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Expert foresees end-of-year rush to implement tax avoidance strategies

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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

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.

Also for the affluent to consider: The year-end expiration of the $5.1 million gift and estate exemptions. Absent Congressional action, the estate tax regime will revert to a $1 million applicable exclusion amount and a top tax rate of 55 percent (up from 35 percent currently), as existed before passage of the Economic Growth and Tax Relief Reconciliation Act of 2001.

Preparing for the changes

To help high net worth clients prepare for higher taxes on investment income in 2013, Friedman recommended that advisors counsel their clients to sell by year-end assets that have enjoyed gains, thereby locking in the still low long-term capital gains tax rate of 15 percent.

“I expect that we’ll see a lot of money in motion over the next couple of months,” he said. “I also think we’ll see a lot of volatility in the stock markets.”

Clients seeking to redeploy assets into more tax-efficient investment vehicles, he added, should consider tax-exempt municipal bonds, tax-deferred variable annuities and variable life insurance policies, as well tax-favored individual retirement accounts.

Clients should also consider executing an IRA-to-Roth IRA conversion. Because of the pending tax increases, said Friedman, clients are better off paying income tax on a conversion now rather than deferring distributions and paying a higher income tax rate later.

He noted, too, that individuals can undo a conversion until October of 2013. This option may prove useful in the event that Congress acts to reduce income tax rates.

Affluent clients should also take advantage of gifting opportunities. Even if Congress agrees to a permanent estate tax, clients likely won’t be able to give away next year as much as they can now without incurring gift tax.

Still favored among market-watchers is the $3.5 million individual exclusion amount and top tax rate of 45 percent, as existed in 2009. But Friedman thinks that Congress will more likely favor the pre-2001 gifting regime, which limited the lifetime exclusion amount to $1 million.

Don’t worry about claw-backs

Turning to so-called “claw-backs”—the taxation of gifts made in 2012 that exceed exclusion amounts instituted for 2013 or later years—Friedman said most observers believe this scenario is unlikely. But even if Congress were to claw back excess gifts into a client’s estate, taking advantage of the current $5 million gifting exemption still makes sense because the appreciation of gifts remain out of the estate.

“Assuming you give away $5 million this year and don’t die for another 20 years, and assuming also that $5 million gift appreciates in value to $20 million, then at most $4 million—and not $15 million—gets clawed back into the estate,” said Friedman. “All appreciation of assets remain out of the estate.”

Turning to prospects for investing in commodities, such as gold, silver or commodities-based exchange-traded funds, Friedman said these assets are not likely rise in value significantly next year because inflation remains low and because of a continuing “deleveraging” worldwide (i.e., the simultaneous reduction of debt levels in the private and government sectors).


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