More On Tax Planningfrom The Advisor's Professional Library
- Cafeteria Plans The income tax treatment of cafeteria plans is key to their popularity. Learn how to maximize the tax benefits of these “flexible benefit plans”.
- Annuities: Estate Tax The value of certain types of annuities may be included in an estate’s value. Understanding the intricacies of these inclusions is a critically important aspect of estate planning.
The fierce Congressional floor debate over extending expiring Bush tax cuts except for the nation’s top two percent of wage earners was postponed in September. But forward-thinking financial advisors have wasted no time all year long implementing strategies to protect their affluent clients’ wealth. The tax cuts, enacted by the Republican Congress in 2001 and 2003, are due to lapse on Dec. 31, 2010. The fall floor debate was pushed back till after the November elections, signaling the possibility of a compromise.
In a changing tax landscape for families earning $250,000 or more, and individuals with at least $200,000 in annual income, expiration of the cuts would mean higher personal income tax (top bracket rising from 35 percent to 39.6 percent) and increased capital gains tax. Plus, come Jan. 1, 2011, the estate tax makes a comeback — after a year without any.
But that’s not all: A number of other tax-relief provisions already expired on Dec. 31, 2009. That’ll be a surprise to most taxpayers when they hunker down to file this year’s return. These scheduled hikes, for everyone, are already in law and include numerous increases on businesses — with small business expensing chopped too. Further, charitable contributions made directly from IRAs will no longer be permitted.
The tax shake-up is widespread and significant.
“All these changes are going to impact investors, small and large, across the board — business owners, retirees. It’s broader in scope than anything we’ve seen before. You name an area, it will be impacted — from capital gains to retirement cash flow,” says Susan Hartman, tax and estate planning consultant at Raymond James, based in St. Petersburg, Fla.
For financial advisors, it is critical to map out and apply investing techniques that safeguard client assets by minimizing liability while, of course, maximizing returns. If FAs don’t get busy taxwise, it could put their advisor-client relationships at risk, Hartman notes.
For starters, according to John E. Ledford, whose practice, Ledford Financial, boasts 13 CPA sub-advisors, FAs “should have a big conversation with clients about mindset. Give them a dose of reality that taxes are going up and that they need to start planning appropriately. You need to build some basis in the tax conversation rather than just jump into a strategic change,” says the certified financial planner, based in Orlando, and affiliated with Commonwealth Financial Network.
But above all, both advisors and clients must focus first on the investment — second, on tax ramifications.
“Don’t let the tax tail wag the investment dog,” says Denver Gilliand, a Merrill Lynch private wealth advisor who heads The Gilliand Group, in Minneapolis. He holds both a law degree and a degree in tax law. “Taxes are going to take a percentage of investment depreciation, so you still need to have a good underlying investment plan that will produce positive returns. Then you want to ask: What are the tax implications of that plan?”
It isn’t only the most affluent investors who should be concerned about tax hikes. Clients below the top income level sooner or later won’t be spared either. Therefore, for those not participating fully in their 401(k) plans, now is the time to do so. Another tack: Convert from a traditional IRA to a tax-deferred Roth IRA.
“What has been talked about is rising income taxes on the highest brackets; but it’s possible that, in time, tax rates could be increased on lower income earners as well,” says Gilliand. “Whenever you have higher income taxes looming, the strategy is to either offset the timing of the receipt of income or use deferred tax techniques. That’s what we’re doing with our clients.”
The strategy of shifting more income into 2010 rather than receiving it in 2011 will be widely employed. But in some cases, the smart approach is the exact opposite.
Former IRS auditor Garth Terlizzi, an independent advisor whose firm, GET Financial Services, in Lawrence, Kan., is affiliated with LPL Financial, says that for a number of clients, he’s “accelerating some income this year into a lower tax bracket to reduce income next year.”
Ledford, however, warns that in recommending pushing more income into 2010, some clients “might look at you like you have nine heads. They get a bit leery when you advise things that have a radically different curve than what they’ve had in the past.” That’s precisely why he has prepared clients upfront with that “mindset conversation.”
Likewise, Tom Sedoric, managing director-investments, The Sedoric Group of Wells Fargo Advisors, in Portsmouth, N.H., launched a “drip campaign” as far back as last April recommending that clients see him for a proactive tax-planning session. Nowadays, he says, “you need to be ahead of the curve and protect clients not just from market risk but from policy issues. That type of risk management is part of our job today. Soon, tax planning will be as important, if not more important, as some of the work that [FAs typically] do.”
