Legislators were very busy New Year’s Eve and into the early morning hours of New Year’s Day to draft and ultimately pass legislation to avoid what was commonly referred to as “The Fiscal Cliff.” But what really happened? In summary, not much new was passed, but rather the legislation in large part made permanent the system of estate and income tax that has been in effect for the past two years. The new law did put off for two months some important spending cuts that must take place due to a process called “sequestration.” It is these additional cuts that could have a significant impact on our senior population and their loved ones.
This issue of the ElderCounselorTM will take a look at the new legislation and what is yet to come in the next several weeks in the way of spending cuts, including possible cuts to programs that serve the elderly.
The Bottom Line on What Was Passed
This newsletter provides a summary of the legislation that was passed and what remains to be decided. If you have questions or need additional information, please contact us directly.
Estate taxes. An estate tax is a federal tax (and in some states also includes a state tax) on the transfer of a deceased person’s assets to his heirs and beneficiaries, and can include prior transfers made to those heirs and beneficiaries. However, under federal law, there is a certain amount that can be transferred without incurring any tax liability. In 2010, every individual could transfer (gift) up to $5 million tax-free during life or at death to avoid paying estate taxes on that amount. This amount is called the “basic exclusion amount” and is adjusted for inflation (usually on an annual basis). In 2012 it was raised to $5.12 million per person.
This year’s new “fiscal cliff legislation” did not change how much an individual could transfer during life or at death to avoid paying federal estate taxes on that amount. And, on January 11, 2013, the IRS announced that the estate tax exclusion amount for individuals who die in 2013 is now $5.25 million, as the prior figure has now been adjusted for inflation.
What if no action had been taken with regard to estate taxes?
Without the new legislation, the $5.12 figure would have automatically reverted to $1 million per person, and the rate for most estates would have gone up to 55%. Instead, the only thing the new legislation changed was the gift and estate tax rate, which has gone up to a top rate of 40%, from a maximum of 35% in 2012.
Married couples. The new legislation did not change prior law that stated that spouses do not have to pay estate tax when they inherit from the other spouse. Rather, when the first spouse dies, the other spouse can inherit the entire estate and any estate tax due would be postponed until the second spouse dies. This is called the “marital deduction.” If the surviving spouse is not a U.S. citizen, then there are restrictions on how much can be passed to the surviving spouse tax-free. It is also important to remember that this type of tax benefit between spouses is not always automatic – any married couple who may be subject to estate tax should seek the advice of an attorney to make sure their estate plan is properly set up to take advantage of this particular tax incentive.
What about lifetime gifts? The current basic exclusion amount of $5.25 million per individual is an exclusion for both lifetime gifts and gifts at death. This is often referred to as the “unified credit” amount. For example, an individual could transfer assets of $2 million duringtheir lifetime and an additional $2.25 million at death, and the total, $5.25 million, would not be subject to either gift or estate tax. However, if an individual transferred more than the $5.25 limit, that individual (or the heirs) will owe a tax of up to 40%.
The donor should report any gifts made during their lifetime to the IRS so a proper calculation can be made at the donor’s death. Using the above example, the $2 million lifetime gift would have been reported to the IRS even though no gift tax would be due. And, the IRS would then know that individual had $2.25 remaining to pass at death free of estate taxes.
There are additional gifting advantages available to married couples during their lifetime, and advice should be sought from an attorney versed in this area to determine what, if any, gifting incentives may be available.
Lifetime gifts that do not count toward the $5.25 million exclusion amount. There is an amount each year that can be transferred without counting toward the $5.25 exclusion amount. In 2013, that amount is $14,000 per year, per person (called an “annual exclusion amount”). For example, an individual can give three different people $14,000 in 2013, and it will not count toward the $5.25 lifetime exemption amount. Couples can double this amount and give $28,000 per person per year.
Planning Note: It is important to remember that any gift (unless designated as an exempt transfer under the federal and state Medicaid rules) will cause a penalty for Medicaid purposes. Individuals often believe that because they can transfer $14,000 per year per person under the tax rules, the same applies to Medicaid. The rules are very different for Medicaid, and a penalty will apply if that type of gift is made.
