By: Randall A. Denha, Esq.
We can all agree that Congress has much to do before the end of the year. Considering the cost of the stimulus, soaring U.S. government debt, a $3.72 trillion federal budget, a projected record-breaking $1.6 trillion deficit, expiring tax cuts passed in 2001 and 2003, and proposed tax legislation, income tax rates are sure to increase. As a result, every taxpayer will need to consult with their financial and tax advisors to implement investment and tax strategies that benefit from a rising tax environment. The information below is worst-case scenario planning (subject to Congressional reversal) that will afford you and your family some reprieve from the dreaded tax man and possibly put more in your pocket. I apologize for the length of this article, but there is much ground to cover and I want this to serve as your personal reference guide in navigating this rough terrain.
By way of background, should the current tax legislation merely sunset, taxes on ordinary income, capital gains, dividends, gifts and estates will all increase. If no new legislation is passed, clients will begin 2011 in a much higher tax environment than they have grown accustomed to.
As we know, Congress recently passed The Health Care and Education Reconciliation Act, which provides for an increase in the tax rate for high income earners on both earned and unearned income beginning in 2013. The Medicare tax on earned income will increase by 0.9 percent to 2.35 percent for high-income earners. The new 3.8 percent surtax applies to income such as capital gains, dividends, rents and taxable distributions from annuities. It doesn’t apply to business income, tax-exempt municipal bonds or income from retirement accounts such as 401(k) plans, 403(b) plans, pensions, individual retirement accounts or Roth IRAs. The 3.8 percent surtax isn’t triggered merely by crossing the income threshold of $200,000 for single filers and $250,000 for married filers. Instead, the tax is applied to the lesser of the taxpayer’s unearned income or the amount by which the taxpayer’s income exceeds the threshold.
Accelerate income/postpone deductions — A common income-planning strategy in the past was to defer income to later years and take deductions as soon as possible. But, with income tax rates expected to rise, some may want to actually accelerate income so it’s earned in 2010 and taxed at historically low rates as opposed to deferring the income to later years when the tax rates could be considerably higher. Conversely, it may make sense to defer certain deductible payments, such as charitable contributions, to a time when they will be worth more when the higher income tax rates take effect.
Tax loss harvesting — Taxpayers should spend time trying to identify valuable tax loss harvesting strategies. For instance, many small businesses incurred a net operating loss in recent years. That loss can be passed down and used to offset the business owner’s income on his personal tax return. The loss can also be carried forward to reduce income in future years. Generally, the value of these losses will be determined by the tax bracket of the owner in the year that they’re used to offset income. In a rising tax environment, this loss becomes more valuable in future years when their income is subject to a higher tax rate.
Take capital gains now — This may be a good time to conduct a thorough capital review. Review all capital assets and estimate the unrealized gains or losses of those investments. With the top capital gains rate scheduled to increase to 20 percent in 2011 and 23.8 percent in 2013, it may make sense to take gains now while they would still be taxed at 15 percent. Conversely, consider deferring capital losses to offset capital gains in a year when they could be worth more due to the increase in the capital gains tax.
Life insurance and variable annuities — For taxpayers who would like to pass an inheritance to their heirs, life insurance has always been a valuable tool. Since life insurance proceeds payable at death aren’t subject to income tax, the value of those proceeds will increase as tax rates rise. For taxpayers looking for an investment that they can benefit from, annuities are also attractive. When dividend and capital gains rates were cut to 15 percent, the tax-deferral component of an annuity became less appealing. Annuities grow tax deferred but when the gains are distributed they will be taxed as ordinary income. Investments that produced qualifying dividends or capital gains were often favored. As a result, annuities were bought and sold not necessarily because of their tax-deferred feature but because of other benefits and features, such as guaranteed death and lifetime payments. With capital gains and ordinary income taxes both rising, however, the tax-deferral component of an annuity will become increasingly more valuable.
Retirement Planning Strategies
Maximize retirement plan/IRA contributions — A key benefit to IRAs, 401(k) plans and other qualified retirement plans is that they grow tax deferred. Of course, this benefit becomes more apparent as income taxes increase. Furthermore, the value of ongoing tax-deductible contributions into these plans will increase in a rising tax environment. An obvious strategy in an environment of higher taxes would be to increase tax-deductible contributions to IRAs and qualified retirement plans.