Sedoric continues: “When it comes to investing and taxes, the thing to remember is flexibility. You don’t know what Congress may do five or 10 years down the road. When you’re 75 and the tax code is different from today, you want flexibility — and that’s what we’re building into everyone’s situation going forward.”
Sedoric, for one, isn’t convinced that tax-deferred investments are a good way to go right now. “Many people utilize them, only to find themselves in a higher tax bracket,” he cautions.
This year, the estate tax is nonexistent. Next year, it returns, with an anticipated 55 percent top rate on estates of $1 million or more. Terlizzi, though, predicts that the “death tax” will stay at the 2009 level, when taxable estates were those only “over $3.5 million.”
With the estate tax here again, Merrill’s Gilliand recommends creation, for certain clients, of a GRAT (grantor retained annuity trust). It allows investors to transfer wealth and remove appreciation from their estate.
But since the future of the estate tax is chiefly a question mark, Ledford advises clients to draft “very flexible” documents. “We want them to be able to take full advantage of all available exemptions,” he says.
As a result of expected tax hikes, some clients will probably show renewed interest in establishing charitable remainder trusts, which, in recent years, because of lower taxes and reduced capital gains rates, were largely ignored. “I think we’re going to see those coming back into play much more significantly for investors who want the advantages of leveraging an asset,” Ledford says.
As for higher capital gains taxes, Terlizzi is counseling clients who expect capital gains in the near future to take them now.
Ledford concurs. “If there’s an opportunity to sell an asset in 2010, we’re encouraging those sales to happen. And if there’s an opportunity to utilize embedded losses, we’re trying to push that — to offset gains — into 2011 to get a [bigger] bang for the buck.”
With impending higher taxes, now is the perfect time to set up retirement plans and zero in on retirement planning strategies. Certain clients might do well to start funding a defined benefit plan before the end of the year. Such plans are advantageous to small business owners and even salaried individuals who have high-income-producing sidelines, like consulting practices.
“The defined benefit plan can be a much better fit for these clients tax-wise because it allows a larger contribution. They get a higher deduction. It comes off the top dollar of total income too,” says Terlizzi, who specializes in setting up the age-based plans. “Owners can put up to about $200,000 away, versus a defined contribution plan, where the most you can put away is about $22,000.”
He adds: “But there are rules. You must keep the plan for five years; then the IRS will accept the fact that it wasn’t set up as a one-year tax shelter.”
Other tax-efficient investments include exchange-traded funds and municipal bonds. “ETFs don’t [carry] the same tax burden as mutual funds because they have the benefit of not being commingled,” says Gilliand. “With a mutual fund, at the end of the year, gains are distributed across the board. So whether you’ve held the fund for a day or a year, you participate in the underlying fund’s taxes as opposed to your individual tax situation.”
Tax-free municipal bonds are “having a great year, and the dividend is very attractive,” according to Ledford. “As we go into 2011, muni bonds are going to become even more popular; we’re encouraging clients to invest in them.” For his part, however, Terlizzi counts current rates as too low “to get excited about.”
With a radically different tax tapestry, and steep phase-out of itemized deductions and personal exemptions on tap for next year, even Ryan Ellis, tax policy director of Americans for Tax Reform, in Washington, finds the scenario “counterintuitive and very weird. Up is down; down is up: it makes sense to accelerate income into this year and to also accelerate deductions because 2010 doesn’t have any phase-outs of itemized deductions at all,” he says.
Further unsettling news: In 2013, a 3.8 percent Medicare surtax on investment income is due to go into effect, says Raymond James’ Hartman. “One of the reasons, I believe, is to cover the cost of the program. It could [even] happen before 2013 — who knows?”
To give advisors a grounding in changing taxes, broker-dealers have distributed a whole host of materials for both FA and client use. Commonwealth, for instance, has sent out a comprehensive 10-bullet-point summary of areas to be impacted. Raymond James offers FAs live classroom instruction with real-world case studies. And last summer Merrill Lynch conducted a webcast, “Preparing for Higher Taxes,” with a panel of experts, including Bank of America president of global wealth and investment management Sallie Krawcheck.
“It’s uncommon to have this amount of uncertainty around tax laws all coming to a head at the same time, says Gilliand. “We’re looking at major changes within a short period.”
Adds Sedoric: “This is a very big deal. Tax planning used to be a part-time exercise done on April 10 and December 20. It can no longer be that way. You have to be proactive.”
That being the case, take note of ex-IRS auditor Terlizzi’s prediction: “I don’t think the tax situation will get any better. It can only get worse. In other words, I don’t see any big tax cuts coming through with the current administration.”