An unfortunate casualty of this year’s mid-term elections is the uncertainty regarding what awaits tax payers in the coming year.
You may not have heard of Dan Duncan, but rest assured the IRS has. Duncan was No. 30 on the Forbes Fortune 400 list in 2009 with an estimated net worth of $8 billion. On March 28, 2010, Duncan died. With the estate tax on hiatus for 2010, you can imagine the broad smiles spread across the faces of his heirs after their tears, given that much of what Duncan built may not end up being lost to estate taxes. But, even if you are not a billionaire, there is much to lament in this uncertainty.
First, let’s be clear on what actually is happening with the estate tax. Until 2009, the value of one’s estate protected from federal estate taxation had been rising, reaching $3.5 million last year. With proper planning, that meant an individual potentially could shield up to $3.5 million with married couples able to protect up to $7 million. The same legislation that established these limits abolished them altogether for tax year 2010, but allowed them to revert to $1 million in 2011.
So who does this really affect? Generally (I say generally, because personal tax situations are very unique), any individual with a net worth of greater than $1 million or married couples with net worth exceeding $2 million, could be affected. But, what does this mean for your situation, and what, if anything, should you do before the end of the year?
Gifting may allow you to reduce the value of your eventual estate by transferring assets to heirs now. Keep in mind that gift taxes may apply to any gift of more than $13,000 in value. But, consider if a married couple wanted to gift to one of the children who was married, each spouse might give $13,000 to the child and their spouse for a total of $52,000. For those with substantially larger estates, they might consider gifting this year beyond those limits, creating a gift tax liability taxed at 35 percent if they believe the estate tax will be reinstated with rates up to 55 percent.
Another provision “temporarily” suspended is the Generation Skipping Tax. For the same reason to gift substantial assets this year, it might make sense to transfer assets to grandchildren rather than to children. And, through the proper use of trusts, one might ensure that the assets are invested and protected to eventually pay for college or other benefits down the road.
The caveat to any estate planning strategy at this point is whether and how Congress changes estate tax laws before the end of the year. Any of the provisions currently providing an advantage may be changed or eliminated, even retroactively. So what this really means is that those with substantial net worth, who have not revisited their estate plan in several years, should do so with a qualified attorney. Where a “wait and see” attitude may be fine for some, it could be costly for others.
Beyond the estate tax, chatter continues about how marginal tax rates will change if the current tax cuts in place are allowed to expire. The consensus seems to be rallying around raising rates for “high income earners,” defined as an individual making more than $194,050 or a married couple with more than $235,450 in annual income. Specifically, the current 33 percent bracket is slated to revert to 36 percent while the 35 percent bracket would go back up to 39.6 percent. Before you think this leaves you unscathed, consider the proposed changes to capital gains and dividend tax treatment.
The maximum tax rate on long-term capital gains would go from 15 percent to 20 percent and from 15 percent to as high as 39.6 percent on qualified dividends. So, for example, if you are relying on investment income for retirement, the IRS may be giving you a pay cut. If adopted, this means meeting with your investment adviser and accountant should be at the top of your year end checklist. The two pieces of information you are looking for are 1) do you have substantial long-term capital gains that it would make sense to realize in 2010 if those rates will be higher in the future, and 2) how much of your investment income is derived from qualified dividends that might warrant a shift to more tax efficient instruments like municipal bonds.
Perhaps higher on the list of “tax pitfalls to avoid” are not the actual changes to tax laws, but the financial products and strategies marketed as a way to alleviate them. For 2010, beware of the temptation of the Roth conversion. Two things have changed that have made this an enticing strategy. Before you could not convert if your income exceeded $100,000, but that limit has been eliminated. More importantly, the typical Roth IRA conversion generates taxes due in the year of conversion. For 2010 only, the tax due from conversion can be delayed and split between tax years 2011 and 2012.
I have seen three common mistakes investors are making this year when it comes to Roth conversions.
First, without a liquid source of funds to pay the conversion tax, the benefits are diminished if you have to take a withdrawal from the IRA to pay them.
Secondly, while it seems logical to delay paying the tax until 2011 and 2012, consider the earlier dilemma of uncertainty about where tax rates will be in 2011 and 2012. The main objective in converting should be to pay less overall tax, but if you have an unexpected windfall of income or are bumped into a higher tax bracket, the tax on conversion could negate this.
The third Roth conversion pitfall has less to do with taxes than derailing your investment strategy. The financial industry has identified conversion as a major marketing opportunity to sell their products. Here is an example. An insurance agent recommends converting an old 401(k) to a Roth IRA, using an annuity that can provide guaranteed, tax-free income in retirement. Keep in mind that converting has nothing to do in itself with what types of investments you choose. Given that 401(k) plans can have very low expenses and that some annuities have recurring annual expenses approaching 4 percent, you should be wary of conversion as justification to alter your investment strategy. This is a classic bait and switch tactic, where a good strategy and a bad product do not make a happy investor.
The bottom line with tax challenges and opportunities is that one size does not fit all, and when trying to be innovative, you should consult a financial expert, not a salesperson to work on behalf of your best interest. This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Investors should consult a tax or legal professional regarding their individual situation.