Having a comprehensive tax strategy has never been more important. The recently enacted American Taxpayer Relief Act of 2012 (ATRA) is likely to have a significant impact on taxpayers going forward, even those who don't meet the government's new definition of "high income." Learn what you can do to minimize ATRA's tax bite.
Much of the discussion around the recently enacted American Taxpayer Relief Act of 2012 (ATRA) has been about transfer taxes. ATRA makes permanent the $5 million exemption for federal estate, gift and generation-skipping transfer taxes, indexed for inflation ($5.25 million for a single person and $10.5 million for a married couple in 2013). In addition, ATRA raises the maximum federal estate tax rate from 35 percent to 40 percent. But along with this relative simplification of transfer taxes comes new income tax complexity, especially for higher-earning taxpayers.
ATRA adds a 39.6 percent top income tax bracket and increases the tax rate on capital gains and qualified dividends to 20 percent for high-earning taxpayers with incomes above $400,000 for single filers and $450,000 for married couples filing jointly. The new 39.6 percent top tax bracket extends also to trusts and estates with taxable income in excess of $11,950 remaining in the trust.
This is in addition to the 3.8 percent Medicare surtax on net investment income mandated under the Patient Protection and Affordable Care Act. The Medicare surtax impacts individuals with adjusted gross income (AGI) over $200,000 (single filers) and $250,000 (married filing jointly). Combined with the tax law changes of ATRA, this means higher-earning taxpayers ($400,000 single/$450,000 married filing jointly) will now pay 23.8 percent on long-term capital gains and qualified dividends and 43.4 percent on short-term gains and other investment income.
Higher-earning taxpayers aren’t the only ones who may feel the pinch of higher taxes. ATRA also reinstates limitations on itemized deductions and the personal exemption phase-out, both of which had been temporarily eliminated as part of the Bush-era tax cuts. Limits on itemized deductions (such as mortgage interest, property taxes and charitable deductions) and the personal exemption are likely to result in higher tax bills for many below the top 39.6 percent tax bracket.
What can you do to minimize the impact of these significant tax changes on your estate planning? Consider the following:
- Top Off Gifts
If you haven’t used your lifetime gift exemption, consider doing so. Even though ATRA is considered permanent, that doesn’t mean Congress can’t lower the exemption or raise taxes in the future. The only way to lock in the current favorable exemption is to use it now. Making the transfer sooner, rather than later, will also move all future appreciation out of your taxable estate.
If your net worth continues to grow in excess of $5.25 million, it also may make sense to consider making gifts that trigger gift tax. Gifts made during one’s lifetime will enjoy a more favorable tax treatment, will suffer less shrinkage due to taxes, will avoid state estate taxes and will enjoy future growth free of any state and gift tax.
- Think About Which Assets to Give Away—and Which to Keep
Prior to ATRA, lifetime gifts provided a tax-efficient way to remove assets and their future appreciation from taxable estates and to avoid higher estate tax exposure. However, the implementation of higher tax rates, the net investment income tax, and “permanent” transfer tax rates and exemptions have made more complex the overall tax analysis of whether and what assets to gift during life, if any.
When you give away assets during your lifetime, the recipient typically takes a “carry-over” income tax basis for the gifted property. Depending upon the asset, a subsequent sale or other taxable disposition of the property may result in capital gains tax to the recipient on the difference in the property’s fair market value when sold and its original, carry-over basis.
In contrast, when you pass property at death, that asset receives a new income tax basis equal to the property’s fair market value as of the date of death—typically referred to as a “step up” in basis. Thus, an immediate sale of the property by the beneficiary does not generate capital gain.
The analysis of which is more beneficial—lifetime gifts or transfers at death—will depend on a number of issues, including your current and projected net worth and life expectancy, the types of assets intended for transfer, their current and projected values, and the anticipated federal and state income and transfer tax rates at the time of the planned gift and at your death in both your state of residence and your beneficiary’s. The goal is to understand the tax impact of giving assets during your lifetime versus at death.
