They call them experts for a reason. While tax changes are freaking out the average Joe, many advisors are calmly going about their business, lessening the tax burden on wealthy and high-net-worth clients. Strategies that were in place long in advance of the election, the fiscal cliff and the sequester are ticking along despite market booms and busts and worries over what might happen tomorrow. We spoke with a number of them who were willing to share their best and most effective tactics in protecting client assets as they grow.
Trusts are feeling the effects of tax law changes more than other planning stratagems. Martin Shenkman of Martin M. Shenkman PC in Paramus, N.J., said that trustees of non-grantor trusts may need to consider gathering information on trust beneficiaries to determine tax consequences of distributions from the trust. “Bear in mind that trusts face a very compressed tax rate structure so that a trust will bear the maximum income tax rate and the 3.8% Medicare tax on about $12,000 of income,” Shenkman explained. “If beneficiaries are in lower brackets, they may demand distributions justifying those demands by the tax savings.”
However, there’s considerably more to it than that. “Income tax status information on the beneficiaries, including federal tax bracket, adjusted gross income to ascertain the impact of a distribution, state of residence to ascertain state income tax consequences, and more” may be required to determine whether distributions are warranted, and if so, to whom—particularly if one beneficiary is in a substantially lower tax bracket than others. Some of the other factors that must be considered include everything from the detailed terms of the trust to its investment policy statement and the Prudent Investor Act in the state whose laws govern the trust.
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Bypass trusts may have been abandoned in some estate plans in the wake of the American Taxpayer Relief Act of 2012 (ATRA), with “some clients [… opting] for outright bequests or marital trusts so that the assets bequeathed will be included in the taxable estate of the surviving spouse to receive a step up in income tax basis on the second spouse’s death,” Shenkman said. “In contrast to the past, these clients will likely rely on portability to avoid federal estate tax on the death of the second spouse.”
However, he pointed out, “Those opting for non-trust ‘simple’ distribution plans will expose assets to creditors, remarriage and other risks that could prove more devastating than the estate or income tax.”
When all is said and done, changes in the tax laws will necessitate rethinking on trusts. “It might have been best in the past to pack equities into the bypass trust to maximize estate tax savings,” said Shenkman. However, “under the new paradigm it might make more sense to have 100% bonds invested in a bypass trust to limit the potential for growth in the bypass trust. Locating equities in the marital trust (or surviving spouse’s investments) should result in concentrating appreciation in the surviving spouse’s estate where those assets can qualify for a step up in basis. This is quite the opposite of what was typically done in the past.”
Shenkman concluded, “Investment planning and, in particular, asset location decisions have been affected by the new Medicare tax on passive income, the new relationship of income and estate tax, terms of the governing trust (which sometimes can be changed), the Prudent Investor Act and more.”
Strategic Investing 101
Some tax-efficient planning begins when investments are chosen. While it’s common to look at factors like equities versus bonds (more about that later), some parts of the puzzle are lesser known. Wealth manager Derek Tharp of Mote Wealth Management LLC in Cedar Rapids, Iowa, said that among the factors his firm considers is the tax cost ratio of a stock, since the lower the ratio, the less the asset’s value falls annually due to taxes.
Specific identification of shares also offers more flexibility, said Tharp, by allowing investors “to identify the shares that best accomplish their tax objectives. They could be identifying highly appreciated securities for charitable gifting, […] securities with large losses to tax loss harvest, or even […] securities with large gains to tax gain harvest if they felt it was appropriate.”
Asset Location, Location, Location
Tharp mentioned another strategy experts use: where to place a client’s assets. He explained: “Many advisors make a location determination based on either expected return or tax efficiency of a fund. However, research suggests that optimal location is actually determined by a combination of both tax efficiency and expected return.”
He pointed out that “when asset class returns are low, such as a bond fund,” where the asset is located has less effect on overall wealth accumulation than the location of an asset class with high returns. “This stresses the importance of placing high-return, low-efficiency asset classes in qualified accounts first.”
Planner Bobbie Munroe, owner of Fraser Financial in Atlanta, said of asset location, “It often surprises me when I work with new clients [that] all of their accounts hold exactly the same investments.” It may make an advisor’s job easier, she said, to “come up with a basic allocation and repeat it … [and w]hen it comes time to rebalance, all accounts may be rebalanced to the same percentages. But,” she added, “it is NOT tax efficient” [emphasis hers]. She suggested putting a client’s “riskiest investments”—those with the potential for the highest return, such as “tech, emerging markets or even high-yield bonds”—into Roths, where they can grow tax free.
Munroe added that while she does still use mutual funds, she does so largely within retirement accounts for dollar-cost averaging purposes. She prefers ETFs, which are usually more tax efficient than mutual funds thanks to their ability to do tax-free swaps.
An additional method of locating assets in a tax-efficient manner comes from Alan Clopine, CFO and director of tax planning for Pure Financial Advisors in San Diego. “We look at Roth conversion strategies in which our clients slowly move assets from IRAs/401(k)s to Roth IRAs,” said Clopine. “You don’t want to convert all of your assets to a Roth in one year because it will push you into too high of a tax bracket.”
Instead, he said, his firm maximizes clients’ current tax brackets, up to the 28% bracket, by converting to the top of that bracket. “The other tax brackets are often too expensive to justify a Roth conversion,” he added, “particularly considering the AMT.” The firm also considers a client’s expected tax bracket in retirement and “combine[s] several other tax deduction strategies to reduce taxable income, thereby increasing our Roth conversion recommendations.”
Mark Germain, founder and CEO of Beacon Wealth Management in Hackensack, N.J., pointed out that dividends coming out of a 401(k) account are “taxed at the current tax rate, not the capital gains rate” or any other rate. “So putting dividend payers into a 401(k) is not necessarily the best choice, because outside [of a 401(k)], the dividend is taxed at a lower rate.”