Roth conversions — A Roth conversion in 2010 is a good way to hedge against the risk of rising income tax rates. Convert the taxable retirement account to a Roth IRA now and pay taxes while the tax rates are low and, due to the recent recession, while the taxable value of the retirement account is depressed. Furthermore, a conversion now will reduce future taxable income that could force other investment income to be subject to the 3.8 per-cent Medicare surtax beginning in 2013. By being able to supplement retirement income with tax-free income, retirees will increase the likelihood of keeping themselves in a lower income tax bracket.
Gifting and Estate-planning Strategies
Conduct estate review — Anticipated changes to the estate tax environment make it imperative to conduct an estate plan review. Effective Jan. 1, 2010, both the estate tax and GST were repealed. Both taxes are scheduled to return in 2011 but at more unfavorable rates than in 2009, with estates more than $1 million being subject to a 55 percent estate tax. The current uncertainty of estate taxes would suggest that families take an inventory of their estate, determine whether assets are titled properly and review all estate-planning documents including wills, trusts and beneficiary designation forms.
Intra-family transfers — Gifting income-producing property to family members in a lower tax bracket can save the family taxes. Since the tax increases are more likely to affect those in the higher tax brackets while leaving the rates for lower-income earners unchanged, transfer of assets to family members in a lower tax bracket will become a much better strategy. The increase in the spread between the tax rates of family members will be greater than before. Additionally, such a transfer will also reduce the transferor’s taxable estate.
In addition to the annual gift exclusion of $13,000 per person, per year, taxpayers may be looking to use their $1 million lifetime gift exemption. A married couple could transfer up to $2 million without a gift tax. Although, using the $1 million lifetime exemption will also reduce the available estate tax exemption by an equal amount, any subsequent gains will be outside the parents’ estate and be taxed at the children’s lower income tax rates. Considering real estate, stocks, mutual funds and other assets have decreased in value in recent years, a wealthy taxpayer may actually be able to transfer a larger portion of their taxable estate to their heirs without paying a gift tax. Furthermore, any subsequent recovery of the loss in value of those transferred assets will be taxed at the heir’s lower income tax rates.
Use of Internal Revenue Code Section 529 plans could become more popular in future years. These college savings plans can have fairly long investment time horizons whereby assets can grow tax deferred and distributions for qualified educational expenses can be taken tax free. Furthermore, taxpayers can accelerate their annual gift tax exemption and take five years worth of exemptions in one year. That means a married couple could transfer $130,000 into a 529 plan for each child and pay no gift tax. Finally, some families may wish to directly pay a child or grandchild’s tuition. The payment would reduce their taxable estate but will not result in a gift tax nor reduce their annual gift exclusion amount.
Grantor retained annuity trusts (GRATs) — The current low interest rate environment and legislation currently allowing for a two-year term may make GRATs an appealing structure to facilitate intra-family transfers. A GRAT allows for a donor to gift assets into a trust for the benefit of their beneficiaries and in return receive an income stream for a given term. The donor will need to recognize a taxable gift equal to the present value of the remainder interest in the trust. However, a “zeroed-out” GRAT can be created where the present value of the remainder interest will be zero and the creation of the GRAT will generate no gift tax liability. To the extent the trust assets then grow to more than 120 percent of the federal mid-term rate (sometimes referred to as the “hurdle rate”), those gains can be transferred to the trust beneficiaries gift and estate tax free.
Depreciated assets, such as investments that recently declined in value or underperformed, may be ideal assets to be placed into a GRAT. These donors may also want to consider transferring these assets while the hurdle rate is so low, increasing the likelihood that the beneficiary will retain more of the appreciation in the depreciated asset after the trust’s term. The hurdle rate for the month of October is 2.0%. By comparison, in October 2000 the hurdle rate was 7.33%. Advisors who anticipate a rising interest rate environment may want to evaluate implementing a GRAT strategy while interest rates are at historic lows.
Congress is currently considering legislation that would significantly impact the GRAT strategy. The House recently passed H.R. 4849, which could modify GRATs in two ways. First, it would increase the minimum term of a GRAT to 10 years. This will end the common strategy of a series of two-year rolling GRATs as well as subject the strategy to more longevity risk. This legislation would also require that the remainder interest of the GRAT be greater than zero, thereby eliminating the zeroed-out GRAT strategy. While this legislation has not yet been passed by the Senate and may never become law, advisors who are considering implementing this strategy for estate planning may want to consider implementing those strategies under the current legal structure before a new structure becomes law.