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Time to Stop Deferring Taxes?

BobCarlson — Thu, 19 Mar 2009 17:34:00 GMT

Conventional investment advice has been turned on its head by changes in the fundamentals of the economy and markets. Now, fundamental changes in the government, demographics, and the economy are forcing changes in tax policy and tax planning advice.

The age-old advice is to defer taxes whenever possible and for as long as possible. Over the years, I have pointed my subscribers to a few exceptions to this strategy discovered in our research. Soon, the classic rule might become a relic. For many people, the best tax planning advice in coming years could be to pay income taxes as early as possible, because rates will be higher later.

The structural changes leading to this conclusion are significant:

We have a new President and Congress. They explicitly campaigned on promises to raise taxes, at least on the wealthiest Americans. "Wealthy" tends to be defined downward after an election, and that is likely to be the case now.

Social Security and Medicare cannot be sustained under current tax and spending policies. Either benefits must be reduced or taxes raised or both.

The policy response to the financial crisis was for the federal government to bailout, subsidize, insure, and otherwise commit to spending a lot of money. There is a chance some money will be recovered from the government's "investments," but most likely the government will have net negative cash flow.

The new government leaders plan to spend a lot more money, especially on medical care, energy, and the environment. The details are not clear at this point, but higher spending by the government clearly is part of the plan.

Environmental policy is likely to include significant tax increases.

A result of the current crisis likely will be less leverage in the economy, leading to lower economic growth. Lower growth means less tax revenue from the current tax structure and a need for higher taxes.

The President proposed a few specific tax increases in his budget plan, but others won't be known for a while. We do have a lot of clues, however, and can begin to plan.

Higher income individuals are likely to face higher income taxes. During the campaign the income cut-off for higher taxes initially was $250,000. But at times lower numbers were used, and Congress traditionally defines “high income” much lower than $250,000. The current plan is to let the 2003 tax cuts expire after 2010, which will affect many taxpayers.

All Americans are likely to be hit with indirect and non-income taxes. These include gasoline taxes, other carbon and energy taxes, and various fees and charges.

Means-testing is another likely form of tax increase. Already upper income people receive a lower return on their Social Security taxes and pay higher Medicare premiums. Benefits from Social Security and Medicare likely will be reduced above some income level. Expect similar actions in other government programs.

Tax benefit reductions also are likely in lieu of tax rate increases. Itemized deductions and personal and dependency exemptions now are reduced at higher incomes, effectively increasing tax rates. Congress likely will search for other tax breaks to phase out as income rises. Many phase outs were included in the economic stimulus law that recently was enacted. Related changes will be "closing loopholes" by eliminating deductions and income exemptions.

A long shot in the short term is imposition of a value added tax or some kind of a national sales tax. This tax can be hidden in the cost of goods and services, raised easily, and will generate a lot of money for the government.

Taxes on long-term capital gains are likely to rise above their current 15% level. A rise to 20% seems almost certain after 2010, and an increase to 28% is possible. Taxes on dividends also will rise. The question is whether they will be taxed the same as long-term capital gains or will return to being taxed as ordinary income.

The bottom line is reduced benefits, higher taxes, and fewer opportunities to reduce taxes. Most people should plan to spend less, save more, and work longer.

A good guess is that most over age 55 won't have to deal with lower benefits from Social Security and Medicare, except those with higher incomes. Those farther from retirement likely will face changes.

What should you do?

The good news is the economic crisis prevents the imposition of higher taxes for a year or more. That gives you time to plan.

IRAs and retirement accounts likely will be hurt by future tax increases. All distributions are ordinary income, and you cannot spend the money without taking a distribution.

In the past I showed subscribers when it makes sense to pay taxes early on an IRA by either emptying it or converting to a Roth IRA (if adjusted gross income is $100,000 or less). These strategies will be profitable now for more people if income tax rates rise. In 2010 and later years under current law anyone will be able to convert a traditional IRA to a Roth IRA.

More people should give serious thought to emptying their IRAs early or converting to Roth IRAs. Details are in the members section of my web site and in my book The New Rules of Retirement.

