Volume 8, Issue 5
The Wealth Counselor
Income Tax Planning: What Estate Planners Need to Know
The American Taxpayer Relief Act of 2012 (which became law on January 2, 2013) made permanent the temporary estate/gift/generation-skipping transfer tax exemptions established in December 2010, increased the rate on non-exempt estates/gifts/generation-skipping transfers to 40% and introduced substantial new income tax burdens on high income taxpayers and trusts. In addition, 2013 is the year in which both of the Medicare surtaxes of the Patient Protection and Affordable Care Act of 2010 (sometimes referred to as “Obamacare”) kick in. As a result, many wealth planning professionals will be doing more income tax planning, and estate tax planning will become less of a driving force.
In this edition of The Wealth Counselor, we will examine some of the new income tax provisions clients will face in 2013 and beyond and potential planning opportunities that remain in light of these provisions, as well as some different ideas to consider.
Classic Income Tax Planning
* Maximize deductions
With these new tax laws, some review and new approaches will need to be considered for non-grantor trusts and high income taxpayers.
* For high income taxpayers, the new tax law takes away part of each deduction. Up to 80% of a deduction can thus be eroded. This can make the timing of when to take deductions especially important.
Adjusted Gross Income (AGI) Is Key
Individual Income Tax Rates
Planning Tip: There are different thresholds for head of household and married filing separately taxpayers.
Capital Gain and Dividend Rates
Planning Tip: As with the income tax rates, there are different capital gains and dividend tax thresholds for unmarried head of household and married filing separately taxpayers.
Planning Tip: The increase in the top capital gain and dividend tax rate from 15% to 20% is a 5% increase in the tax rate, but results in a 33% increase in the amount of the tax. Adding in the 3.8% Medicare surtax bumps the combined tax rate to 23.8%. That is an 8.8% increase in the tax rate and a 59% increase in the amount of the tax.
Itemized Deductions Phase Out
NOTE: Mortgage interest and charitable deductions are included in the phase out.
Planning Tip: As with the income, capital gains, and dividend tax rates, there are different phase-out thresholds for unmarried head of household and married filing separately taxpayers.
Planning Tip: The timing of the deduction now becomes more important for the high income taxpayer. A client may want to delay a substantial charitable gift to a year in which his AGI is lower in order to fully utilize the deduction.
Planning Tip: The itemized deduction phase out makes the direct IRA to charity transfer doubly important to eligible (i.e., over 70.5) high income taxpayers. Amounts so transferred do not increase AGI and are not subject to the itemized deduction phase-out.
Medical Expense Deduction Floor Increase
Phase Out of Personal Exemptions
Planning Tip: There are different thresholds and phase-out rates for unmarried head of household and married filing separately taxpayers.
Medicare Surtax on Investment Income
Planning Tip: Previously, investment (also called “passive”) income was taxed at a lower rate than earned or “active” income and could be offset against deductions on real estate. Examples of passive income would include payouts to a participant in an LLC who is not involved in management or to a former business owner who is now in a limited partner role.
Medicare Earned Income Surtax
Summary of Major Tax Rate and Deduction Changes for Ordinary Income
Planning Tip: Remember that state and local income taxes are in addition to the federal income tax. These taxes, which can exceed 11%, are also subject to the itemized deduction phase out.
Planning Tip: Income tax planning does not focus on the client’s average tax rate, which is the cumulative effect of the various tax brackets and the combined deductions and credits. Tax planners look at the client’s highest marginal rate. Deductions that can be taken and income that can be deferred/offset/eliminated saves at the marginal rate. A lot of people think they are in a lower tax bracket than they actually are and are surprised to learn their marginal tax rate.
Summary of Tax Rates on Investment Income
Income Tax Minimization Strategies for Non-Estate Tax Clients
* Annuities remain attractive for the right client in this environment. A 70-year-old client with a 16-year life expectancy can place $1 million into a single premium immediate annuity (SPIA) and receive about $70,000 a year in guaranteed cash flow. A good amount of this annuity’s cash flow income is tax-free because it is a return of the client’s own capital. For the rest, the income tax on the growth inside the annuity is deferred to the year in which the distribution is received, which can be after the client’s retirement. An annuity can be coupled with a life insurance contract held in an irrevocable life insurance trust to provide for the family in the event the client becomes incapacitated or does not live long enough to collect the full annuity payments.
* The Alaska Community Property Trust provides a way for married taxpayers resident in any of the non-community-property states to get the double stepped-up basis on the first death that was formerly available only to residents of the 9 community property states. An Alaska community property trust can save a married couple a considerable amount in capital gain taxes. The right type of client for an Alaska community property trust has assets with high value and low basis and is in a long-term stable marriage.
* Family income shifting through family entities. This was mentioned earlier in the classic strategies. If the client has enough money to live on, he can hire a family member to manage the assets in a family entity and shift income to someone in a lower tax bracket.
* Installment sales of real estate and business assets or entities. Instead of taking a lump sum payout and increasing AGI greatly for one year, taking the payout over time will help to keep AGI at more reasonable levels.
* Tax-free cash value and guaranteed growth of life insurance held in an accessible grantor retirement trust. Because growth in a life insurance policy is tax free if the policy is held to maturity and policy cash value growth is subject to a guarantee, life insurance is more and more often thought of as an asset class.
* Remove or reduce IRA and 401(k) assets from owner and beneficiary income taxes. Eventually someone will have to pay the taxes on these tax-deferred assets, and the beneficiary may be in a higher tax bracket than the owner. Also, often the smallest tax to pay is the soonest tax to pay and instead of continuing to put money in, some clients may be better off to pay the taxes now and take money out or, better still, convert the account to a Roth.
Planning Tip: Use IRA annuitization combined with an ILIT. The client can buy a single premium annuity within an IRA (it’s part of the investment, not a distribution). The annuity then provides a guaranteed cash flow stream that can be distributed and used to make gifts to an ILIT to pay life insurance policy premiums. This can result in paying the least amount of income taxes and providing a greater benefit, especially in the case of the premature death of the insured.
Planning Tip: Use a retirement trust for maximum IRA stretch out over the beneficiary’s lifetime to save income taxes. Ideal is a beneficiary with the least amount of income (lowest tax rate) and longest life expectancy.
* Potential IRA/401(k) Roth conversions. Start timing these conversions to start sooner rather than later. Remember, it is better to pay a little tax now to avoid a larger tax later.
* Intra-family loans and sales. Money can be loaned or property sold for an installment note with 3 – 9 year rates as low as 1% in May 2013 (1.2% Section 7520 rate). This makes now an ideal time for intra-family loans and sales.
Planning Tip: Loans can go the other direction as well. A child with substantial income can loan money to a parent at the applicable federal rate instead of investing it, thereby lowering the child’s income tax rate.
Business Tax Extensions (Opportunities)
Also, there is a 100% exclusion for capital gain from sale of qualified small business stock extended for stock acquired before January 1, 2014, if the stock was owned longer than five years. (The AMT preference rules also do not apply.)
* Grantor trusts still avoid estate tax, including intentionally defective grantor trusts (IDGTs) and irrevocable life insurance trusts (ILITs).
Law Offices of J.R. Hastings • 1003 Third Street, San Rafael, California 94901 • 415-450-6692