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Four top lessons for financial advisers from this year's tax sticker shock

With clients still smarting from April 15, now is the time to talk with them about strategies for lowering their tax burden

Jun 5, 2014 @ 11:55 am

By Chad Smith

tax, irs, capital gains, medicare, advisers, high net worth, affluent, uncle sam
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One topic that was a focal point at CONNECT14, the annual HD Vest national conference is the extent to which many clients, both affluent and mass affluent, were caught off guard by the checks they had to write to the Internal Revenue Service this year, in connection with the size of their 2013 tax obligations.

Though tax increases on investment income had been in the works for years and were widely publicized, an unusually large number of taxpayers were shaken when they actually had to write an outsized check to the IRS in 2014 for their prior year tax obligations.

Most people don't grasp what tax increases mean for them until the actual checks to Uncle Sam are due. But now, with their wallets still smarting from April 15, clients have become hyper-sensitive to tax issues. This creates an opening and an opportunity for advisers to address.

To recap, last year individuals and married couples earning $200,000 and $250,000, respectively, were hit with a 3.8% Medicare surtax while individuals earning over $400,000 and married couples earning over $450,000 experienced a 5% rate hike on dividends and capital gains. These changes meant that investors at the top end of the spectrum saw their investment income tax rates jump to 23.8% in 2013 from 15% in 2012, a surge of nearly 60%.

Not surprisingly, advisers who lead off their client discussions this year with tax mitigation strategies should find their audiences very receptive. Indeed, as the calendar turns to the second half of 2014, it's possible that an increasing number of clients will find that strategies for lowering their tax burden will take precedence over more traditional ideas focused simply on return on investment. In particular, here are four basic ways advisers can best 'lead with taxes' with their affluent clients:

Defer, defer, defer — Clients need to get the most out of their qualified retirement plans, taking advantage of 401(k) and IRA contribution limits to significantly lower their level of taxable income. This is especially important for affluent clients, since a significant percentage of individuals in the top income bracket are small business owners whose retirement plan options have much higher contribution limits than most employer-sponsored plans.

Emphasize tax-efficient investment products — Advisers should seek out tax-efficient products, such as investment vehicles that have low turnover. Not only are such vehicles often less expensive but they don't trigger as many taxable events. Perhaps the most time-honored way to achieve tax efficiency in fixed income is through buying and holding municipal securities. The derived interest income is generally exempt from federal and, in many instances, state income taxes.

Combine estate planning and tax planning — Trust and estate tax strategies can get complicated, but there are a number of ways in which advisers can help older clients alleviate their estate tax burden, both at the federal and the state level. Quite often, it can be as simple as transferring a portion of their income-generating assets to the next generation directly, which is likely to pay taxes at a much lower rate.

Reposition assets — Another way to effectively deal with income-generating assets is to strategically plan your asset allocation by keeping assets that are likely to produce capital gains in non-qualified accounts and moving income-producing assets into qualified accounts. The qualified plan assets are not subject to taxes until the plan participant begins the draw-down phase, when, ideally, he or she is in a lower tax bracket. Meanwhile, long-term capital appreciation vehicles, which tend to have much better tax treatment, should be in non-qualified accounts, if possible.

Many of the above strategies are not new. But given the dramatic changes in the tax structure, they've taken on new urgency and advisers should give them greater consideration when addressing clients' tax situations across their bigger financial picture.

Our nation is facing serious financial challenges. As baby boomers continue to retire at a breathtaking rate, there are simply not enough younger workers to replace them to prop up the tax base, which is putting enormous strain on healthcare and entitlement programs. What's more, much of the nation's infrastructure needs to be replaced or repaired. All of this will cost money.

And while lawmakers in Washington have known about these issues for decades, at some point someone is going to have to pay the piper. That time is coming. Higher taxes and a more complex tax regimen are probably here to stay, so it's more imperative than ever to get your clients ready with some simple blocking and tackling.

Chad Smith is Wealth Management Strategist at HD Vest Investment Services, an independent broker-dealer with approximately $34 billion in assets under management as of Feb. 28, 2014.


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