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Financial Planning > Tax Planning

A word to the wise: plan for the unexpected

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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.

Shakter insists, however, that uncertainty over the direction of taxes should not prevent life insurance professionals from nudging clients out of self-induced paralysis. For whatever the future of the federal tax code, planning opportunities abound. In the estate planning arena, for example, non-tax-related trust planning may appeal to clients who want to make the distribution of trust assets contingent on heirs fulfilling certain objectives, such as obtaining a college education, marrying or having children.

Also, while individuals and couples with estates valued at less than $5 and $10 million, respectively, need not be concerned about federal estate tax, Shakter says they may need life insurance to cover state estate tax, which some 20 states decoupled from the federal tax in 2001. Shakter says advisors can also help optimize after-tax returns on investment portfolios and implement strategies to circumvent the alternative minimum tax or AMT.

Anticipating higher income tax brackets, more individuals may also want to shift retirement savings from traditional individual retirement accounts to Roth IRAs. As Baystate Financial Services Principal Herbert Daroff points out in my April feature, these individuals can also purchase life insurance to pay for the income tax on a Roth conversion at death, thereby increasing the legacy for surviving heirs.

“There may be value in keeping the [cash] powder dry in anticipation of a future planning opportunity,” he says. “We’ve advised some of clients who are doctors to maintain the cash build-up until the time is ripe for spending on business expansion needs, such as opening a surgery center.”

Irrespective of the financial objective, this much is clear: Advisors need to flexibly structure planning recommendations so they can later be adjusted to accommodate a changed economic and tax environment or revamped personal goals. Only then can clients rest easy in the knowledge that their financial futures are assured.


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