Journal of Financial Planning: November 2012
It’s the fall of 2010. You’re meeting with a client couple and beginning your review of their situation. Standard practice. But then you notice that they’re glancing at each other, fidgeting … something is off. Finally, one of them expresses their concern: they’re worried—very worried—that “our taxes will be going up.” Your recent meetings with clients have revealed that many have the same fear. The details don’t matter to them; the fear is overwhelming.
Along comes December 17, 2010, when a two-year tax-cut extension was signed into law. A reprieve. An opportunity to evaluate actions taken or postponed.
Now, fewer than two years later, that temporary stay is fading and once again tax-related anxiety is spreading like a virus among your clients. This time, it’s even more intense. “Taxmageddon” and “fiscal cliff” have entered the lexicon, while “sunset” now has a truly dark side.
Is a fundamental shift under way? Or are we just being reminded, yet again, of a basic fact that’s held true for the almost 100 years of the modern American tax system: that the most effective tax planning is done on a year-by-year basis?
The first step to untangling emotion from analysis is to break down the facts about the tax laws. It’s helpful to keep in mind what we know about current legislation and possible future legislation.
2012: Where We Are Now
Barring any further legislative activity, we know for 2012:
- Our federal income tax rates remain at historic lows, ranging from 10 percent to 35 percent
- In general, capital gains and qualified dividend income will be subject to taxation at 0 percent or 15 percent (nominal rate)
- No phaseouts of personal exemptions or itemized deductions will occur
- Estate, gift, and generation-skipping (GST) exemptions are at historic highs
We don’t know whether these and other so-called “extenders,” which have expired, will be revived before the end of 2012:
- The alternative minimum tax (AMT) patch
- The up-to-$100,000 direct charitable distribution from IRAs
- Certain above-the-line deductions
- Various tax credits
And finally, the payroll tax holiday (the 2 percent reduction in the employee portion of FICA) is currently on the books only through the end of 2012.
2013: What’s on the Schedule (but not certain)
We know that, as of August 2012, the following is on the docket for 2013:
- A return to federal income tax rates of between 15 percent and 39.6 percent
- Capital gains rates of 10 percent or 20 percent (with an opportunity for 8 percent or 18 percent for five-year qualifying property)
- Elimination of qualified dividend income (QDI) preferred tax rates
- Full return of phaseouts to itemized deductions and personal exemptions
- A return to $1 million for estate, gift, and GST exemptions (with an inflation adjustment for the GST)
And the following provisions contained within the recent health-care legislation will begin in 2013:
- 0.9 percent increase in the employee portion of FICA above certain income thresholds
- 3.8 percent Medicare surcharge on various types of net investment income above certain thresholds
- An increase, to 10 percent of adjusted gross income (AGI), in the floor required before medical expenses may be deducted (a delay in this change applies to those 65 or older)
- Annual amounts set aside into a flexible spending account (FSA) for medical expenses are limited to $2,500 per year
Many clients will find the idea of realizing a long-term capital gain at a nominal rate of 15 percent appealing. An investment motivation—reducing a concentrated position, meeting a specific expense, establishing a cash reserve—would strengthen the argument for doing this, especially if future rates stay the same or increase. Remember, however, that a step up in basis at the death of the owner may eliminate the tax on the gain for heirs.
The allure of income-tax-free growth will drive many clients to favor converting some or all pre-tax retirement accounts into Roth accounts if tax rate increases are expected in the short term. The tricky part is often the amount of conversion and how it is determined. Interestingly, the option of recharacterization makes Roth conversion almost immune from such short-term pressure because taxpayers may have time beyond the end of the year to evaluate the tax consequence of a conversion.
In many ways, planners serve as a voice of reason with their clients. We may be about to experience a true test of our ability to speak clearly and be heard.
Back to Basics
A taxpayer must be willing to work with their adviser to project, as accurately as possible, the amounts of income, deductions, exemptions, and credits (by category) that they expect to report in the current year; these numbers will serve as a foundation for identifying tax-planning opportunities. A review of at least the most recent two years of complete federal and, if applicable, state income tax returns may help uncover factors (carryovers, for example) that will be important to look at for this year.
For clients, finding the patience needed for this review can be a challenge, because many people want specific answers about a specific proposed transaction or event. It also can be challenging for them to hear, again and again, my two favorite words: “it depends.”
I’ve found it helps to remind clients that this review has a payoff.
Projections to Possibilities
The taxpayer’s estimates will identify the projected marginal tax rate. They will also identify an even more important element: the room remaining in the projected bracket.
For example, a married couple filing a joint tax return in 2012 can have taxable income of up to $70,700 and stay within the 15 percent tax bracket. If the couple projects having less than this level of taxable income—especially if they expect it to be significantly less—then consideration of the recognition of additional ordinary income may be warranted. This situation also would allow the couple to recognize capital gains at a 0 percent nominal rate.
Our federal income tax system has constantly benchmarked qualifications for and limitations to particular deductions and credits, as well as other components of an individual’s tax return, on the concepts of AGI or modified adjusted gross income (MAGI). Managing above-the-line activity will generally have the greatest impact on tax due. Some examples, such as the deferral of earned income into retirement plans, may be common, while others, such as the decision to immediately expense the purchase of qualifying property, are likely to be unique to the client’s circumstances.
Sometimes 0 Percent Isn’t Really 0 Percent
To take another example, you could have clients who are married, filing jointly, and project a taxable income of $30,000 for 2012. They understand that taxable income under $70,700 will result in capital gains and QDI taxed at 0 percent. They have a position in their portfolio that, if sold, would produce a capital gain of $40,000. Would their federal income tax increase if they sell the position, they ask. Well, you answer, it depends. If the $30,000 of taxable income includes medical expenses and/or miscellaneous itemized deductions, deductible contributions to IRAs, or any other line item that is subject to an AGI or MAGI limit or phaseout, the true cost of recognizing the capital gain may be X, even though the nominal rate applied to the capital gain is 0 percent.
The makeup of the higher taxable income also increases the possibility—perhaps even making it into a probability—that your clients may be subject to the alternative minimum tax (AMT). Here, too, the nominal rate applied to capital gains and QDI would be 0 percent, but the actual tax may be costly.
A Word, or Several, About AMT
Planners must recognize our two distinct federal income tax systems and how they work. On a fundamental level, all taxpayers should compute federal (and perhaps state) income tax under both systems with the higher of the two prevailing on the tax return. It is reasonable to approach AMT by turning conventional wisdom on its ear through the acceleration of certain income and the deferral of certain deductions. This should be evaluated on a case-by-case basis. Effective income tax planning may, in the right circumstances, give rise to an alternative maximum tax, a mathematical phenomenon not consistent with the expectations of taxpayers.
One specific caution with regard to AMT for 2012: this is the last scheduled year for a taxpayer who is carrying forward an unused AMT credit to potentially qualify as a “refundable” credit. Clients and their tax advisers should review prior federal income tax returns (IRS Form 8801) for the existence and use of AMT credits.
Unless the Mayans are correct there will be a full December on the calendar this year, as well as many occasions beyond, for planners and clients to engage in tax planning. The most effective will incorporate tax planning as part of a comprehensive engagement that integrates investment, retirement, estate, and possibly other financial planning disciplines.
John Kilroy, CPA, CFP®, is a senior wealth planner for Vanguard Asset Management Services in Phoenixville, Pennsylvania.