Given the likelihood of increased income tax rates, it's important to review financial, retirement and estate-planning objectives with your clients
For decades, the United States had a top marginal tax rate as high as 50, 70 and even 90 percent.1 As a matter of fact, for the past 50 years there have only been five years (1988 to 1992) when the top marginal tax rate was less than the current 35 percent tax rate. 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.
An Uncertain Tax Environment
President George W. Bush implemented several tax cuts with the passage of both the Economic Growth Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). These laws contained sunset provisions that take effect at the end of 2010 and will require new legislation to continue those tax cuts. The uncertainty of the future tax environment makes it difficult to plan properly.
Even widely held industry assumptions have proven to be inaccurate. For example, during 2009 many believed that Congress was going to pass some form of patch for the estate tax in 2010. This patch was expected to maintain the exclusion of $3.5 million and the 45 percent rate from 2009 and extend them into 2010 to give Congress time to create a permanent fix.2 As of the date of this publication, Congress has not passed the patch and currently we have no federal estate tax. Given the busy schedule of Congress, the probability of a retroactive fix becomes increasingly unlikely as the year passes.
Should EGTRRA and JGTRRA merely sunset, taxes on ordinary income, capital gains, dividends, gifts and estates will all increase.3 Qualified dividends, which are currently taxed at a maximum rate of 15 percent, will be taxed at ordinary income rates in 2011. Capital gains tax rates will rise from a top rate of 15 percent to a top rate of 20 percent. The top tax rates on ordinary income will rise from 33 percent to 36 percent and from 35 percent to 39.6 percent.4 Coupled with continued phase-outs of personal exemptions and itemized deductions, a taxpayer's effective tax rate could increase further. Both the estate tax and the generation skipping transfer (GST) tax will return in 2011, with a $1 million exclusion and a top rate of 55 percent. This is substantially less favorable than the 2009 maximum rate of 45 percent with a $3.5 million exclusion. In addition, the gift tax rate will rise from a maximum rate of 35 percent in 2010 to 55 percent in 2011. If no new legislation is passed, clients will begin 2011 in a much higher tax environment than they have grown accustomed to.
Health care reform and the Medicare surtax — 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.5 High-income earners for this purpose will be those who are married and filing jointly with income over $250,000; those who are married filing separately with income over $125,000; and those who are single and head-of-household filers with income over $200,000.6 The additional 0.9 percent Medicare tax is only paid by the individual. There's no increase in Medicare taxation to the employer. This legislation also creates a new 3.8 percent surtax on unearned income for high-income earners.7 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. For example, if a married couple filing jointly had $60,000 of capital gains, but an adjusted gross income (AGI) of $280,000, they will only have to pay a 3.8 percent tax on the $30,000 of excess over the $250,000. Although certain income is exempt from the surtax, such as distributions from qualified retirement plans, such income could indirectly increase the taxpayer's liability by increasing the taxpayer's AGI and causing more investment income to become subject to the surtax. In the example above, if the couple had withdrawn an additional $30,000 from their 401(k), then their income would have been $310,000 and the 3.8 percent tax would be assessed on the full $60,000 of unearned income that year. Advisors will need to carefully consider how a client will be accessing their qualified accounts after 2012 to prevent accidentally triggering additional taxation on other unearned income.
Trusts and the Medicare surtax — Clients who use irrevocable trusts for estate planning will need to consider how the new 3.8 percent Medicare surtax could affect these trusts. The 3.8 percent tax applies once the trust income becomes subject to the top marginal tax bracket. For 2010, trust income will be subject to the top marginal tax rates of 35 percent once the income exceeds $11,200.8 Should the top tax rate increase to 39.6 percent in 2011, this 3.8 percent surtax will cause even relatively small trusts to be subject to a marginal tax rate of 43.4 percent. Even income exempt from the surtax, such as IRAs, that are paid to a trust could become taxable later if the assets are retained by the trust and generate additional income. Clients establishing new trusts will also want to carefully review the trust language regarding which assets are considered suitable for accomplishing the trust goals and in what circumstances the trust will retain assets in light of this new tax.
