Key Tax Changes for 2013

March 17, 2013

In another down-to-the-wire scenario, Congress moved on New Year’s Day to avoid the tax side of the fiscal cliff by passing legislation that extended many of the Bush-era tax cuts. But the new law raised taxes for high earners, posing new planning considerations. The eleventh-hour extension of many of the Bush-era tax rates narrowly skirted an across-the-board increase in most federal tax rates. But the new rules differ in a number of ways from the old—particularly for those in the top tax bracket. Here are some of the important tax alterations you’ll want to be aware of as you plan for 2013:

Higher marginal tax rates: Legislation that resolved the fiscal cliff created the first upward tax-bracket revisions in decades. With the top marginal income tax rate now 39.6%, tax management strategies that once had limited cost-benefit may now be more attractive. For example, if you are relying on cash flow from a fixed-income portfolio in a taxable account, you may find that municipal bonds might offer better net cash flows now than they might have last year, even if their gross yields might be lower.
Capital gains and equity dividend taxes: The favorable tax rates on long-term capital gains and qualified equity dividends are now effectively graduated for many taxpayers. That means you may have to do a complex calculation to estimate the tax rate you might be liable for on your income from these sources.As a general rule, long-term capital gains and qualified dividend tax rates for those in the 10% and 15% income tax brackets are zero. For those in the 25% to 35% brackets, the rate is 15%. And for taxpayers in the top bracket (39.6%), it’s 20%. Here’s where it becomes interesting: You may be subject to a higher rate on long-term gains and dividends than your ordinary marginal tax bracket might imply. That’s because your capital gains and dividend income tax bracket will be assigned according to what your ordinary tax bracket would have been if the capital gains and dividend income were tallied as ordinary income instead. For example, assume that your employment earnings put you in the 33% tax bracket and you also have significant income from qualified long-term capital gains and qualified dividends. To estimate your dividend and capital gains tax liabilities this year, you’ll need to add your investment income total to your ordinary income total. You could then see what tax bracket the combined tally would put you in, and by how much. In this case, the portion of investment income that brings you up to the 39.6% threshold would still be taxed at 15%, but any portion of capital gains and dividend income beyond that would be taxed at the higher 20% rate. You could pay the top rate on favored investment income even though your ordinary income tax bracket would still be 33% for wages, salaries, interest income and the like. Keep in mind that the new 3.8% Medicare tax on investment income (more below on this) applies to qualified dividends and capital gains, effectively increasing the net tax rate even further for some taxpayers.
Medicare tax on unearned income: This tax is new for 2013 even though strictly speaking it was not part of the fiscal cliff legislation, but rather, mandated by the Affordable Care Act. The actual tax is assessed only on “unearned” income— typically interest, dividends, royalties, annuities, rents and other passive activity income, capital gains on investments and trading of financial instruments and commodities. The trigger for this tax is your modified adjusted gross income (MAGI): $200,000 for single taxpayers, $250,000 for those married filing jointly. Any strategy that effectively defers or reduces your reportable income can help you manage the impact of this tax in 2013.
Estate, gift and generation-skipping taxes: The taxes on inherited wealth and major gifts are higher now than they have been in recent years. But they are lower than they would have been if there had been no new action by Congress. What is more, for the first time in a decade, there may be a sense of statutory stability. As the law now stands, estate and gift taxes will remain as they are, without sunset or expiration provisions. The maximum exclusion amount ($5.25 million in 2013) will be indexed for inflation in the future if needed, but there are no scheduled changes in tax rates or other assessment policies. One new feature stands out: A taxpayer’s unused estate/gift exclusion allowance can be passed on to a surviving spouse and added to his or her own personal exclusion amount. Keep in mind that this transfer of a future tax benefit can be made only to a spouse who is a US citizen.
Alternative minimum tax: Like the estate tax, the alternative minimum tax (AMT) gained a new measure of predictability from the fiscal cliff law. Inflation adjustments have become a permanent part of the basic AMT calculation. That means that for income earned in 2012 and reported on tax returns filed this year, the basic exemption amount is $50,600 for individuals and $78,750 for couples. For income earned during 2013, the exemption amounts are $51,900 for singles and $80,800 for couples.

This is only a general summary of highlights from the new laws. It is not tax advice. Before you take any tax management steps you should consult your tax advisor. Also, please keep in mind that in federal tax discussions, tax benefits for spouses are available only to those couples whose marriages can be recognized by federal law. That said, please feel free to contact me with any investment-related tax questions you might have. I would be pleased to help you assess the impact of tax changes on your investment and financial accounts.

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Sources: Tax information was compiled from Internal Revenue Service Revenue Procedure 2013-15, IRS news release IR-2013-4 (Annual Inflation Adjustments for 2013, January 11, 2013), Internal Revenue Bulletin No. 2013-2 (January 7, 2013), and IRS news release IR-2012-78 (In 2013, Various Tax Benefits Increase Due to Inflation Adjustments, October 18, 2012).

If you’d like to learn more, please contact Angel Chavez, CIMA®, 415-984-6008, angel.chavez@morganstanley.com. Article by McGraw Hill and provided courtesy of Morgan Stanley Financial Advisor. The author(s) are not employees of Morgan Stanley Smith Barney LLC ("Morgan Stanley"). The opinions expressed by the authors are solely their own and do not necessarily reflect those of Morgan Stanley. The information and data in the article or publication has been obtained from sources outside of Morgan Stanley and Morgan Stanley makes no representations or guarantees as to the accuracy or completeness of information or data from sources outside of Morgan Stanley. Neither the information provided nor any opinion expressed constitutes a solicitation by Morgan Stanley with respect to the purchase or sale of any security, investment, strategy or product that may be mentioned. Tax laws are complex and subject to change. Morgan Stanley Smith Barney LLC (“Morgan Stanley”), its affiliates and Morgan Stanley Financial Advisors and Private Wealth Advisors do not provide tax or legal advice and are not “fiduciaries” (under the Internal Revenue Code or otherwise) with respect to the services or activities described herein except as otherwise agreed to in writing by Morgan Stanley. This material was not intended or written to be used for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Individuals are encouraged to consult their tax and legal advisors regarding any potential tax and related consequences of any investments made under such account, their tax advisors for matters involving taxation and tax planning and their attorney for matters involving trust and estate planning and other legal matters. Interest in municipal bonds is generally exempt from federal income tax. However, some bonds may be subject to the alternative minimum tax (AMT). Typically, state tax-exemption applies if securities are issued within one’s state of residence and, local tax-exemption typically applies if securities are issued within one’s city of residence. Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall; additionally, the longer a bond’s maturity (duration), the more sensitive it is to this risk. Bonds face credit risk if a decline in an issuer's credit rating, or creditworthiness, causes a bond's price to decline. Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made. NOTE: High yield bonds are subject to additional risks such as increased risk of default and greater volatility because of the lower credit quality of the issues. Morgan Stanley Financial Advisor(s) engaged Silicon Valley Latino to feature this article. Angel Chavez, CIMA® may only transact business in states where he is registered or excluded or exempted from registration www.morganstanleyfa.com/elcaminogroup/. Transacting business, follow-up and individualized responses involving either effecting or attempting to effect transactions in securities, or the rendering of personalized investment advice for compensation, will not be made to persons in states where Angel Chavez, CIMA® is not registered or excluded or exempt from registration. Investments and services offered through Morgan Stanley Smith Barney LLC, member SIPC. CRC 619858 [03/13]