Tax tips that can lighten a client’s 2014 bill

A high tax bill next April is a certainty for many high-net-worth clients, but tax gurus say there are still opportunities to scramble for savings.

You just have to know where to find them.

At the beginning of this year, Congress passed the American Taxpayer Relief Act of 2012 — a last-ditch effort to avoid the fiscal cliff and avert the enactment of draconian tax hikes.

The wealthiest individuals wound up with increases to a number of key taxes. The highest income tax bracket is now 39.6% and the highest capital gains rate is 20%.

Add to this a pair of new levies for high earners. The net investment income tax of 3.8% applies to either net investment income (such as income from rent and annuities, as well as dividends and capital gains) or marginal adjusted gross income over $250,000 for married couples or $200,000 for single filers, whichever is less. An additional Medicare tax of 0.9% on earned income also is applied over those thresholds.

And estate taxes are now at a maximum of 40% after a $5.25 million exemption, meaning that plenty of planning is still in order for the largest estates.

A more punitive tax system has led accountants to sharpen their approach toward managing these new levies. Priorities are shifting, and new strategies are emerging, ranging from tactics to keep clients out of the highest tax brackets to deliberately “breaking” old estate-planning strategies.

“We need to rapidly transition from a two-dimensional tax system to a five-dimensional tax system,” said Robert S. Keebler, partner at Keebler & Associates. “There will be a quantum leap in how we approach and analyze client situations.”

Bracket management

On the top of the tax tips list is the concept of bracket management, or the use of income-smoothing and tax deferral strategies to ensure that clients “fly below the radar,” as Mr. Keebler put it. Clients must think about doing their tax planning on a time horizon that spans five to 15 years, ensuring that their income sources are managed to keep them out of the highest brackets.

“Bracket management is still a concern for someone who’s retired,” he added. “Clients will be demanding that kind of expertise from their -advisers.”

Next is harvesting capital gains and losses, a subset of strategies that can help manage income streams and mitigate capital gains taxes.

Harvesting gains

Harvesting gains at the end of the year might make sense for taxpayers who think they’ll be in a higher bracket in the future. Sell assets this year, pay the tax on the gains at a presumably lower rate and then step up the assets’ basis to the sale price. The client can buy back the asset and sell it whenever he or she otherwise would have sold it had the gains not been harvested.

The end result is that the gains are recognized in a year with lower capital gains taxes, rather than in the future, when they would be subject to higher levies, according to Mr. Keebler. The catch, however, is knowing what the tax brackets will be for clients in future years.

Because the stock market fared so well this year, advisers will need to be especially cognizant in helping clients manage capital gains. Those with mutual funds in taxable accounts could be taxed on distributions that the mutual funds will make after selling securities. Those distributions are taxed as short-term gains from securities that are held for a year or less — which are taxed at the same rate as ordinary income, a maximum of 39.6%, plus the 3.8% net investment income tax — or long-term gains for those held more than a year. Clients could consider selling their holdings so they miss the distribution and then buying back their mutual fund shares after the distribution has been made to shareholders, said Richard Gotterer, a managing director and senior financial adviser with Wescott Financial Advisory Group.

Harvesting losses

Loss harvesting is also valuable, considering not only the steep capital gains taxes but also the fact that those gains have an additional 3.8% surtax attached to them. Capital losses also can be carried forward up to seven years from when they occurred.

“Losses become very valuable tools going forward; you can offset capital gains distributions,” Mr. Gotterer said.

For maximum efficiency, Mr. Keebler recommends using long-term losses to offset short-term gains. (For more on loss harvesting strategies, see Page 20.)

Roth IRA conversions

Another suggestion for managing taxes and income brackets is to look at Roth individual retirement account conversions, a perennial favorite tax tip.

Roth conversions require an upfront payment of income taxes on the amount converted, so clients need to consider whether they’ll be subject to higher income taxes in the future when receiving distributions, according to Mr. Keebler. Roth IRAs provide tax-free income, unlike their traditional-IRA counterparts, and distributions aren’t counted in modified adjusted gross income or the net investment income — so they are not subject to that 3.8% net investment income tax, Mr. Keebler noted.

Estate planning

With estate tax exemptions permanently set at $5.25 million, adjusted for inflation, many clients with estate plans may require revisions. For instance, in the past, it made sense to transfer certain assets out of the estate in order to mitigate taxes.

“There are people who took those plans when the exemptions were lower, and they may now wish they didn’t transfer their asset out of the estate,” said Andrew Katzenstein, a partner in the personal-planning department at Proskauer Rose, a law firm.

Transferred assets that might be worth another look include an interest in a family business a client may have transferred out of his or her estate to a grantor trust for the children. It might be time to think about getting that asset back into the estate by repurchasing it for cash or a high-basis asset, take advantage of the new estate tax exemption rates and get a step-up in basis on the business interest when the client dies.

“There are examples where -people have made transfers, and because the exemption is so high, they will wish they haven’t lost the basis step-up,” Mr. Katzenstein said. “So the question is how to clean up the plans you set up before so the client receives this tax benefit.”

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