This year was the first one in which clients had to file tax returns reflecting the changes under the American Taxpayer Relief Act of 2012. Clients and advisers are now creating a playbook that involves considerable teamwork to address the altered reality.
A raft of new taxes and higher tax brackets called for some fancy footwork by advisers and accountants who sought to mitigate the effects of the tax law changes. What has made 2014 notable is how investment tactics have melded with tax planning to create a unified strategy.
“One thing all these tax changes mean is that the investment adviser is now the quarterback of the estate- and tax-planning team,” said Martin M. Shenkman, a tax- and estate-planning lawyer with his own firm.
In that sense, financial advisers direct the income tax savings play because they oversee client assets and know which accounts hold them.
Meanwhile, estate-planning lawyers and accountants provide additional support by creating trusts and tax strategies.
This kind of teamwork has become even more imperative with the planning complications wrought by ATRA.
Here's a refresher on what made those tax bills so steep back in April. If you've been doing your tax-planning homework, you've probably been beating the drum about ATRA. Marginal tax rates rose to 39.6% for single filers with taxable income over $400,000 and for married-filing-jointly taxpayers with taxable income over $450,000. People in both groups face a tax rate of 20% on long-term capital gains.
Singles with modified adjusted gross income of $200,000 and married-filing-jointly couples with MAGI of $250,000 face a surtax of 3.8% on the lesser of income over those thresholds or net investment income. And there's a 0.9% Medicare tax on wages over those amounts.
Last is the tax-planning dynamic duo of PEP and Pease. That is, the phaseout of personal exemptions (PEP) and itemized deductions (Pease, a provision of the tax code named after the late Rep. Donald J. Pease) for singles with over $250,000 in adjusted gross income and married couples with over $300,000 in AGI.
BACK TO BASICS
With taxes playing an ever-bigger role in clients' planning, advisers need to familiarize themselves with the intricacies of the tax brackets and the applicability of certain taxes for different types of income. Taxable income isn't the same as modified AGI, and different taxes apply to varying thresholds of both types of income.
“The thing advisers should be aware of is where the income will fall,” said Ed Slott, an IRA expert and founder of his own firm. “You can be subject to the 3.8% surtax, but your income might not be high enough for the higher rate on capital gains or for the phaseout of personal exemptions and itemized deductions.”
Knowing where clients land in terms of taxable income, MAGI and AGI lays the framework for a tax mitigation strategy.
“Some people think if they bulk up on itemized deductions, it'll help [reduce taxes],” Mr. Slott said. “It reduces taxable income, not AGI, which is where the biggest deductions and credits are based. If your AGI goes up, you'll pay more in taxes.”
The question then becomes: How do you reduce your AGI? Clients with bonds can amortize them and reduce their AGI in the current year, according to Craig Richards, director of tax at Fiduciary Trust Co. International. They can also defer bonuses, choosing to take them in January instead of December.
There's also room for creativity, depending on the client's situation.
“Opportunities aside from investments include property: We can talk about postponing a real estate sale, or whether an installment sale makes sense,” Mr. Richards said.
GAS OR BRAKES
Once the income from the 2014 tax year is sliced and diced, the discussion turns to whether accelerating deductions and deferring income are good moves.
“The intuitive thought is to hit the gas on the deductions and put the brakes on income so you can lower taxable income and reduce current taxes,” said Chris Price, an advanced-sales lawyer for the retirement solutions distribution business of Lincoln Financial Distributors.
That doesn't always apply, though. Clients subject to the alternative minimum tax may want to consider accelerating their income so that they're subject to a lower marginal tax rate of 26% on the first $182,500, and 28% on the excess, according to Mr. Price. Doing so allows significant savings over the maximum ordinary income tax rate of 39.6%.
“An easy way to accelerate income is to do it at year-end by taking some IRA money and doing a Roth conversion,” he said.
A weight was lifted from many families with the announcement that the 2014 estate tax exemption for an individual would be $5.34 million. Executors of estates below that threshold don't have to file an estate tax return.
But that doesn't mean those clients don't need planning, particularly if they're married and count on taking advantage of the portability of their individual exemptions. Portability allows a surviving spouse to assume the unused portion of the deceased spouse's exemption.
“Portability is supposed to bring simplicity into estate planning for almost all estates. You can leave everything to your surviving spouse,” said Lisa R. Featherngill, a certified public accountant, personal financial specialist and managing director of planning at Abbot Downing. “When we started working the numbers, we found that it's not that easy.”
The unused exemption isn't indexed for inflation, which means problems will arise if the surviving spouse's estate increases in value, setting the table for steep estate taxes.
Planners need to revisit estate documents and ensure there's enough flexibility to allow other methods to mitigate estate taxes in the event the portability exemption isn't enough, Ms. Featherngill said.
Further, with the estate tax exemption so high, the focus has turned to lowering income taxes as part of estate planning.
“It may have made sense in the past to give stock to someone early in life, knowing that they would avoid the estate tax,” said Robert M. Baldwin, a CPA and personal financial specialist at Baldwin & Associates. “If they won't have the tax, then it makes sense to hold the stock until death to get the step-up in basis.”
Older clients could be holding on to assets that have appreciated significantly. With a step-up in basis, heirs receive the asset at its higher value — meaning they won't have major capital gains tax consequences in the case of a sale.
Though federal estate taxes may not be a concern for estates below the exemption, be wary of state-level estate taxes. Strategic giving may be a good move for clients who want to shrink their estate.
Low-basis stock can be given to young-adult children or grandchildren — ideally those making less than $36,900, so they avoid capital gains taxes altogether if there's a sale, said Gail Cohen, vice chairman and general counsel of Fiduciary Trust Co.
Funding medical expenses and tuition is also an effective way to shrink the estate, provided those checks are written directly to the institution, Ms. Cohen added.
“We continue to encourage clients to pay medical and educational costs that continue after ATRA,” she said. “It falls out of your estate.”