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Wanted: Smart Strategies for Wealthy’s Steeper Tax Landscape

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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. 

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

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.

“You contribute highly appreciated stock into the trust, which sells the stock; and there are no taxes on the gains. Then you reinvest the proceeds and end up earning money on funds that otherwise would have gone to the taxman,” Frankiel explains.

In contrast, with a charitable lead trust, the charity receives income upfront in the form of annual distributions. When the term of years is up, distributions are made to the family.

Another tax-avoidance strategy is income-shifting between grandparents and children, likewise between grandparents and grandkids.

With this approach, “instead of putting all the income on your return,” Keebler says, “you can spread it out over your children’s tax returns. For example, if you’re in a partnership and they own 80%, then 80% of the income would show up on their returns, not on yours.”

Of course, incorporating also can be a highly advantageous way to reduce taxes. “The tax rate on the first $50,000 is 15%,” Frankiel says. “And if you own your own business, there are special benefit provisions that were retained and extended [in ATRA], such as R&D credit.”

Converting a traditional individual retirement account to a Roth IRA should be given strong consideration too. This “applies to the ultra-wealthy,” Kern says, “because they’ve accumulated significant balances in 401(k) plans. But you must keep in mind:  (a) cash needed to pay taxes upfront and (b) expectations for your tax situation when you start taking distributions.”

Tax attorney Kaye A. Thomas, publisher of Fairmark Press and, both of which provide tax help, stresses that “even though the tax rate is now higher, a Roth conversion is still an attractive opportunity for someone to get income entirely tax-free.”

Further, ATRA has made the Roth more widely available since, for one, it permits folks to convert their 401(k) accounts “without leaving the company,” says Kaye, who is based in Elgin, Illinois.

Another option is investing in master limited partnerships. These are publicly traded limited partnerships; the most popular concern the storage and transfer of oil and natural gas.

“For upper-income taxpayers, there are certainly tax benefits to investing in qualifying MLPs as a source of income,” Kern says. “The investments are vulnerable to tax reform, though. But right now the income they generate is receiving favorable tax treatment.”

Adds Keebler: “There are still some good deals with oil and gas transactions, where you’re allowed an income tax deduction upfront. With the intangible drilling cost deduction, if you invest, say, $100, sometimes you can get an upfront deduction of $75 or $85.”

The 529 college-saving plan is one more type of investment that, for tax-planning purposes, now offers increased appeal.

Thomas puts it this way: “Because investment earnings are being taxed at higher rates, the consequences of not using a 529 are greater. That makes the potential savings greater than before.”

The plans, Frankiel concurs, appear ideal for gifting; still, he views them with some concern. “I know a lot of people who put money into 529 plans, and the investment performance lagged; so,” he says, “the purported benefits didn’t materialize.”

And therein lies an important principle: the potential performance of any tax-reducing investment should be considered first. “We need to focus on the bread and butter of making money and not let the tax tail wag the economic dog,” Frankiel warns.

Earlier this year, lots of dollars from income-oriented investors in the top tax bracket began flowing into both municipal bonds and municipal bond funds. However, Kern is not alone in voicing reservation about investing in munis as a tax-reducing strategy.

“Number one,” he says, “if interest rates go up dramatically down the road, municipal bonds won’t be immune from the impact. Two, a lot of municipalities are under extreme stress. Three, there’s speculation that the tax treatment of municipal bonds will change when the next round of tax changes comes in. I don’t see a major change, but it’s certainly a risk worth being aware of.”

Keebler bluntly calls ordinary-income-generating bonds “the worst type of investment you can make because they’re subject to the 39.6% tax and the 3.8% Medicare surtax. Paying a lot of income tax is the ‘price’ you pay for bonds.”

As for the tantalizing notion of setting up an offshore account to legally shelter income, Frankiel has this word to the wise: “Making more money off-shore than onshore and not having it taxed in the U.S. is wonderful, but the opportunities for that aren’t as great as they once were. Be aware that there are now extensive reporting requirements to the U.S. government that require a great deal of disclosure.”

Start Meeting

Right now, financial advisors should make haste to initiate meetings to present tax-reducing strategies to top-tax-bracket clients. Reviews of both financial plans and trusts are imperative. 

“You have to avoid trapping dollars in trusts,” Keebler cautions. “There’s need for a lot of tax planning to figure out how to minimize the income tax on trusts. This might mean more distributions out of trusts to beneficiaries.”

Moreover, because many investors created trusts with complicated provisions designed to protect against a less favorable tax code, taking a fresh look to see what can be eliminated is a good idea.

For example, “bypass trusts are no longer needed because the estate tax exemption is portable to a surviving spouse,” Kitces says, referring to ATRA’s “portability” rule that if the $5 million exemption isn’t taken when the first spouse dies, it can be transferred upon the death of the second spouse, for a total $10 million exemption. 

“Using a bypass trust can now be bad,” Kitces says, “because you’ll lose a step-up in basis when your spouse passes away. You want to have money in your name when you die because that’s how you get the income tax benefits from step-up basis. [So] transferring businesses into trusts outside the estate would be less popular too.”

To manage the new tax liability, efficient communication between FA and CPA, in team-like fashion, is a must.

“It’s very important that they talk,” Keebler notes, “because every strategy the FA puts into play is going to have an impact on both the estate side and the income tax side.”

Lack of such contact is “quite unfortunate,” Frankiel says. “Sometimes they can be working at odds with one another.”

That scenario is certainly to be avoided.

“The more the team works together toward a common set of goals,” Kern says, “the more likely the client will meet their goal.” 


Check out AdvisorOne’s special report home page: 20 Days of Tax Planning Advice for 2013.


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