2011 budget proposal — Both houses of Congress and President Obama have expressed their desire to pass legislation extending the current tax cuts in whole or in part. President Obama's budget would reinstate the estate tax, GST tax and gift tax to their 2009 levels permanently. For taxpayers who make less than $250,000 married filing jointly ($200,000 single), the dividends, capital gains and ordinary income rates will be almost identical to their 2010 rates with the exception of an inflation adjustment. However, for those taxpayers with an AGI above $250,000 married filing jointly ($200,000 single), the capital gains and dividend rates would rise to 20 percent and the top marginal income tax rate would rise to 39.6 percent in 2011.
Indications from Congress — The Senate Budget Committee recently passed a resolution for the 2011 budget with many of the same provisions as President Obama's budget,9 except the Committee's resolution would tax dividends at the maximum ordinary income rate of 39.6 percent. While the industry consensus over the last few months has been that dividends would have a maximum rate of 20 percent, this is becoming increasingly less certain in light of the Senate resolution. Many political analysts have pointed out that the budgetary rules in the Pay-As-You-Go Act of 2010, otherwise known as PAYGO,10 may require that dividends be taxed as ordinary income and not the 20 percent rate as President Obama has proposed in his budget.11 The PAYGO rules require that reductions in revenue must be offset by an increase in revenue through either tax increases or spending cuts. We don't know whether President Obama's plan, the Senate plan or some entirely different set of changes will become effective in 2011. The uncertainty of the future tax environment should be a call to all taxpayers to consult with their tax and financial advisors, thoroughly assess their financial, retirement and estate plan, and determine what income, investment, retirement and estate-planning strategies they could implement now to help prepare for a rising tax environment.
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 — A changing tax environment appears to be following on the heels of a major recession. As a result, 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.
The capital review shouldn't be limited to stocks, bonds and mutual funds. Review other capital assets such as real estate, personal assets and certain business assets that aren't depreciable or held for sale (inventory). Also, review certain retirement assets. Although distributions from qualified retirement plans are taxed as ordinary income, there's an often overlooked exception to employer securities held in an employer sponsored retirement plan. The appreciation of employer stock held in the plan, known as net unrealized appreciation, will be taxed as a capital gain, and not ordinary income, if the appreciated stock is distributed in-kind pursuant to a lump sum distribution.12
Some taxpayers could avoid the capital gains tax altogether.13 Married taxpayers with taxable income under $68,000 ($34,000 for single filers) pay no tax on capital gains. After adding in a standard deduction of $11,400 and a personal exemption of $7,300 ($3,650 for each), a married couple could have as much as $86,700 of taxable income but pay no tax on capital gains (capital gains recognized will count toward the income limitation).14
Municipal bonds — The tax-equivalent yield of municipal bonds will increase as the income tax rates do. For someone in the current top tax rate of 35 percent, a municipal bond paying 3 percent will have a tax-equivalent yield of 4.6 percent. If the top tax rates increase to 39.6 percent next year, as it is now scheduled to, the tax-equivalent yield of that same bond will increase to 4.97 percent. If tax rates continue to increase and rise to 50 percent, the tax-equivalent yield of that same investment jumps to 6 percent.
Tax-efficient mutual funds — Tax-efficient mutual funds with an increased buy-and-hold strategy will become more attractive in a rising tax environment. Each year mutual funds will pass short-term gains (taxed at ordinary income rates) and long-term gains to the mutual fund investors. With the tax rates increasing for ordinary income and capital gains, mutual fund owners will likely pay more in taxes. Some may even have to liquidate mutual fund assets to pay the resulting tax liability. Managers of tax-efficient mutual funds will look to reduce short-term gains by minimizing the turnover of the funds underlying investments, invest in stocks that pay qualifying dividends, delay recognition of gains and take advantage of other tax hedging strategies.
Growth oriented stock and mutual funds — For the past several years, dividend-paying stocks have looked very attractive because qualifying dividends were taxed at the same 15 percent rate as capital gains. If the tax cuts passed in 2001 and 2003 expire, dividends will be taxed at the higher ordinary income tax rates in effect at that time. Preferred stocks may also become less attractive if these tax cuts expire. Unlike common shares in which businesses could choose to change their dividend structure to reflect changes in the tax regime, preferred shares are typically inflexible in their payment of dividends. As a result, we could see a shift from preferred stock, dividend-paying common stocks and mutual funds to growth-oriented stocks and mutual funds.