It is too soon to sell appreciated capital assets to avoid higher taxes. A retroactive capital gains tax increase is unlikely. The government wants to tell investors in advance that the tax will increase, because the announcement will trigger asset sales by people seeking to lock in the lower rate, boosting government revenue. Be ready to sell appreciated assets in a year or two to avoid higher capital gains taxes, and expect lower after-tax returns from capital assets after that.

The same advice applies to dividends. There won't be much you can do to avoid the eventual increase. Factor lower after-tax income from dividends in your plans. As the tax rate on dividends increases higher after-tax income might be available from bonds or other income investments.

Reconsider plans to defer future income. Your income tax rate in the future is likely to be higher than today. You could have more money in the long-term by paying taxes today and investing the after-tax amount.

That means you should review IRA and 401(k) contributions and deferred compensation arrangements. Those earning $50,000 or less probably won't be hit with higher income tax rates and can safely continue tax deferrals. But the higher your income is above $50,000, the greater your risk of paying higher rates in the future. Income tax rate increases might very well be retroactive at some point. In a rising income tax regime, it is better to pay taxes today than in the future.

Forget the notion you will be in a lower tax bracket in retirement. Many of us will be in higher tax brackets, especially when all types of taxes are included. This is another reason to reduce tax deferral.

Retirement spending plans should be revised to reflect higher costs. If you are not already retired, consider working longer and saving more. You might have to pay more for medical care, utilities and other energy-using services, and more. Your Social Security benefits might be reduced because of means-testing. As the tax proposals become more specific and are closer to enactment, investment plans will need to be revised or you will have to accept lower after-tax returns.

Bob Carlson is editor of the monthly newsletter and web site Retirement Watch (www.RetirementWatch.com). He also is the author of The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Asset Declines=A Planning Opportunity

BobCarlson — Fri, 13 Feb 2009 19:33:00 GMT

There is at least one silver lining in today's dark clouds—estate planning opportunities are being created. Falling market prices and low interest rates are a great combination for estate planners. If the price depression of the assets is temporary, there is the potential to transfer significant future wealth at a substantial tax discount.

You probably have been postponing estate planning, because of uncertainty about the law and the value of assets. In 2009 or perhaps 2010, the estate tax law probably will be made permanent. The President essentially favors making the 2009 law permanent: A lifetime estate tax exemption of $3.5 million and a top tax rate of 45%. Some details might change, but the final law should be close to that.

Another advantage is that the annual gift tax exemption is indexed for inflation and rose to $13,000 as of Jan. 1, 2009. Each person can give up to $13,000 free of gift taxes to any person in 2009. The tax-free gifts can be made to as many people as you want. A married couple can give $26,000 jointly. In addition, the first $1 million of all lifetime gifts by a person above those sheltered by the annual exclusion are exempt from gift taxes. To the extent the $1 million gift tax exclusion is used, the estate tax exclusion is reduced.

Today's relatively low asset prices highlight a reason to give assets now instead of later through the estate.

Estate and gift taxes are imposed on the value of property. If a mutual fund has declined in value, you can give more shares tax free than you could have before the decline. For example, Dodge & Cox Stock was valued at $132.63 on Feb. 1, 2008. You could have given 90.47727 shares of the fund to someone tax free using the $12,000 annual exclusion. At the recent price of $67.48 you could give 177.8305 shares if you wanted to give $12,000 worth, or 192.6497 to take advantage of the new $13,000 limit. After the financial crisis and economic decline end, the share prices will recover. The future appreciation above the $67.48 price would be out of your estate and into the hands of your heirs with no estate or gift taxes.

This strategy applies to real estate, small business interests, and other assets that have declined in value over the last year or two. If the steep declines of the last year are temporary, this is a rare opportunity to shift assets out of your estate at a fraction of their real or long-term value.

Before giving an asset, however, determine your tax basis in it. Under gift tax law, your heirs will take a tax basis equal to the lower of your basis and the market value at the time of the gift. If the asset has declined below your basis, it makes sense for you to sell it, deduct the loss on your tax return, and give the cash proceeds from the sale. Or if you are concerned that the heirs will spend a cash gift, buy an investment that is not substantially identical to the one you sold and give that new asset. That generates two tax benefits. You deduct the current loss against your income, and all future appreciation is out of your estate.

The best assets to give are those in which you do not have a paper loss but that are likely to appreciate significantly once the financial and economic situation improves. By giving such assets you are likely to transfer the maximum amount of wealth to future generations at the lowest tax cost.

