Financial advisers this tax season are coping with what they say is an unprecedented level of client anxiety over recent tax code changes and the potential for higher taxes.
Clients have many questions about changes to the estate tax that became effective Jan. 1, whether they should take capital gains now if it is likely that tax rates will rise and whether they should convert to a Roth individual retirement account.
“We're certainly hearing from lots of people concerned about taxes,” said Harold Evensky, president of Evensky & Katz Wealth Management, which has more than $600 million in assets under management.
Although taxes are always a hot topic this time of year, fears over these specific issues have made it even more of a “conversation starter” this month, said Matt Mikula, a wealth manager with Balasa Dinverno Foltz LLC, which manages $1.5 billion in assets.
Many of the discussions that his firm is having with clients center around whether, given the likelihood that taxes will go up, investors should take capital gains now at the present tax rate of 15%, with the expectation that next year, it will be 20%, he said. The 15% rate on long-term capital gains, which was originally set to expire in 2008, will expire at the end of this year unless it is extended again — an unlikely prospect, Mr. Mikula added.
While many clients want an immediate resolution to their concerns about capital gains, some advisers are actually suggesting that they do nothing.
“We're not recommending anyone take action unless they have reason to believe they will be taking money out a year from now,” Mr. Evensky said.
It makes little or no sense for long-term investors to take a tax hit now, just on the assumption that taxes will go up, he said. Even if taxes do increase, the amount that would be saved by making a move now would be minimal at best, Mr. Evensky said.
MORE DIVERSIFICATION
But Scott Kays, president of Kays Financial Advisory Corp., said that it may be appropriate for long-term investors to take capital gains now. The firm manages $120 million in assets.
“You have a lot of people who have held on to particular stocks for a number of years,” Mr. Kays said.
Changes to the estate tax can be even more confusing for investors.
The federal estate tax expired Jan. 1 but will be reinstated next year at a maximum rate of 55%.
The generation-skipping transfer tax — a separate tax imposed at the highest estate tax rate that applies to the transfer of wealth to grandchildren or future generations — was also temporarily repealed.
And while the gift tax remains in effect, there is a $1 million exemption amount and a gift tax rate of 35%, down from 45% last year.
All this has “created some planning issues,” said Mr. Mikula, whose firm organized a webcast last month to answer clients' questions.
Some of the firm's recommendations to clients include making taxable gifts early this year to take advantage of the relatively low 35% gift tax rate, retaining sufficient resources in a decedent's estate to pay for any “retroactive” fix to the estate law, and to delay funding trusts after death in the event the legislation is retroactive.
But the biggest issue on clients' minds continues to be whether they should convert from a traditional IRA to a Roth.
New rules took effect Jan. 1 that allow individuals who earn more than $100,000 annually to convert to Roth IRAs. Previously, only those who earned less than that amount could convert.
Advisers, however, warn that Roth IRAs aren't for everyone.
“We're looking at it on a client-by-client basis,” Mr. Evensky said.
FIVE-YEAR CLOCKS
Considering the advantages of a Roth over a traditional IRA — for example, withdrawals of principal and income are free of income tax, and heirs don't pay income tax on withdrawals from inherited IRAs — the decision to convert would seem an easy one.
Additionally, though investors still must pay ordinary income tax on each dollar converted, they can spread the tax bill over two years, splitting it between their 2011 and 2012 tax returns.
But there are several issues investors need to consider, according to advisers.
For example, many investors don't understand that there can be multiple “five-year clocks” running simultaneously that apply to Roth IRA withdrawals.
A five-year clock starts the day a Roth IRA is opened and funded. Earnings can be withdrawn tax-free without penalty after five years and a qualifying event such as turning 591/2 occurs.
An additional five-year clock, however, is set for each IRA that is converted.
That means that if an investor is younger than 591/2 when a particular conversion is completed and that investor withdraws money before the clock associated with that conversion runs out, he or she will be hit with a 10% penalty.
E-mail David Hoffman at [email protected].