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 more 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. For someone already in the 35 percent tax bracket, a $10,000 contribution will save the taxpayer $3,500 in income taxes. Next year, when the top tax rate is 39.6 percent, a $10,000 contribution will save the taxpayer $3,960, or $460 more. If tax rates increase to 50 percent, the same tax-deductible contribution will be worth $5,000 in tax savings. 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. A Roth conversion will also help tax diversify a retirement portfolio. Retirees will have an account that will grow tax-free and will be immune to whatever tax environment they retire into. 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. With many wills and trusts written assuming that an estate tax will exist and with distributions being paid to the survivor's spouse and other heirs pursuant to formula clause, a year with no estate tax could actually have the unintended result of everything being transferred either to a bypass trust or a spouse and nothing to another beneficiary. The current uncertainty of estate taxes would suggest that wealthy 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,15 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.
These transfers are especially valuable if a taxpayer can gift depreciated assets. Due to all of the events in the market over the last two years, many clients are holding assets that are worth far less than they used to be. Using the gift strategies outlined above, by gifting those assets that have depreciated but are still above their cost basis, a taxpayer can remove all future appreciation of the assets from their estate. For those assets that are currently below their cost basis, the taxpayer may consider selling the assets to take a capital loss and then gifting the cash proceeds to the beneficiary. Beneficiaries are generally not able to take a capital loss for a gifted asset.
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.16 That means a married couple could transfer $130,000 into a 529 plan for each child and pay no gift tax. Finally, wealthy 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 otherwise reduce or affect their annual gift exclusion amount.17
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”),18 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 March 2010 was 3.23 percent.19 By comparison, in March 2000 the hurdle rate was 8.12 percent. Since 1989, there have been only 11 months that have had lower hurdle rates than today.20 Advisors who anticipate a rising interest rate environment may want to evaluate implementing a GRAT strategy while interest rates are at historic lows.
For a GRAT to successfully complete an intra-family transfer the grantor must survive through the end of the trust's term. Under current law this term can be as short as two years; many estate plans include a series of rolling two-year GRATs to minimize the risk of the grantor dying during the term. Financial planners in the current low interest rate environment will need to balance the longevity risk and flexibility of a short GRAT term against the desire to lock in historically low rates by using a longer-term GRAT.
Congress is currently considering legislation that would significantly impact the GRAT strategy. For more information, see Wealth Watch E-letters, “A Last Bite at the GRAT Apple?” and “Transfer Opportunities in Advance of GRAT Legislative Change“ on the Trusts & Estates website, www.trustsandestates.com. 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.
- H.R. 4154.
- Section 901, Economic Growth Tax Relief Reconciliation Act of 2001.
- Section 107, Jobs and Growth Tax Relief Reconciliation Act of 2003.
- Section 9015, H.R. 3590, Patient Protection and Affordable Care Act.
- Section 1402, Health Care and Education Reconciliation Act.
- Section 10906, H.R. 3590, Patient Protection and Affordable Care Act.
- Revenue Procedure 2009-50.
- 111TH Congress 2D Session S. Con. Res. 60, http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111_cong_bills&docid=f:sc60pcs.txt.pdf.
- Statutory Pay-As-You-Go Act of 2010, Public Law 111-139.
- Peter Cohn, “Dividend Rate Increase Is Looming,” National Journal, March 23, 2010.
- Internal Revenue Code Section 402(e)(4).
- IRC Section 1(h).
- Rev. Proc. 2009-50.
- IRC Section 529(c)(2)(b).
- IRC Section 2503(e).
- IRC Section 2702(a)(2)(B).
- Revenue Ruling 2010-6.
- Historical Revenue Rulings, www.irs.gov.
Brandon Buckingham, far left, is an advanced planning attorney and Michael Leaser is a special markets advisor in the special markets department at John Hancock in Boston