Because of the potential to shift a significant amount of future appreciation to your loved ones at today's relatively low values, it makes sense to give more than the $13,000 gift tax exemption and begin using the lifetime $1 million gift tax exemption. If you do not need the assets to maintain your standard of living and know you eventually will leave them to your children or other heirs, consider making the gifts now. You will be able to transfer far more assets tax free at today's values than you could have in the recent past and than you will be able to after appreciation resumes. Your heirs will end up with far more wealth, because the taxes on your estate will be much lower than if you retained the assets and let them be taxed as part of your estate.

Those are the basics for taking advantage of today's economic distress. Next week we will discuss ways to leverage these strategies and the current economic environment.

Bob Carlson is editor of the monthly newsletter and web site Retirement Watch at www.RetirementWatch.com. He also is the author of The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Taking Advantage of the 0% Capital Gains Tax Rate

BobCarlson — Fri, 30 Jan 2009 22:21:00 GMT

For the two lowest tax brackets, the tax rate in 2008 through 2010 is 0% for qualified dividends and long-term capital gains. This compares to the 15% top rate others will pay on those types of income. Single taxpayers with taxable income up to around $33,000 and married couples filing jointly with taxable incomes up to about $65,100 qualify for the 0% rate. The 0% rate applies to any long-term capital gains that qualify for the 15% rate for other taxpayers, not to just to gains on publicly-traded stock.

But there is a lot of confusion and misunderstanding about the 0% tax rate.

It is not an all-or-nothing situation. Because the tax rates are graduated, even some taxpayers with incomes above the threshold could have some income taxed at the 0% rate.

Many retired couples have taxable income below $65,100. Suppose a couple normally has taxable income of $30,000. In 2009 they realize a long-term capital gain of $70,000, bringing their taxable income to $100,000. The first $35,100 or so of that capital gain is taxed at the 0% rate. The rest of the gain is taxed at the 15% rate.

Keep in mind that interest from tax-exempt bonds is not counted in determining the threshold, so well-off taxpayers can qualify some or all of their qualified income for the 0% rate.

This situation provides opportunities for low-bracket retirees to realize some long-term capital gains on asset they otherwise might not held and pay a 0% rate on at least part of the gains. There also is an incentive to switch some investments to dividend-paying stocks that qualify for the 15% rate for other taxpayers.

Another opportunity presents itself for taxpayers who are supporting parents in a low tax bracket. The taxpayers could give some appreciated securities to the parents, who sell them and pay 0% tax. The amount given should stay within the annual gift tax exclusion amount of $13,000 to avoid owing gift taxes or using part of the lifetime gift tax exemption.

Gifts of appreciated securities also could be made to children in low tax brackets, but the gifts would have to be made to adult children. Congress changed the law on the Kiddie Tax to prevent high income parents from giving securities to their minor children to sell and pay 0% capital gains taxes. To avoid the restrictions, the children must be over 21, or over 23 if they are full-time students. The restrictions also can be avoided if the children do not qualify as dependents on their parents’ tax return by providing more than 50% of their own support and earning income. Youngsters who do not meet those exceptions must have incomes less than $1,800 to qualify for the 0% rate.

Couples receiving Social Security benefits will have to be careful when executing these strategies. Increasing taxable income through the recognition of long-term capital gains also could make more Social Security benefits subject to income taxes.

In most cases, the additional tax on the Social Security benefits will be quite low and will make the effective tax rate on taking the capital gains just a few percentage points. Even so, one should run the numbers to determine the effect such a transaction would have on the full tax picture.

A taxpayer needs to consider the non-tax picture before plunging ahead to take advantage of the 0% tax rate. There must a reason for selling the asset other than to cash in the gains at a low rate. The difference between the 0% rate and 15% rate is going to be small in actual dollars, especially considering that only the gains below the taxable income thresholds for the lowest brackets qualify for the 0% rate.

Yet, if someone planned to sell the asset in the next few years, needs to reposition a portfolio, or has a new opportunity, taking a look at how to qualify at least part of the gain for the 0% rate is worth doing.

