Just a year ago in an Investment Advisor cover story and follow-up (October 2006, “Eureka,” and November 2006 Wealth Advisor column, “Digging Deeper“), we described a strategic framework to determine the potential wealth management opportunities from clients’ tax returns. Information from tax returns, we said, could help you to better understand your clients and to help you provide appropriate investment solutions for them.
As we all know, taxes are not a one-time event. Like an annoying relative, they keep coming back year after year. But fortunately, unlike an annoying relative, taxes can be a good thing in at least this one way: they let you enhance your relationship with clients.
To accomplish this, it is important to keep up with the tax changes and their respective planning opportunities. This article will help you do just that, as well as suggest some planning opportunities for today’s market conditions and provide you with items to keep you “in the know” (i.e., noteworthy tax-related items that may be of interest to your business as they affect affluent individuals).
Wealth Enhancement Opportunities
We all know children can be taxing, especially teenagers. Unfortunately, beginning in 2008, they will be even more so, when the “kiddie tax” will be expanded to include children up to 19 (it had been 18) as well as dependent, full-time students up to age 24.
As you will recall, the purpose of the “kiddie tax” is to discourage people from transferring investments to a child just because they are in a lower tax bracket (i.e., shielding income from taxation). The kiddie tax consists of a series of rules that determine the tax on a child’s investment income. Here’s how it works: In 2007, the first $850 of a child’s investment income is tax free and the next $850 is taxed at his or her own rate. But any unearned income in excess of $1,700 in 2007 is taxed at the parents’ presumably higher tax rate. Please note that these limits are adjusted for inflation.
Why all the hubbub over this? Some people, perhaps your clients included, were holding off shifting assets, and having their children sell them from 2007 to 2008 when a 0% capital gains tax rate would apply to those in the two lowest-income-tax brackets.
However, if your clients have kids who are 18- to 23-years old by the end of the year, there is still time to act before January 1 and take advantage of the 5% rate on long-term capital gains available to taxpayers in the two-lowest brackets, versus being subject to their parents’ 15% (most likely) capital gains tax rate in 2008.
Now is the time to look through your book and your clients’ tax returns. Do you have clients with appreciated securities or perhaps concentrated positions (see Schedule D or Schedule B) and have children in this age range (on the front of the tax return)? Ask your clients if they are considering making a large purchase (i.e., a car) in the next year. Perhaps it would make sense to transfer the funding assets and sell before year-end. Do you have any accounts in the children’s names in that age bracket and do you have their tax returns? Look for Form 8615–”Tax for children under age 18 with investment income.” If the children have reached 10 years of age, should the assets be sold to pay, for example, future college tuition, in 2007, so that, upon sale, only 5% is subject to tax versus next year when it would be 15%? Also, clients who are grandparents and tend to gift would benefit from a discussion regarding acceleration of gifts.
Parents looking to save for college will find that saving money for the children’s education in their children’s own names is not tax effective. The benefits of saving through 529 plans will be even more powerful under the new tax changes. Remember, as long as the money is used for qualified college expenses, withdrawals from 529 plans are tax-free and avoid the kiddie tax issue altogether.
Since we are talking about 2008, you’ll want to keep this in mind as well: For plan distributions after December 31, 2007–from 403(b), 401(k), and 457(b) plans–participants will be able to directly roll over to Roth IRAs. The rollover is still subject to existing Roth conversion rules, which have a $100,000 modified adjusted gross income (MAGI) limitation (but the MAGI limitation is gone in 2010!). This is important because a direct Roth IRA rollover avoids the IRA aggregation rules, and may be advantageous for clients with substantial after-tax contributions in their employer plans. To see if a client has changed jobs recently, look on page two of the client’s Form 1040 under the taxes paid section or on Schedule A to see if that client had moving expenses.
Wealth Transfer/Charitable Giving
There was no major estate tax legislation this year and nothing is expected in the near future. The exemption amount remains at $2 million through 2008, while the planning philosophy remains the same–try to reduce the estate without incurring any gift tax.
Speaking of wealth transfer, there was no new legislation regarding charitable giving. However, there are still opportunities in 2007: Taxpayers over the age of 701?,,2 can donate up to $100,000 to charities directly from their IRA or Roth IRA accounts, due to last year’s Pension Protection Act (PPA). The benefit is that the donation will not be included in their taxable income and is considered part of a required minimum distribution (RMD). Look at your clients’ Form 1040, line 15 (2006) to see if they are they taking RMDs. Did they give to charity in 2006? Look at Schedule A to see if they are charitably inclined.
As we mentioned in our earlier article, this strategy may be quite attractive to residents of states with no state income tax (e.g., Florida, Texas, Nevada, and Washington) because relatively fewer taxpayers in those states itemize, having no state income tax to deduct from their federal tax. In addition, this may appeal to taxpayers who look to maximize their ability to claim income tax deductions due to the AGI 50% limitation. These rules do not affect other gifts to which the limitations apply.
Market Performance Opportunities
In any market, helping working children save for retirement is brilliant, but especially when assets can be transferred at a lower value. You may want to consider suggesting that your clients gift some of these assets to match working children or grandchildren’s earned income up to $4,000 to their Roth IRA. As the assets “snap back,” their retirement plans grow tax deferred.
If your clients are interested in reducing their estates in a more sophisticated manner, you may want to suggest a grantor retained annuity trust (GRAT). Given the recent market volatility, now may be a good time to introduce or reintroduce this concept to them. If you do not manage all their assets, look at Schedule D and perhaps Schedule B to uncover any assets whose value may have fallen and are expected to appreciate or assets in general anticipated to appreciate significantly.
Remember, a GRAT is an irrevocable trust that allows a portion of a client’s underlying asset’s appreciation to pass through to beneficiaries transfer-tax-free. During the term of the trust, the grantor (i.e., grandparent) receives an annuity payment, leaving any property remaining at the end of the term for the beneficiaries (i.e., grandchildren). Thus, if GRAT assets produce a return in excess of the Section 7520 rate at the time the trust was created, appreciation will be transferred. To avoid incurring any current gift tax, many people choose to “zero out” the GRAT–if the retained annuity’s actuarial value is approximately equal to the value of the property transferred.
This is a low-risk strategy for both you and your client because if stocks go up, the upside goes to their heirs, and the client still receives annuity payments. If stocks are flat or down: the client gets the stock back with minor transaction costs.
No Taxing Issues
It is more important than ever to show your clients that you add value to their entire wealth management situation. Although you may not be a tax specialist, with a little explanation of the items noted here, you should be able to uncover opportunities to build client relationships and your business.
Most people associate taxes with something being taken away from them–money! Differentiate yourself and show how effective tax management can give something back–sound strategies to help them manage and preserve their wealth.
Susan L. Hirshman, CFP, CPA, CFA, CLU, is a managing director for JPMorgan Asset Management in New York. In that position, she develops strategies to provide wealth solutions to the affluent market. She can be reached via e-mail at firstname.lastname@example.org.