- Revisit the Tax Implications of Trusts
Many individuals prefer to make gifts through a trust rather than outright to beneficiaries. Trusts continue to be an important estate planning tool; however, in today’s higher tax-rate environment, it’s important to understand the income tax rules that apply to trusts.
For income tax purposes, an irrevocable trust is categorized as either a grantor trust or a non-grantor trust. A grantor trust means that you, as the grantor (the person who established the trust), are treated as the owner of the trust assets for income tax purposes. As such, any taxable income or deduction earned by the trust will be included on your personal income tax return. The benefit of a grantor trust is that trust assets are able to grow for your beneficiaries’ benefit without placing the burden on them of paying income taxes on any income earned by the trust.
With a non-grantor trust, the income generated by the trust is taxed to the trust and/or the trust beneficiaries. For 2013, a trust will pay income tax at the 39.6 percent tax rate on taxable income above $11,950. The trust will also be subject to the net investment income tax (NIIT) of 3.8 percent for income over the same threshold. As a result, many trusts will be taxed in 2013 at 43.4 percent on ordinary income and 23.8 percent on qualified dividends and long-term capital gains; some will also be subject to state income taxes. In contrast, individual beneficiaries may be eligible for lower tax brackets, and the NIIT wouldn’t impact them unless their AGI is greater than $200,000 ($250,000 for beneficiaries who are married filing jointly).
The trustee may choose to manage the trust’s taxable income through assets that don’t generate a lot of (or any) income, such as cash value life insurance. Permanent life insurance provides the potential for cash-deferred growth of cash values and a tax-free death benefit.
With non-grantor trusts, trustees may have the option, where appropriate, to make distributions to beneficiaries in lower tax brackets in order to carry out trust income, making the income taxable to the beneficiaries rather than the trust.
- Consider a Roth IRA Conversion
Most traditional IRA owners will have to take required minimum distributions (RMDs) from their IRA starting at age 70 1/2. Even if you don’t anticipate needing that money to fund your lifestyle in retirement, those RMDs increase your AGI and thus your tax liability. In contrast, there are no RMDs required during the participant’s lifetime with a Roth IRA. This means you can leave your money to grow tax-free for as long as you like—even for your lifetime. The conversion to a Roth IRA is taxable in the year it’s completed. One strategy for married couples with traditional IRAs they don’t intend to use for retirement is to buy life insurance to fund a rollover to a Roth IRA after the first spouse’s death.
- Make Charitable Gifts Through Your IRA
ATRA also reinstated for 2012 and 2013 a provision that is often referred to as the “Qualified Charitable Distribution,” or charitable rollover. This provision allows IRA owners over age 70 ½ to make charitable donations of up to $100,000 per year directly from their IRAs without paying income tax. While you can’t take a charitable deduction for any gifts you make through your IRA, the money given will count toward that year’s RMD.
- Contribute to a Health Savings Account (HSA)
The Affordable Health Care Act increased the threshold for deducting medical expenses from 7.5 percent of AGI to 10 percent. For high income earners, that can be a difficult benchmark to reach. However, if you qualify for an HSA, you can make tax- deductible contributions to your account and use your accumulated funds for unreimbursed medical expenses tax-free.
As estate planning broadens its scope to include income tax minimization, life insurance continues to offer distinct advantages. These include the potential for tax-deferred growth of any cash value; the ability to access funds, income tax- and NIIT-free, through withdrawals (up to the policyowner’s investment in the contract); and a death benefit that is completely free of income taxes (and estate tax if the policy is held in an irrevocable trust).
When used in a trust, life insurance can provide income to a surviving spouse while protecting the death benefits from estate taxes at death. When held outside an estate, life insurance proceeds can also be used to offset any additional estate taxes that might accrue from holding other assets until death rather than giving them away. It may also provide liquidity for asset retention, should your heirs desire it.
In this higher-tax environment, tax planning has become more important than ever. Given the complexity of ATRA’s tax law changes, it makes sense to consult with a wealth management and tax advisors to determine how ATRA will impact your personal situation.
This information should not be used as a basis for legal or tax advice. Clients should seek tax advice regarding their particular circumstances from an independent tax advisor.