When deciding which assets to sell, one strategy is to sell stocks or other assets with the least amount of capital gains. Normally, with a tax-advantaged strategy one wants to maximize the gains taxed at the low rate. But there is a ceiling on the amount of gain that qualifies for the 0% rate each year. The goal should be to generate the maximum amount of cash at the lowest tax cost. By selling assets with the least appreciation, it is possible to free up more after-tax cash than if assets with higher appreciation were sold. This is a good strategy for retirees who are deciding which assets to sell to pay for their expenses the next few years.

The main problem now for most people will be to find assets that have capital gains in them. But those who have held assets for a long time likely have gains they have not recognized.

The 0% tax rate is tricky. But there are many retirees who qualify for it, and they should review asset sale strategies.

Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site www.RetirementWatch.com.

Your Retirement Plan and the New Washington

BobCarlson — Fri, 07 Nov 2008 17:44:00 GMT

Come January, Democrats will be in charge all over Washington. They campaigned on a theme of change, and we should expect major changes. The questions are which changes and how will they affect your retirement finances?

I will focus on the changes I think are most likely to occur. When evaluating the prospects for change, it is important to keep in mind the tension that will exist in the New Washington. Congress will be run by very liberal politicians who have a long list of legislation they wanted to pass for many years. These wish lists generally involve higher spending, more government control and regulation, rewarding favored activities and punishing others, and of course higher taxes. The new President, on the other hand, wants to be re-elected and probably recognizes that the country is center-right, not liberal, on most issues. There will be tension between the President and Congress, and the great unknown is which one will prevail. I assume that for at least the first couple of years the President will have the upper hand and will be able to move the more extreme liberal measures to the back burner.

Here are things you should prepare for over the next year or two. Other changes might be coming after that.

Medicare: This health program for those over 65 is approaching bankruptcy. Social Security will begin spending more than it receives in a few years. Medicare passed that point long ago. It soon will have exhausted the “trust fund” set up for it and rapidly is taking a larger share of the federal budget.

A few years ago “means-tested” premiums began as we discussed in Retirement Watch. Premiums increase as a beneficiary’s income rises. Similar changes are likely to occur. Premiums for higher income beneficiaries could rise even more and some types of care might not be covered for higher income beneficiaries. Or deductibles and co-payments also might be means-tested. Higher income beneficiaries might be required to cover the first $5,000 to $10,000 of their medical expenses in addition to paying higher premiums.

The government might have a stronger role in “negotiating” drug prices. Medicare prices are a basis for prices providers charge to private insurers. If the government negotiates very low prices, manufacturers might conclude that some drugs are unprofitable to produce or reduce research spending on new drugs.

The government also might take over the Part D prescription drug program instead of allowing private insurers to compete for beneficiaries.

Medicare Advantage plans also might take a hit. Democrats in Congress have targeted these since returning to the majority after the 2006 election. These plans run by private insurers receive higher reimbursements than other Medicare plans but usually offer greater benefits. Democrats want to eliminate them and bring everyone back into traditional Medicare.

Greater use of technology is likely to be mandated across the medical profession, and the government will assume cost savings from this move. It also is a way of pushing costs from the government to the private sector. That could affect the quality or availability of care for a while and increase costs on care not covered by Medicare.

Estate tax: Congress has to address the estate tax soon. The current law eliminates the estate tax for 2010 and returns to the 2001 law beginning in 2011. Congress is unlikely to let either the expiration or return to 2001 law occur.

The most likely outcome is, after a great deal of debate, something similar to current law will be enacted. That means the estate tax exemption will be fixed at $3.5 million and might be indexed for inflation. The top estate and gift tax rate will be 45% or 46%, though it could go up to 50%. It will be interesting to see if the lifetime gift tax exemption remains capped at $1 million or is allowed to rise. Also unclear is whether the current step-up in basis that is allowed for inherited assets will continue or whether heirs will have to take the deceased’s basis and pay capital gains taxes on appreciated that occurred during the deceased’s ownership.

Retirement plans: Here is a sleeper issue that came up only in the last month. Many in Congress do not like President Bush’s “ownership society” concept, and they view 401(k) plans as part of that. They are looking at ways to change qualified retirement plans.

A longstanding goal was to require private employers to provide minimum pensions. That might be replaced by a plan to have the government take over private pensions. Recent committee hearings highlighted a plan that eventually would eliminate tax breaks for 401(k) plans and give individuals a window during which they would receive some benefits for converting their private 401(k) plans into government retirement plans. This approach clearly has support from congressional leaders, but its support beyond that is unclear.