Changes to the income tax rules. This newsletter highlights the main points of the income tax rules that could directly affect seniors and their loved ones. For additional information on the alternative minimum tax or charitable gifting, please contact us directly.
In prior years, everyone enjoyed a 2% Social Security tax reduction as a stimulus measure. Under the 2013 legislation, this “tax holiday” was not extended; therefore, everyone will see a decrease in their net pay.
Ordinary income tax rates increase from 35% to 39.6% for singles earning more than $400,000 a year ($450,000 a year for married couples). All other ordinary income tax rates effective in 2012 were made permanent.
For those individuals earning over $250,000, and for married couples who earn over $250,000, there is a new Medicare 0.9% surtax on ordinary income and a new 3.8% surtax on investment income. These additional taxes were part of the 2010 health care legislation, much of which begins implementation in 2013.
The top capital gains and dividend rate increased to 20% for those earning more than $400,000 a year ($450,000 for married couples).
Additional Cuts Are on the Way
The current fiscal cliff legislation did not address the automatic spending cuts that were to take place on January 1, 2013. Instead, the automatic cuts, known as sequestration, were pushed back two months to March 1, 2013. Sequestration was one portion of the spending cuts included in the Budget Control Act, passed and signed in August 2011.
The Budget Control Act of 2011 allowed the president to raise the debt ceiling by $2.1 trillion, and it instituted two rounds of significant spending cuts. One round of cuts involved government programs like defense spending, education funding, the FBI and other government agencies that would receive automatic budget cuts relative to their scheduled growth over the next 10 years.
The second half of the spending cuts was supposed to be decided on by Congress through a Joint Select Committee on Deficit Reduction. This Committee (referred to as the “supercommittee”) was to come up with a list of cuts that would then be put to Congress for a full vote. If the committee couldn’t agree on the cuts, $1.2 trillion in further spending reductions over 10 years would be implemented starting Jan. 1, called the “sequester.” No cuts have yet been agreed upon, and the automatic spending reductions have been moved back to March 1, 2013, to allow Congress time to come to an agreement.
Programs like Medicare, Medicaid and Social Security have been the topic of discussion for the second portion of the spending cuts. We will continue to monitor and report on the progress of Congress as it pertains to these spending cuts and how they will impact our senior population and their families.
The fiscal cliff legislation is in place; however, there is more legislation to occur that could have a significant impact on those affected by programs like Medicare, Medicaid and Social Security. While many families may not be affected by the current estate and income tax rules, there are many who could have their life savings consumed by long term care costs. We help seniors and their families plan ahead to avoid a financial crisis, even if a health care crisis occurs. If you would like to learn more or if we can help someone you know, please give us a call.
To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this newsletter was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax advisor based on the taxpayer’s particular circumstances.
With the recent discussions about closing tax loopholes and increasing taxes for the “wealthy” incident to increasing the national debt limit, clients are beginning to fear that the taxes on their wealth will increase. Even without higher tax rates, wealthier Americans will pay more in taxes if allowable deductions (possibly charitable) and exemptions (probably estate tax) are lowered.
We need to be prepared to help our clients as they begin to draw down retirement savings and look for more tax-efficient investments for their stocks, bonds, real estate and savings.
In this issue of The Wealth Counselor, we will examine some of the top income tax planning ideas to implement in 2011 and 2012.
Income Tax Overview
Anything can happen between now and January 1, 2013, but, based on current law, that will be the date the top income tax rate increases from 36% to 39.6%, qualified dividends become subject to ordinary income tax rates, the tax on long-term capital gains jumps from 15% to 20%, and the 3.8% Medicare surtax kicks in (unless the Florida Federal District Court decision striking down the health care reform act is upheld). Let’s look more closely at how these taxes can impact your clients, and what you can do to help them.
