on you.
However, remember that taxes aren't the only factor you should consider in making a decision. Dividends can still represent a welcome income alternative to interest rates that are expected to remain at rock-bottom levels through mid-2015. And with baby boomers beginning to reach retirement age, interest in any and all sources of ongoing income is unlikely to disappear. As with capital gains, many factors will affect your decision about the role of dividends in your portfolio.
2012 | As of January 1, 2013 | |
---|---|---|
Ordinary income | 10%, 15%, 25%, 28%, 33%, 35% | 15%, 28%, 31%, 36%, 39.6% |
Capital gains (generally) | 15% maximum; 0% for those in 10% and 15% income tax brackets | 20% maximum; 10% for those in 15% income tax bracket (slightly lower rates will generally apply to a sale or exchange of assets acquired after December 31, 2000 and held for more than five years) |
Qualified dividends | Taxed at long-term capital gains rate (15% top rate) | Taxed as ordinary income (39.6% top rate) |
Medicare contribution tax on unearned income | N/A | 3.8% on net investment income for individuals with MAGI over $200,000 ($250,000 for married couples filing jointly; $125,000 for married individuals filing separately) |
There's another factor you may need to be aware of. Beginning in 2013, a new 3.8% Medicare contribution tax will be imposed on some or all of the unearned income of individuals with high modified adjusted gross incomes (see table). Also, the hospital insurance portion of the payroll tax is scheduled to increase by 0.9% for higher-income individuals. However, unless you exceed the specified thresholds, neither provision will affect you.
If you expect to be affected by the new taxes and/or a higher tax bracket, the benefits of tax-free investments might become even more pronounced. Taxable bonds typically pay higher interest rates than municipal bonds, but if you're in a high tax bracket, munis can potentially offer a better after-tax return. As with any investment decision, there are many factors to consider. Local and state governments have come under severe financial pressure, and though the default rate on munis has traditionally been low, a default is always possible. Also, interest rates have been at historic lows since the end of 2008; since bond prices move in the opposite direction from their yields, rising interest rates would not be good news for bond prices.
If you do decide to make adjustments, this year will require a tradeoff in timing them. Postponing action may give you more clarity, but waiting until the last minute could potentially leave you caught in a stampede for the door at year's end, or trying to make decisions during a volatile period. If you decide to sell, make sure you've allowed enough time to accommodate trade settlements and holiday schedules.
Investments in tax-deferred accounts, such as IRAs or 401(k)s, won't be affected by any tax changes until you withdraw the money, so unless you're contemplating the timing of a withdrawal, you may not need to worry much about them. However, if you've been considering a Roth IRA conversion, find out whether you would reduce your tax liability by converting in 2012 rather than later.
Even if 2013 seems unlikely to have much impact on you, this could be a good time for some routine portfolio maintenance. And if you think you might be affected by any of the above situations, it's especially important to get expert help.
The information contained on this website and from any communication related to this website is for information purposes only. The National Institute of Financial Education (NIFE) does not hold itself out as providing any legal, financial or other advice. NIFE also does not make any recommendation or endorsement as to any investment, advisor or other service or product or to any material submitted by third parties or linked to this website. In addition, NIFE does not offer any advice regarding the nature, potential value or suitability of any particular investment, security or investment strategy. The material on this website does not constitute advice and you should not rely on any material in this website to make (or refrain from making) any decision or take (or refrain from making) any action. This website contains links to other websites which are not under the control of and are not maintained by NIFE. NIFE is not responsible for the content of those sites. NIFE provides these links for your convenience only but does not necessarily endorse the material on these sites. NIFE does not make recommendations for buying or selling any securities or options. We provide financial education and it is up to our students to make their own decisions, or to consult with their advisors when evaluating the information. We respect your privacy and will never knowingly reproduce any personal information that would jeopardize your privacy. |
Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2012. |
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This is an excellent Quarterly Review. It's a great way to look at larger and smaller aspects of how the market is responding.
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