Investing: Anticipate some surprises here. Presidents are not able to implement all their campaign proposals. Congress and circumstances can change the plans. Don’t invest based on campaign rhetoric. Wait until proposals are closer to becoming laws.

There could be a positive surprise in the change of power. The financial problems largely have developed into a confidence problem. People do not trust current leadership or the information it puts out. Financial companies do not know what to expect from the government, so they are hoarding cash to protect themselves. Investors simply are not buying anything with risk, and financial firms are not doing business.

Some shrewd moves by the new President in the next few weeks could start to restore confidence at least temporarily. Appointment of a popular choice for Treasury Secretary and announcement of an effective tax cut and regulatory reform plan could spur optimism among investors.

Of course, stumbles on any or all of these issues could extend the crisis. Further down the road, higher taxes, spending, and regulation could reverse any positive trends. But there is an opportunity now to restore optimism even as the economic slump deepens for the next quarter or so.

Congress also could squander the opportunity. There is a movement to expand the government rescue plan to include a range of industries and to impose very tight regulations on financial and other firms taking government money that effectively nationalizes them. A move in that direction would further diminish investor confidence.

Don’t believe simple analyses of how the new administration will affect investments. It is normal for analysts to look at campaign proposals and target companies they believe will benefit from the proposals. Those forecasts almost never work out. Ignore analysts who recommend that you buy “green companies” and short defense contractors and health care companies. Wait for detailed plans to be proposed and make their way through Congress.

Taking action simply on the new election of politicians can be a risky business. I have outlined what I think are the most likely changes over the next few years. But be prepared for surprises. You need to build a cash cushion in your retirement plan for the possibility of paying a higher share of medical expenses. Be ready to revise your estate plan sometime next year or early in 2010. Keep an eye out for early signs of changes in retirement plans and be ready to move your assets into other types of accounts in case a major change is in the works. With your portfolio, don’t fall for obvious analysis. There is the potential for surprise in the next few weeks.

Avoiding IRA Inheritance Disasters

BobCarlson — Fri, 19 Sep 2008 17:31:00 GMT

IRAs are supposed to be simple, but when it comes to inheritance IRAs are more complicated than most people realize. It is not unusual for IRA heirs to misunderstand some key rules. A wrong move or two triggers high taxes, often causing most of the IRA to end up with the IRS. Income taxes can take 35% or more of the IRA. Estate taxes can take another chunk.

Part of your estate planning should ensure that your heirs know what to do — and what not to do — with the IRA. Don't expect that they will get good advice from the IRA custodian, or just any accountant, or financial professional. We are in the early stages of the first generation to inherit IRAs, and many advisors are not up to speed on the rules. IRA custodians are not in the business of advising beneficiaries or their best moves. You need to get good advice and pass it on to your heirs.

Here are the key inherited IRA mistakes and how to avoid them.

Disappearing documents. Your will or living trust has no effect on an IRA. Only the beneficiary designation on the form held by the IRA custodian determines who inherits the IRA. IRA owners often make the mistake of not designating a beneficiary or not updating the form after a beneficiary passes away. Another common mistake is the heirs’ misplacing or not being able to find the designation form. They have to depend on the custodian to have a current copy. Custodians don’t always have a copy, especially if it was filed many years ago or the original firm has merged one or more times.

In any of those cases, the custodian's rules (if it has any) determine the beneficiary. It might be your estate, which is the worst result from a tax standpoint. Or it might be a spouse when you intended the IRA to go to your children.

Keep copies of your beneficiary designation forms in a file that is easy to find, and keep the designations up to date. Let your executor and heirs know where the forms are.

Ignoring spousal benefits. When a surviving spouse inherits an IRA, a special option is allowed.

One option is for the inheriting spouse to treat the IRA the same as any other beneficiary can. Or the spouse can roll over the inherited IRA into a new IRA in his or her own name. The rollover allows the surviving spouse to start a new required minimum distribution schedule based on his or her own age. It also allows the spouse to name new beneficiaries.

The rollover often allows the IRA to last longer both during the spouse's lifetime and when his or her beneficiaries inherit the IRA. Without the rollover, required distributions must begin soon after the IRA is inherited and might use a shorter distribution schedule than the spouse could establish under a rollover.