Under current law, in tax years beginning on or after January 1, 2013, qualified dividends will be subject to ordinary income tax rates. Therefore, C Corporations with accumulated earnings and profits and the cash to do so should consider making larger dividends in 2011 and 2012.
Example, Distribution of C Corp Dividends: Should the sole shareholder of a C Corp make a $1 million dividend to himself in one lump payment in 2012 or in $200,000 increments over five years (2012-2016)? Assuming he is in the highest marginal income tax bracket, 15% capital gains tax rate on dividends in 2012, and 39.6% + 3.8% = 43.4% ordinary income tax rate on dividends for 2013 and beyond, he would pay $150,000 in taxes on the lump sum distribution in 2012 and $377,200 on the incremental distributions paid over five years. He would save $ 227,200 by taking the lump sum in 2012.
Long-Term Capital Gains
Under current law, in tax years beginning on or after January 1, 2013, long-term capital gains will be taxed at a top rate of 20%. Taxpayers should consider selling (or otherwise disposing of) appreciated property and recognizing the taxable gain in 2011 and/or 2012. Taxpayers who have realized capital gains deferred on an installment note may want to consider accelerating the unrecognized gain in 2011 and/or 2012.
Example, Acceleration of Gains: In 2012, Judy sold her business for $1 million in exchange for a nine-year installment note. At the time of the sale, she realized a $900,000 gain. By electing out of the installment treatment, she would pay $135,000 in capital gains tax on the lump sum in 2012 vs. $175,500 on the installments in 2012-2021, and would save $40,500 in taxes (900,000 x .15 = 135,000 versus 900,000 x .1 x .15 = 13,500 plus 900,000 x .9 x .2 = 162,000).
Under current law, in tax years beginning on or after January 1, 2013, ordinary income tax rates will increase to their pre-2001 levels. Taxpayers should consider accelerating certain types of ordinary income (bond interest, annuity income, traditional IRA income, compensation income) into 2011 and 2012 if they expect to be in the same tax bracket or higher in future tax years. This is especially true for top bracket taxpayers who may pay the 3.8% Medicare surtax on their “net investment income.”
Example, Accelerating Bond Interest: Mike has $100,000 of accrued bond interest that will be paid on January 3, 2013. Mike is in the 35% tax bracket for 2012 and 39.6% + 3.8% for 2013. If he sells his bonds (at par) before the end of 2012 and recognizes the accrued interest income, he will pay $35,000 in taxes vs. $43,400 if he waits and collects the interest in 2013, and will save $8,400 in taxes.
Example, Sale/Repurchase of Bond: James purchased $1 million of corporate bonds in 1993 at par value; they mature December 31, 2011. On December 31, 2012, he sold them for $1,050,000. On January 3, 2013, he repurchased the same bonds for $1,050,000. Under tax law, this $50,000 premium can be used to offset his interest income over the remaining life of the bond (one year). By selling the bonds in 2012 and repurchasing them in 2013, he realizes a net income tax savings of $14,200 ($21,700 in income tax savings on the bond premium, less $7,500 in capital gains tax on the sale of the bonds = $14,200).
Additional Income Tax Planning Ideas
Oil and Gas Investments
Intangible drilling costs (IDCs) provide a large immediate income tax deduction (up to 85% of the initial investment). Losses, if any, created as a result of IDCs will be ordinary and will lower the taxpayer’s Adjusted Gross Income. Depletion and other depreciation provide for additional deductions during the term of the investment. Additional tax credits may be available for certain oil and gas ventures.
Planning Tip: Be careful with oil and gas investment where the client may be subject to the alternative minimum tax (AMT). The AMT may limit the amount of deductions allowed.
Generally, gold held as coins or bullion is treated as “collectibles,” for which the long-term capital gain rate is 28%. All short-term capital gains are treated as ordinary income. Therefore, a taxpayer in a lower tax bracket would be better off triggering short-term rather than long-term capital gain on gold coins or bullion. On the plus side, the “wash sale rule” (explained below) does not apply to “collectible” losses.
