What's on Deck for Investment-Related Taxes in 2014


Robust equity market returns appear to be stoking investors' appetite for risk-taking.

But given that valuations are such a strong predictor of future market performance, savvy investors would do well to ratchet their future market expectations down--not up--in the wake of the market's recently strong gains.

And lower market expectations make it critically important to watch all of the costs you incur as an investor. If you're lucky enough to earn 10% on your equities and 3% on your bonds during the next decade, whether you pay 1% or 2% in portfolio management costs will make a big difference in your take-home return.

Tax costs matter more than ever in a lower-return environment, too. That makes it crucial to stay attuned to tax management for your taxable holdings and to maximize your investments in tax-sheltered accounts, among other factors. Here's the skinny on what's changing in the tax landscape for 2014 as well as what's staying the same. Note that I've focused on those taxes that intersect in some fashion with your investment plan.

Dividend and Capital Gains Taxes
For most investors, dividend and long-term capital gains tax rates will remain unchanged from 2013 to 2014. As in the past, investors in the 10% and 15% tax brackets will pay nothing on qualified dividends and long-term capital gains, and those in the 25%, 28%, 33%, and 35% tax brackets will pay a 15% rate on their qualified dividend income and long-term capital gains. Those in the 39.6% tax bracket--in 2014, that's single filers with incomes greater than $406,750 and married couples filing jointly with incomes of more than $457,600--will pay a 20% tax rate on qualified dividends and long-term capital gains.

For investors who expect to be in the 10% to 15% tax bracket in 2014 but may not always be, selling winners from their taxable accounts and realizing long-term capital gains at a 0% rate is an attractive strategy, particularly in the wake of 2013's equity market runup. Such investors can even rebuy the same securities immediately thereafter, but by doing so they will reset their cost basis to a new, higher level. Thus, if they eventually do owe tax when they sell again, they will owe tax on a smaller amount than if they sold with their previous cost basis.

For investors who are in the 25% tax bracket or higher, it still makes sense to consider parking dividend payers in tax-sheltered accounts and reserving taxable accounts for holdings that don't pay dividends. The key reason is loss of control. If a company that you hold in your taxable account pays a dividend, that's a taxable event for you, whether you wanted that dividend or not. (If you hold a dividend-paying fund, you'll owe taxes on any dividends paid out, even if you've reinvested those dividends back into the fund.) By holding nondividend payers in your taxable accounts, by contrast, you won't be on the hook for taxes unless you take action and sell shares.

Medicare Surtax
The 3.8% Medicare surtax will be imposed on the lesser of an individual's net investment income for the year or adjusted gross income in excess of $200,000 for single filers and $250,000 for married taxpayers filing jointly. Note that these income thresholds are the same as they were in 2013; they're not inflation-adjusted and thus are apt to ensnare a higher number of taxpayers in the future.

What counts as net investment income? Short- and long-term capital gains, the taxable portion of annuity income, royalties, and rents. In addition, net investment income includes trading of financial instruments and commodities and income from passive activities (earnings from a business in which you have limited involvement). Net investment income does not include municipal-bond income, distributions from IRAs or other qualified retirement plans, pension and Social Security income, or capital gains from the sale of a principal residence, assuming the gains don't exceed $250,000 for individuals and $500,000 for couples and meet the other requirements to qualify for the Section 121 exclusion. This article (http://news.morningstar.com/articlenet/article.aspx?id=585907) discusses the surtax in depth.

The year 2013 ushered in an additional surtax related to the Affordable Care Act--this one linked to salary and not investment income--and it will apply in 2014 and beyond, too. Single taxpayers will pay 1.45% in Medicare tax on the first $200,000 of salary received and an additional 0.9%--or 2.35% total--on salary of more than $200,000; that threshold is $250,000 for married couples filing jointly.

IRA Contribution and Income Limits
Contribution limits for IRAs are staying at the same level in 2014 that they were in 2013. Investors under age 50 will be able to contribute $5,500 to their IRAs--either Roth or Traditional--whereas individuals over age 50 can contribute $6,500.

Income limits for IRA contributions have bumped up a bit, however. Individuals with incomes of less than $70,000 in 2014 who are covered by a company retirement plan can make at least a partially deductible contribution to a Traditional IRA. (Contributions phase out, or are reduced, for individuals who make between $60,000 and $70,000.) Married couples filing jointly can make at least a partially deductible IRA contribution for a spouse who is covered by a workplace retirement plan if their combined income is less than $116,000. (Contributions begin to phase out for couples in this situation who make between $96,000 and $116,000.) If the IRA contribution is for a spouse who is not eligible to contribute to a company retirement plan but the other spouse is covered by a company retirement plan, the contribution for the noncovered spouse is deductible if their income is less than $191,000. (The deductibility of contributions phases out at incomes between $181,000 and $191,000.)

