With tax season now in full swing, you may well be looking for opportunities to convert clients’ and prospects’ heightened awareness of current or potential tax liabilities to solutions that will help them attain their financial goals.
You’re not alone. Many life insurance and financial service professionals, observers tell NUL, generate substantial business from planning opportunities stemming from tax issues. Tax avoidance is an especially rich topic this year because of the recently enacted American Taxpayer Relief Act of 2012, which ended the long-running sunset provisions on certain levies while boosting tax rates that will most impact the high net worth, though individuals in lower tax brackets may also be affected.
But as the 2013 tax year is already underway, advisors can do little to affect clients’ 2012 year tax liabilities, apart from serving in “reactive mode,” observes Richard Shakter, a CFP and principal of Financial Compass Group LLC, Wellesley, Mass. The scope of work includes, for example, reviewing documents to ensure the accuracy of items reported on this year’s IRS 1040 form and determining whether tax-deductible items have been overlooked. Among them: income-producing investments that clients may have forgotten about; appreciated stock gifted to charities; debt service (interest deductions) and employee benefits (medical deductions) items.
The main business opportunities, say experts, lie in leveraging tax season to help clients plan for next year’s tax filing.
“The income tax return is an inventory of all of a client’s assets—everything one own gets reported there,” say Herbert Daroff, a CFP and principal of Baystate Financial Services, Boston, Mass. “So it’s a good idea to review the document line by line with the client in advance of tax season. As clients are thinking about paying income taxes, now is a wonderful time to tell them, ‘As you prepare for your 2012 tax filings, let’s see how we can help you reduce your 2013 tax liability.”
See also: 8 annuity tax facts you need to know
And, he adds, it’s a good time to identify gaps in insurance coverage. A review of interest rates and the durations of client debts, may, for example, point up the need for additional life insurance, disability income insurance or long-term care insurance to cover outstanding liabilities in the event of a loss of income.
Leveraging such tax deductions to minimize one’s tax liability is good thing. The same cannot be said of tax refunds, which constitute interest-free loans to the government, money that would be better deployed elsewhere. The objective, says Daroff, should to be to maximize net income and assets after taxes, inflation and fees, then decide how to best to allocate the net after-tax income and assets.
2012 tax legislation
From an estate planning perspective, observers say, The American Taxpayers Relief Act of 2012 is a double-edged sword. Since the legislation provides significantly higher estate tax exemption levels than under the pre-2001 estate tax regime — $5 million per individual under the act versus $1 million per person under the old regime — fewer clients need life insurance to pay for estate tax. Conversely, clients looking to boost their legacy to heirs may be able to purchase additional life insurance without crossing over the estate planning threshold.
“Most Americans can now buy their life insurance with tax-deductible dollars inside qualified plans and not worry about estate tax inclusion of the death benefits,” says Daroff. “If I have a $2 million estate and want to buy life $2 million of life insurance, I’m still under $5 million. So why not buy life insurance through a qualified plan?”
Daroff adds the higher estate tax exemption levels under the Relief Act should also make certain trust planning vehicles more attractive to clients for income replacement purposes. Case in point: married couples reducing the value of their estates while retaining control of income for life by establishing a cross-spousal lifetime access trust.
To illustrate, a husband and wife can each creates a SLAT valued at $10 million ($5 million in assets plus $5 million in life insurance) for the benefit of the other. While alive, the couple generates income from the aggregate $10 million in non-insurance assets placed in the two trusts. At the death of the first spouse, $5 million in policy proceeds are paid to the surviving spouse, thereby replacing income no longer being generated from the trust established for the deceased.
The SLAT is available not only to married couples, notes Daroff. Individuals that don’t qualify for the federal marital deduction—co-habiting gays, lesbians and heterosexual couples, as well as resident aliens—can also leverage a SLAT to care for a domestic partner.
The higher tax rates on income, capital gains and dividends stipulated under the Taxpayer Relief Act, say experts, should also spur tax planning among singles and married couples earning more in annual income than $400,000 and $450,000, respectively. Those looking to defer income tax will have an even greater incentive than in past years to leverage the tax-favored treatment of life insurance and annuities.
These vehicles, market-watchers suggest, will also be more attractive to clients who in past years might have foregone tax-deferred vehicles. The reason: It was less costly to pay capital gains or dividends tax on the sale of securities than to pay income tax at the time of distribution on a life insurance policy or annuity.
“When capital gains and dividends taxes were lower, income tax deferral actually worked against the use of life insurance and annuities,” says Terry Altman, a CFP and financial planner at Global Financial Planning Group LLC, Troy, Mich. Financial professionals who invoked income tax deferral as a reason to recommend annuities or life insurance would lose an argument with a CPA opposed to these products — and justifiably so — because income tax deferral was not in the client’s best interest.
“It’s conceivable that going forward, income tax deferral may be as attractive as it was in the 1980s or 1990s because of the rise in income tax rates,” he adds.
The case for tax-deferral offered through non-qualified deferred compensation plans funded with life insurance is particularly strong in client engagements involving C-corporations, says Altman, because of the “brutally high” taxes these companies might be subject to absent the planning. He adds Internal Revenue Code Section 409A, finalized in 2009, has eased non-qualified deferred comp planning by clarifying rules regarding the timing of deferrals and distributions.
Market-watchers also anticipate greater leveraging of income tax-deferred vehicles for individual planning, and not only in respect to life insurance and annuities. Also likely to attract greater interest are tax-qualified individuals retirement accounts, including 401(k), 403(b) and other ERISA-compliant profit-sharing plans, plus traditional IRAs and Roth IRAs.