Planning Tip: The “collectibles” tax rate does not generally apply to gold held in mutual funds or to non-exchange-traded options on gold. Gold futures must be “marked to market” and the unrealized gain/loss must be recognized each tax year. Moreover, gold futures gains are subject to special tax treatment (60% long-term capital gain or 40% short-term capital gain).
Foreign Currency Transactions
Gains and losses in foreign exchange transactions are ordinary income/loss rather than capital gain/loss. Generally, taxpayers will want to recognize ordinary income in 2011 and 2012 and push ordinary losses to 2013 and later years.
These have special gains treatment on certain broad-based listed options (60% long-term and 40% short-term). For taxpayers in the highest marginal income tax bracket in 2013, this would result in a blended capital gains tax rate of 29.36% ((.6 x .2) + (.4 x .434)).
Loss harvesting can apply to individuals, trusts/estates, and charitable lead and remainder trusts. Considerations include:
Wash Sale Rule: Capital losses are denied to the extent that a taxpayer has acquired (or has entered into a contract or option to acquire) a “substantially identical” stock or security within a period beginning 30 days before the sale and ending 30 days after the sale of a stock that was sold at a loss (“loss stock”). The disallowed loss on the loss stock is added to the cost basis of the new stock, and the holding period of the loss stock is carried over to the new stock. This rule also applies to ETFs, index funds, IRAs and taxable investment accounts. It does not apply to “collectibles.”
Diminishing Real Value of Capital Losses: Because of the cost of capital, the sooner a capital loss is used the better.
Efficiency of Capital Loss Offsetting: In general, capital losses are more tax effective if they can be used to offset income taxed at higher tax rates (short-term capital gains and ordinary income). Long-term losses used against short-term gains are tax-efficient. Short-term losses used against long-term capital gains are tax inefficient.
Income Shifting to Junior Generations
Income taxes can be saved by shifting income-producing assets from parents or grandparents who are in a high income tax bracket to their children and grandchildren who are in lower tax brackets. Planning considerations include asset protection (accomplished through the use of trusts) and the “kiddie tax” for beneficiaries under age 24.
What makes this most attractive in 2011 and 2012 is the $5 million per person gift tax exemption: a married couple can gift up to $10 million and no gift tax will be incurred on the gift. The gift can be made in trust and then used to invest and/or purchase life insurance on the donors.
Example: Husband and wife, who are taxed at the current top (35%) rate, own $16,000,000 in S Corporation stock. They gift $10 million of it to their four adult children (15 5/8% of the S Corporation stock to each child). The S Corporation income is $2 million per year. After the gift, 37.5% is attributed to the parents and taxed at their rate and 62.5% is attributed to the children and taxed at their lower rates (assume 25%). Annual income tax savings: $10,000,000 x 10% = $100,000.
Planning Tip: Income can also be shifted upwards. For example, a high-earning professional can make the gift to his/her elderly parents who are in a lower tax bracket. The additional income can be used to help pay for medical and/or assisted living expenses. After the parents die, the assets can go to the original donor’s children (if the “kiddie tax” does not apply) for additional income shifting.
Roth IRA Conversions
Benefits of converting include a lowering overall of taxable income long-term; tax-free compounding; no required minimum distributions (RMDs) during the owner’s life; tax-free withdrawals for beneficiaries; and more effective funding of the bypass trust. For most people, converting to a Roth IRA is highly beneficial over the long term.
Planning Tip: When exploring a Roth IRA conversion, consider the tax rate in the year of conversion vs. the tax rate in years of withdrawals; the owner’s ability to use outside assets to pay the income tax on the conversion; and the need for the IRA to meet annual living expenses.
Net Unrealized Appreciation (NUA) Planning
If an employee has employer securities in his/her qualified retirement plan, he/she may be able to convert a portion of the total distribution from the plan from ordinary income into capital gain income. The distribution must be made as a lump-sum distribution due to the employee’s death, attaining age 59 1/2, separation from service, or becoming disabled within the meaning of Code section 72(m)(7).
