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Financial Planning > Tax Planning

Preparing for the Coming Tax Increases

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Throughout its history, the U.S. economy has experienced periods of strain and weakness. Although the most recent crisis that provided such massive downward movement has subsided, plenty of questions remain as to what the future holds. Until recently, equity markets had recovered at an impressive rate, though many observers wondered whether we had come too far too fast. Some economic indicators show promise on the horizon, while other factors point to challenging times ahead.

One clear factor that points to challenges is the size of the federal deficit, which has increasingly become a bone of contention among economists. Many commentators assert that the inability to reduce the deficit may derail the recovery that investors believe is well underway. So what is the solution that economists most commonly recommend for reducing the deficit? Curtail government spending and increase government revenue.

As of this moment, the reduction of government spending appears to be next to impossible; programs intended to stimulate economic activity and weather periods of heightened unemployment will be a significant drain against government coffers. Because increased government spending seems likely to continue into the foreseeable future, the remaining option would be to increase government revenues. How can the federal government increase the amount of revenue? The answer to this question is simple: raise current taxes and/or institute new ones.

Taxes are bound to go up for your high-net-worth clients
With the Bush tax cuts set to expire at year-end and recent legislation enacted with a goal of paying for social programs, it is easy to forecast the direction of your high-net worth clients’ marginal tax rates. The current administration has its eyes on these individuals as a potential source of additional tax revenue. In fact, many of your clients who would not be defined as wealthy will see an increase in the amount of taxes owed. Those who earn more than $250,000 per year, for example, will likely be faced with a notable uptick in their marginal ordinary income, as well as in capital gains, rates.

The Patient Protection and Affordable Care Act
Though your high-net-worth clients may be sharply focused on what will happen when the tax cuts expire, as mentioned above, they must also stay alert to legislation that includes new or increased taxes. One example is The Patient Protection and Affordable Care Act (PPACA), or health care reform, which includes provisions to pay for the mounting costs of health care in the U.S. and social programs, including health care, supported by the federal government.

Politicians can debate whether PPACA is the answer to our health care issues, but the bottom line for wealth managers is the impact that this legislation will have on their clients. One PPACA provision, for example, which takes effect on January 1, 2013, levies a 3.8% surtax on the lesser of net investment income or the excess of a client’s modified adjusted gross income (MAGI) above $250,000 for married taxpayers filing jointly ($200,000 for individual filers).

A few safe havens from the new surtax are available. For example, distributions from IRAs and qualified plans are not subject to it. But investment income, including interest, dividends, capital gains, nonqualified annuity distributions, rents (if passive income), and royalties, is.

As you can see, the surtax is wide-reaching. If left unmodified, it is sure to affect your clients’ investment strategy. Coupled with the expiration of current tax rates, it could lead to a federal marginal income tax rate of 43.4% for your highest-earning clients.

What can you do to prepare?
Implementing a strategy to mitigate the impact of the surtax won’t be easy because your high-income clients most likely already follow the steps you would advise them to take. One solution would be to maximize the amount of earnings they can contribute to qualified plans and IRAs, as distributions from these accounts won’t be subject to the surtax. But because your high-net-worth clients are most likely already contributing the federal maximum to these plans to reduce current AGI, this opportunity is not available to most of them.

One option for those who already contribute the maximum amount to their qualified plans would be a Roth conversion of IRA balances. Your clients could pay tax on the converted amount at today’s lower marginal rate while building an account from which future distributions would not be included in MAGI.

Another strategy that has and should continue to hold appeal for high-income earners–even in light of new legislation–involves accumulating wealth within a permanent life insurance policy. Cash value within the policy grows tax-deferred, and distributions from the cash value can be taken tax-free in the form of policy loans or the return of basis. Even prior to the introduction of the surtax, accumulating cash value within a life insurance policy has been popular with high-income clients as a tax-efficient way to save for retirement beyond the federal contribution limits available in their employer retirement plans.

The federal deficit presents looming problems for our economy, and the government sees high-net worth and high-earning clients as sources of revenue for helping to solve our debt problems. Stay alert to the changes that come from Capitol Hill and help your clients best position themselves to continue their financial success and security.

Gavin Morrissey is the director of advanced planning at Commonwealth Financial Network, Member FINRA/SIPC, a registered investment adviser, in San Diego, California. He can be reached at [email protected].


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