Whatever compromises President Obama and a divided Congress agree on to avert the pending fiscal cliff and reform the current loophole-ridden tax code, taxes on wealthy Americans are certain to rise next year. That means that life insurance and financial service professionals need to approach their clients before year-end about leveraging a host of tax-avoidance strategies.
So said, Andrew Friedman, principal of the Washington Update LLC, during a Nov. 8 webcast for the investment community hosted by Sammons Retirement Solutions. Because of likely increases in taxes to be paid on income, investments, estates and charitable gifts, he said, the high net worth would do well to take advantage of still low tax rates available through year-end.
“We know the tax rates this year are lower than they are likely to be next year, at least for affluent taxpayers” said Friedman. “So now is the time for you as advisors to be talking with clients.”
The approaching fiscal cliff
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Absent Congressional action, on Jan. 1, $2.1 trillion in spending cuts will automatically take effect, including $1 trillion in cuts from the Department of Defense budget. In tandem with this budget “sequestration,” said Friedman, tax cuts first enacted in 2001, then extended in 2003 under President George W. Bush, will expire.
“We have a perfect storm coming in December 2012,” said Friedman. “If Congress and the president can’t agree on a solution to address the fiscal cliff, then we can expect a 3.5 percent decline in GDP next year, a contraction that will throw us back into recession. This prospect should encourage Congress to get something done during what I’m calling the mother of all lame duck sessions.”
To avoid an economic downturn, said Friedman, Congress and the president will likely compromise on a deal that meets the Obama’s baseline requirement for avoiding a presidential veto: an increase in taxes on the wealthiest Americans. But the income threshold may be set at an amount above $250,000.
Friedman said the House Republicans’ preference—reforming the tax code in a “revenue-neutral” way that promotes economy growth and, thereby, increases tax-revenue—is a “non-starter” for Democrats. An alternative House Republicans might accept is to proceed with tax reform that produces additional revenue by closing tax loopholes, but that doesn’t increase tax rates on wealthy Americans.
A post-election statement by House Speaker John Boehner, R-Ohio, about the Republicans’ intentions could be interpreted to allow for either option, said Friedman.
“I believe that Speaker Boehner is stalling for time,” Friedman. “He [wants] the president to extend the Bush tax cuts for one more year, and then next year negotiate tax reform and a grand plan to fix the whole problem in 2013. The president might bite, but my gut reaction is that he’ll say ‘no,’”
Instead, he added, the president will likely insist that the tax cuts on high net worth individuals expire at the end of this year, then pursue tax reform that can garner bipartisan support in 2013.
Irrespective of the fate of the Bush tax cuts, said Friedman, taxes will rise on high income-earners next year under the Patient Protection and Affordable Care of 2010. Households who derive investment income from capital gains, dividends and interest of $250,000 or more will be subject to an additional 3.8 percent income tax.
Assuming the Bush tax cuts for these households expire, they’ll be paying an effective income tax rate of 44 percent, up from 35 percent currently. These income earners will also pay a capital gains tax of 24 percent, up from the current 15 percent, and a dividends tax approaching 44 percent, up from 15 percent.