Taxation of Lump-Sum Distribution
Ordinary income is recognized on the cost basis of the employer securities distributed (a 10% early withdrawal penalty is due if the employee is under age 55 at the time of distribution). The difference between the fair market value at distribution and the cost basis is Net Unrealized Appreciation (NUA). NUA is not taxed at the time of distribution, but at a later time when the stock is sold, and is taxed then at long-term capital gain tax rates. (Ten-year averaging is available to those born before 1/2/1936; 20% capital gain applies to pre-1974 contributions only.)
Planning Tip: NUA does not receive a step-up in basis at death, although subsequent gain above the value at distribution should. Also, if an estate or trust contains NUA stock, a fractional funding clause must be used; otherwise, the NUA will be subject to immediate taxation.
If the capital gains tax rate increases to 20% and the 3.8% Medicare surtax applies, charitable remainder trusts (CRTs) could become very attractive again. That’s because appreciated assets that are transferred to a CRT are not taxed, so the full value of these assets is available to provide income to the donor, generating much more income than if the donor had sold the asset, paid the capital gains tax, and re-invested the proceeds.
Planning Tip: With the current historically low 7520 rates, charitable lead trusts can be used now by charitably inclined clients to shift significant wealth while using only an insignificant amount of their estate/gift tax exemption.
An IRA is treated as inherited if the individual for whose benefit the IRA is maintained acquired the IRA upon the death of the original owner. Under the tax law, the IRA assets can be distributed based upon the life expectancy of the beneficiary if the beneficiary is a living person or a trust that meets certain requirements, such as that it is irrevocable, all beneficiaries are natural persons, and the oldest possible beneficiary can be determined.
Spouse as Beneficiary
A surviving spouse named as beneficiary of the deceased spouse’s IRA may roll it over into a new or existing IRA in the spouse’s own name. The spouse is then treated as the owner and may delay taking required minimum distributions (RMDs) until he/she turns age 70 1/2 and then take distributions based on his/her life, often allowing for a greater stretch-out period.
Planning Tip: If the surviving spouse is under 59 1/2, rolling over can expose him/her to the early withdrawal penalty if the IRA funds are needed before the surviving spouse reaches 59 1/2. Safer strategy is to wait until then to roll over and use the inherited IRA withdrawal rules before then.
Non-Spouse as Beneficiary
Naming a non-spouse beneficiary avoids having the IRA assets being subject to estate tax in the surviving spouse’s estate. Required minimum distributions (RMDs) occur over the life expectancy of the designated beneficiary.
Common Inherited IRA Mistakes to Avoid
For non-spouse beneficiaries, it is critical to keep the inherited IRA in the name of the deceased IRA owner. Correct wording for an individual: “John Smith, deceased, IRA for the benefit of James Smith.” Correct wording for a trust: “John Smith, deceased, IRA for the benefit of James Smith as Trustee of the Smith Family Trust dated 1/1/2010.”
Other mistakes include not taking required minimum distributions, not using disclaimers when appropriate, not analyzing contingent beneficiaries, and taking a lump-sum distribution at the death of the IRA owner.
Life Insurance Planning for Inherited IRA
If the IRA owner’s taxable estate does not have sufficient other assets, it could be necessary to use a portion of the IRA to pay estate taxes. Because this use triggers additional income taxes, between 60-80% of the IRA could be lost to taxes.
A solution is to establish an Irrevocable Trust that holds a life insurance policy on the IRA owner’s life. Upon his/her death, the death benefit proceeds can be used to provide liquidity to the IRA owner’s estate and preserve the inherited IRA. To the extent that the grantor does not hold any “incidents of ownership,” none of the trust assets will be included in his/her taxable estate. Another alternative is to annuitize the IRA and contribute the annuity payments to the Irrevocable Trust where they are used to pay premiums for life insurance on the IRA owner.
The current income tax laws and the tax increases that will happen in just 16 months (unless the Congress and President agree otherwise) provide some unique opportunities for estate planning professionals to work together as a team to help our mutual clients. Take advantage of this limited time to meet with your clients, ask the right questions, and make a positive difference for them and their families.