A word to the wise: plan for the unexpected

The American Taxpayer Relief Act promulgated on January 2 ended, to its credit, sunset provisions established under Bush-era tax legislation affecting a host of taxes, among them levies on income, estates and charitable gifts. But given forthcoming Congressional battles over the federal budget, the debt ceiling and tax reform, advisors would be wise to build maximum flexibility into clients’ life insurance-funded financial plans, as the now “permanent” tax regime may not survive the next legislative tinkering with tax code.

That’s my take on the current state of affairs in Washington, a view reinforced while researching my feature this month on tax season, which starts on p. 38. Advisors I interviewed spoke repeatedly of continuing uncertainty among clients, including the high net worth and business owners, over the direction of the economy; and over Congressional efforts to trim federal ink by, for example, closing tax loopholes and so-called “tax expenditures:” revenue losses resulting from special tax benefits.

The uncertainty is evident in the huge cash horde that businesses, most notably large corporations, have amassed in recent years. Current estimates vary between $2.2 trillion (the Federal Reserve’s number) and $5 trillion (Compustat’s). Much of this build-up, to be sure, is held overseas by firms looking to avoid U.S. corporate taxes.

But the holdings also reflect a hesitancy to fund business objectives ranging from capital expenditures on new plant and equipment to recruiting, rewarding and retaining new employees with life insurance-funded non-qualified deferred comp plans.

A key issue preventing a greater flow in the cash spigot is the prospect of still higher income tax rates. Imagine that, as part a “grand bargain” with the White House, Congress were to boost the top marginal tax rate to, say, 50 percent from (under current law) 39.6 percent for individuals earning more than $400,000 annually. If taxes on dividends and long-term capital gains were to remain unchanged, then individuals may decide that investments in taxable mutual funds and stocks are more tax-efficient than tax-deferred vehicles like life insurance and annuities, as taxes paid now would be less than amounts paid later.

Life insurance would also be less attractive for cash accumulation purposes if, as part of a deal to reduce tax expenditures, Congress were to eliminate the tax-deferred treatment of cash values in permanent life insurance policies over a certain a face amount (say, $3.5 million). The negative impact on life sales would be particularly “dramatic” in cases involving sales of policies on the lives of children (e.g., to build a college fund), according to Richard Shakter, a financial planner and principal of Financial Compass Group LLC, Wellesley, Mass.