Beatle George Harrison was so burned up over the U.K.’s whopping 95% income tax rate the top-bracket Fab Four were paying that, in a fit of pique, he penned a song about it, “Taxman”:
“If you drive a car, I’ll tax the street/ If you try to sit, I’ll tax your seat/ If you get too cold, I’ll tax the heat/ If you take a walk, I’ll tax your feet.”
Super-affluent clients won’t be similarly distressed by increases the American Taxpayer Relief Act of 2012 (ATRA) has brought—provided financial advisors use smart strategies to shelter and protect their income and assets.
“The tax bill is pretty bad. For upper-end clients, there are going to be some transitions,” says Robert S. Keebler, CPA and partner, Keebler & Associates, a tax-advisory-CPA firm in Green Bay, Wis., specializing in family wealth transfer.
What Your Peers Are Reading
ATRA, passed by Congress late last year and effective in 2013, raises the federal tax rate by 4.6 percentage points to 39.6% on ordinary income above $400,000 ($450,000 for couples filing jointly).
The super-wealthy, many of whom receive income chiefly from investments, also take another hit: higher rates on long-term capital gains and qualified dividend rates, both of which went up from 15% to 20%. And now there’s also a 3.8% Medicare surtax on net investment income (the latter starts at a $200,000 income threshold).
Further, the act requires reduced itemized deductions and personal exemptions for taxpayers with income over $250,000.
Not since Jimmy Carter’s presidency have the very well-off been subject to such high tax liability. The increases are permanent. (It would probably take another huge crisis, like the fiscal cliff, to pressure Congress to rewrite the rules.)
The good news is that the formerly temporary estate tax exemption of $5 million per person and $5 million exemption for gifts to children and grandchildren during one’s life were made permanent, both exemptions indexed to inflation.
Many feared far steeper tax hikes.
“It could be worse. But it’s very clear that the new taxes are extremely unfriendly for the ultra-high net worth and somewhat unfriendly for people who have significant investment portfolios,” says Dan Kern, president of Advisor Partners, a Walnut Creek, Calif.-based investment advisory firm focused on helping FAs.
The less painful increases, however, are no reason for advisors to ignore the new tax code. Rather, now is the time to set in motion tax-efficient investment strategies for upper-end clients.
“It’s a new world because the tax system is now significantly more progressive, which means higher taxes for higher income individuals, particularly if a client’s net worth continues to rise. The value of proactive tax planning is therefore more valuable because the tax liability advisors are managing is higher,” says Michael Kitces, director of financial planning, Pinnacle Advisory Group, in Columbia, Md., and publisher of Kitces.com.
The key is to assiduously manage clients’ current investments and take the most sensible tax-reducing approaches in choosing new ones with good performance potential.
A basic decision: Where to domicile each investment.
Advisors and investors should “more carefully consider what types of investments are placed in tax-deferred accounts, taxable accounts and tax-free accounts to minimize tax and optimize growth opportunities,” says Gordon J. Bernhardt, president-CEO, Bernhardt Wealth Management, an RIA in McLean, Va.
For instance, investments generating ordinary taxable income that produce short-term gains, like taxable bonds, would best reside in a tax-deferred or tax-advantaged account, Kern notes. For an equity portfolio where long-term capital gains are expected, a taxable account is the more reasonable choice.
Obviously, it is now crucial to carefully monitor the income of very high net worth clients from year to year. This enables you to decide whether to defer income or to accelerate it.
Tax harvesting strategies are of greater interest because they capture capital losses to offset portfolio gains, typically using equities or ETFs to systematically generate tax losses.
For example, “if an advisor creates an index-oriented portfolio, a harvesting program will look at identifying stocks that are going down and sell them to generate a tax loss, which can be used to offset gains elsewhere,” Kern says. “You replace the stocks that were sold with stocks that have the same or similar economic impact—such as selling Chevron and replacing it with Exxon.”
Sheltering wage income using deferred benefit plans, profit-sharing plans or other deferred compensation is another excellent strategy.
“Pension plans are fabulous things now that tax rates are at 39.6%” for the ultra-wealthy. “If they stick money away and let it grow tax-free for 20 or 30 years, they’ve given themselves a great benefit,” says Steven Frankiel, a CPA in West Los Angeles.
Variable annuities are also notably effective in sheltering assets, particularly new, low-cost VAs designed specifically as tax-deferral vehicles, such as those offered by Symetra, and the flat-fee, tax-efficient VAs Jefferson National introduced earlier.
Life insurance is another good opportunity. In fact, though “annuities can be very powerful, life insurance can be superior if you’re earning a good living but your investment income is being chewed up by the tax system,” Keebler says.
He continues. “Whole life insurance is tax-sheltered; all the growth inside the policy isn’t subject to income tax. And when you die, you have forgiveness of the income. The beauty of an insurance trust is that you get the insurance out of your estate and all the income tax benefits.”
The new tax code’s permanent $5 million estate tax exemption will result in “a 95% decline in the number of people subject to federal estate taxes,” Kitces notes.
This means FAs should recommend dismantling clients’ old estate planning strategies that no longer apply or are inefficient.
Kitces forecasts a significant shift in estate planning.
“It’s going to be less about estate tax planning and more about actual estate planning: who gets your money and who controls it after you die,” he says. About 20 states, however, still impose a state-level tax, Kitces notes.
Better to Give
Lifetime gifting to heirs is a potent way for ultra-high net worth clients to reduce estate taxes.
“You can use the exemption to make substantial gifts during your life without paying taxes,” Keebler says. “All the growth would then be in your children’s estates.”
An array of special trusts can shelter income, thereby reducing tax bills. A charitable remainder trust, for instance, allows investors and their families to receive income upfront; later, distributions go to a favorite charity.