Roth IRA income limits have also increased. Individuals filing singly and making less than $129,000 will be able to make at least a partial Roth IRA contribution in 2014. (The amount you can contribute is phased out, or reduced, for single filers who make between $114,000 and $129,000 a year.) Married couples filing jointly can make at least a partial contribution if their incomes are less than $191,000 per year in 2014. (Contributions begin to phase out for joint filers earning between $181,000 and $191,000.) Individuals of any age can make a Roth IRA contribution, as long as they have eligible compensation, such as wages, salaries, tips, and commissions.

Saver's Credit
The federal saver's tax credit provides an additional incentive for families with earnings under certain thresholds to put money in IRAs or qualified company retirement plans. In 2014, married couples filing jointly are eligible for a saver's credit if their modified adjusted gross income is less than $60,000; that threshold is $30,000 for single filers. The lower the income, the higher the credit, up to a maximum level of $1,000 for individuals and $2,000 for married couples filing jointly.

In 2014, married couples filing jointly with adjusted gross incomes of less than $36,000 who contribute $2,000 apiece to IRAs or company retirement plans can claim $2,000 in total saver's credits (the $1,000 maximum credit times 2). The credit is nonrefundable, meaning that if the credit is larger than the amount you owe in taxes, you won't get a refund on the difference.

Note that any credit is more valuable to you than a tax deduction, in that it reduces your tax burden by the amount of the credit. But taxpayers can take both a tax deduction on their contributions and use the credit. Say, for example, a single filer earning $30,000 contributes $5,000 to his 401(k). His contribution would knock down his adjusted gross income, thereby making him eligible for the maximum allowable saver's credit (50% of the contribution, up to a maximum credit of $1,000, for single taxpayers with incomes of less than $27,000 in 2014). This IRS publication provides (http://www.irs.gov/pub/irs-pdf/p4703.pdf) more details on the credit, and this one (http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Retirement-Topics-Retirement-Savings-Contributions-Credit-(Saver%E2%80%99s-Credit)) provides more detail on the income cutoffs for 2014.

Roth IRA Conversions
The current Roth IRA income limits outlined above are little more than a formality because the so-called backdoor IRA maneuver, whereby a person funds a traditional nondeductible IRA and converts it to a Roth shortly thereafter, is alive and well. This strategy is a good one for investors looking to get some assets over into the tax-free withdrawal column, but not such a good one for those with large pools of Traditional IRA assets, as I discussed in this article (http://news.morningstar.com/articlenet/article.aspx?id=364861).

People with large Traditional IRA balances that they'd like to convert to Roth should also stay mindful of the fact that taxes due upon conversion will be higher when the markets--and in turn account balances--are lofty. Executing partial conversions can help ensure that you don't convert your balance at what in hindsight was an inopportune time.

401(k) Contribution Limits
The maximum 401(k) contribution will remain the same in 2014 that it was in 2013: It's $17,500 for those under age 50 and $23,000 for savers over 50. (Contribution limits for 403(b) and 457 plan participants are the same.) If you're just turning 50 this year, note that you can start contributing extra catch-up amounts at the beginning of the year; you don't need to wait until your birthday. Income limits do not apply to contributions to these plans.

Estate and Gift Tax
As in 2013, the estate tax exemption will remain higher than $5 million ($5.34 million, to be exact) per individual.

The very high exemption amount, as well as the concept of portability of exclusion amounts between spouses, makes the creation of bypass trusts arguably less essential than it once was, as estate-planning expert Deborah Jacobs discussed in this video (http://www.morningstar.com/cover/videocenter.aspx?id=580673). Yet generous estate tax laws notwithstanding, everyone needs to mind basic estate-planning matters, including properly drafted beneficiary designations, guardianships for minor children, and powers of attorney for financial and health-care matters. This article (http://news.morningstar.com/articlenet/article.aspx?id=582121) details some of the key estate-planning steps people at all income levels should take.

The annual gift tax exclusion remains the same in 2014 as it was in 2013. That means you can gift $14,000 apiece to an unlimited number of people this year without having to worry about a gift tax or even fill out the gift tax paperwork. Savers in 529 college-savings plans can actually gift $70,000 to a single individual in a single year without triggering a gift tax, assuming they make no further contributions to the same individual's college plan in the subsequent four years. In that case, the Internal Revenue Service assumes that your contribution is spread across five years. Married couples can actually contribute $140,000 to one child's college-savings plan in 2014--assuming they make no further gifts from 2015 through 2018--without getting into gift tax terrain.

Also, if you're gifting to pay educational or medical expenses, you can circumvent the gift tax system altogether by making payments directly to the educational or medical institution.

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