If the inheriting spouse is under age 59½, however, and needs to begin taking withdrawals from the IRA, then a rollover would not be a good idea. Distributions before age 59½ would be subject to a 10% penalty in addition to income taxes. But the 10% penalty does not apply when the RMDs come from an inherited IRA that is not rolled over.

Your spouse should know that he or she has options, and the consequences can be very different. Ensure that a good advisor is available to your spouse or leave some suggestions and guidelines for the spouse to follow.

Rolling over an IRA or changing the title. Non-spouse beneficiaries don't have the same options as surviving spouses. For example, if your children inherit the IRA and roll it over into their own IRAs, then the entire inherited IRA would be fully taxable. The children would be treated as though the inherited IRA were distributed directly to them in cash. They might also owe a 6% excess contribution penalty for each year the money sits in their IRAs. If they roll over the inherited IRA to new, separate IRAs in their own names, they will owe only the income taxes.

Yet, many IRA custodians simply ask the heirs what they want to do with the IRA and don’t explain fully the consequences of the actions.

To prevent immediate taxation, an inherited IRA must be maintained, but it must be retitled by Sept. 30 of the year after the year of the original owner's death. The new title must have the name of the deceased followed by "deceased" or "decedent." Also included must be the beneficiary’s name and statements that the account is "for the benefit of" or "FBO" of the beneficiary and that it still is an IRA. For example: Max Profits, deceased, IRA FBO Hi Profits, beneficiary.

Spending down the IRA. Despite all their parents' planning, an extremely high percentage of nonspouses who inherit IRAs take the balances as lump sums and spend them. That's too bad. The heirs will pay income taxes on the entire balances. The amount they have left to spend depends on their income tax brackets and your estate tax bracket. In most cases, it is a fraction of the IRA’s original value.

Instead of spending the IRA on whatever their current needs are, heirs should let the IRA continue to compound tax deferred. They would end up with significantly more wealth than they would by taking a distribution. It probably even makes sense for the heirs to suspend their own 401(k) and IRA contributions or other savings to free their own cash instead of taking distributions from the IRA.

If your beneficiaries are likely to spend the entire IRA after inheriting, consider leaving them other property if you have it. It would be better to leave the IRA to other beneficiaries or charity. Heirs that plan to spend the inheritance quickly are better off receiving non-IRA assets, if that option is available to you.

Inheritors of IRAs who do not spend the balance right away must begin taking required minimum distributions over their life expectancies. The RMDs have to begin by Dec. 31 of the year following the year of the previous owner's death.

Some heirs fail to begin taking the RMDs, so they pay penalties. Others take the RMDs under the wrong schedule and take larger distributions than they need to. Be sure your heirs who will not spend the IRAs have good information about how to determine the RMDs that will stretch the IRA the most.

Overlooking the tax deduction. Distributions from an inherited IRA are what the tax code calls income in respect of a decedent. This status entitles the recipient to an income tax deduction for the portion of the estate tax attributable to the IRA. Determining the deduction can be complicated. First, determine the amount of the estate tax paid that is attributable to the IRA. Then, the duration of the IRA distributions is estimated. Finally, a pro rata portion of the tax is deducted each year that a distribution is taken. Details are in IRS Publication 3920.

Not splitting the IRA. Until 2001 and 2002 changes, when multiple beneficiaries inherited an IRA most of the time they had to share the IRA. That meant making joint investment decisions and computing required distributions based on the age of the oldest beneficiary.

Now, an inherited IRA can be split into separate IRAs for each of the beneficiaries. Then, each beneficiary makes individual investment decisions and takes required distributions based on his or her own life expectancy.

If splitting an IRA is what your heirs are likely to do, then check with your IRA custodian. Though the tax law allows IRAs to be split, the custodian doesn’t have to allow it. Be sure the custodian will allow a split and will not charge fees or penalties for the split. If it won’t, move the IRA to another custodian now.

Also, be sure your heirs know their options, the consequences, and the deadlines.

IRAs are the prime assets in many estates. They are surprisingly complicated financial accounts — especially when it is time to take distributions. Few people know how to handle them. Be sure your beneficiaries have the information they need to make the right decisions.