Imagine the busiest, most complicated freeway intersection that you've ever experienced. Unfortunately, that scene serves as a pretty good visual of the tax situation for 2012-2013. With old laws sun-setting or exiting and new laws merging, we have potential for epic gridlock in U.S. tax policy. However, as with any traffic jam, those who maneuver the lane changes effectively may benefit by being prepared.
As a financial professional, you can be a GPS tracking device for your clients by providing them tools they can use with their tax advisor that can help them through the complicated maze of tax law changes. An effective way to spark this discussion may be to introduce the following list of eight tax topics that your clients can then utilize with their tax advisor.
If appropriate, a tax discussion can enhance your professional relationship with your clients so they consider you as a knowledgeable financial professional interested in their overall financial well-being. It can also serve as a fact-finder to help you better understand the client's current situation as you explore each topic. Finally, after the conversation you should be sure to recommend that your client meet with a tax advisor to further discuss tax topics -- and you can also make appropriate product recommendations for those strategic financial choices that your client decides to pursue after consultation with their tax advisor.
1. Are you considering converting from a traditional IRA to a Roth IRA?
For clients who are considering a Roth IRA conversion, sooner may be better than later. Federal income tax rates may increase in 2013. Also, starting in 2013 there will be a 3.8 percent Medicare surtax on higher-income client's "net investment income."
Although a Roth IRA conversion is not itself subject to the surtax, it may push a client's modified adjusted gross income over the threshold amount, causing a portion of the client's net investment income to be subject to the 3.8 percent surtax. Higher income is generally a married couple filing jointly with income exceeding $250,000, filing separately with income exceeding $125,000, or an unmarried individual with income exceeding $200,000.
Please remember that converting a traditional IRA to a Roth IRA is a taxable event. Increased taxable income from the Roth IRA conversion may have several consequences including (but not limited to) a need for additional tax withholding or estimated tax payments, the loss of certain tax deductions and credits, and higher taxes on Social Security benefits and higher Medicare premiums. It is generally preferable that a client have funds to pay the taxes due upon conversion from funds outside of the IRA.
If the client takes a distribution from the IRA to pay the conversion taxes, there are potential consequences, such as an assessment of product surrender charges or the additional 10 percent federal tax for early withdrawal. Be sure to have your client consult with a qualified tax advisor before making any decisions regarding their IRA.
2. If you've taken your required minimum distribution, what can you do with it?
Year-end is always a good time to talk to clients who are over age 701/2 and have required minimum distributions coming from an IRA. Your clients could consider buying a life insurance policy if a death benefit is needed and they are interested in leaving a legacy to their beneficiaries. Or, they may wish to purchase a nonqualified annuity contract and get tax-deferred growth of potential earnings if that is appropriate for their situation.
3. If you've incurred capital gains from the sale of a capital asset, or if you received qualified dividends in 2012, how can you use the proceeds?
First of all, this may not be a bad thing. Harvesting gains in 2012 may make sense because 2012 long-term capital gains rates are zero to 15 percent. As of this writing, long-term capital gains rates are scheduled to be 10 percent to 20 percent in 2013. Also, the new 3.8 percent Medicare surtax starts in 2013. Once the capital assets have been sold, your client could consider buying a life insurance policy if a death benefit is needed and they are interested in leaving a legacy to their beneficiaries. Or they may be able to purchase a nonqualified annuity contract to allow for tax-deferred growth, if that is appropriate for their situation. Any taxable distributions from a life insurance policy, which do not usually include the life insurance death benefit, and taxable distributions from an annuity contract are considered ordinary income and not capital gains.
Please note that in order to provide a recommendation to a client about the transfer of funds from an investment product, including those within an IRA, 401(k) or other retirement plan, to a fixed or variable annuity, you must hold the proper securities registration and be currently affiliated with a broker/dealer or registered investment adviser. If you are unsure whether or not the information you are providing to a client represents general guidance or a specific recommendation to liquidate a security, please contact the individual state securities department in the states in which you conduct business.
4. What are your options for setting up a retirement plan?
Annuities may be an effective funding vehicle for many qualified retirement plans (QRP) such as a 401(k) plan, or for a SEP or SIMPLE IRA plan. Although buying an annuity under a tax-deferred retirement plan provides no additional tax deferral, annuities can provide income and death benefit guarantees which business owners and their employees may be seeking in this current environment. All annuity features, risks, limitations and costs should be considered prior to purchasing an annuity within a tax-qualified retirement plan. It is important to work with the client's tax advisor to help select the retirement plan that will work best for your client.
5. Do you want to make a contribution to a traditional or a Roth IRA?
A qualified annuity can provide income for life and death benefit guarantees. Beneficiaries also may be able to stretch distributions after the owner's death. A stretch distribution strategy is most effective when individuals can afford to minimize IRA distributions during their lifetime and are able to pass remaining assets on to future generations. Changes in tax law, the impact of inflation, costs, and risks of underlying funding vehicles may have a significant impact on the long-term value of your IRA. An annuity will not provide additional income tax deferral -- the Internal Revenue Code itself will provide this. All annuity features, risks, limitations and costs should be considered prior to purchasing an annuity within a tax-qualified retirement plan. The client must meet contract minimums, and with an IRA, may not contribute more than the maximum permitted ($5,000, or $6,000 if your client is over age 50 by the end of 2012). The contribution is also limited to the client's earned income for a traditional or Roth IRA, and for traditional IRAs, the client must be under age 701/2. For a Roth IRA, there are income, but no age limits.
6. Do you want to make gifts?
Under the 2012 tax laws, $13,000 per recipient annually can still be gifted without gift tax (that is, there is a $13,000 gift tax annual exclusion). A healthy client may consider buying a life insurance policy to leave a legacy for the benefit of children or grandchildren through an irrevocable life insurance trust. They can fund the policy with premiums as gifts up to the gift tax annual exclusion amount(s). If they want to provide guaranteed retirement income for a child or grandchild, they can consider buying a nonqualified annuity in the child's or grandchild's name. Remember, though, that distributions from an annuity are subject to the 10 percent federal additional tax for early withdrawal until the owner (child/grandchild) is age 591/2, unless some exception to the additional tax applies. In addition, your clients may want to take advantage of the unprecedented unified estate and gift tax lifetime exemption amount of $5,120,000 for 2012. If Congress fails to act, this amount is scheduled to fall to $1,000,000 in 2013. Keep in mind that minor children typically cannot enter into valid contracts, so check on state age requirements and consider using a trust or custodial account as owner if the child or grandchild is a minor.
7. Do you want to make generation-skipping transfers?
Transfers to grandchildren might be appropriate for high-net-worth clients at any time. The client can name a grandchild as death beneficiary of an annuity or life insurance policy. Also, they can buy a nonqualified annuity in a grandchild's name to provide that grandchild with retirement income if the grandchild is an adult. Keep in mind that minor children typically cannot enter into valid contracts, so check on state age requirements. Note that annuity distributions/withdrawals prior to age 591/2 may be subject to the 10 percent federal additional tax for early withdrawal. Also, if the recipient is a minor, your client may want to consider titling the annuity with an UGMA/UTMA designation to avoid costly guardianship proceedings. For high net worth clients, 2012 provides a unique opportunity because the generation skipping transfer (GST) tax exemption is $5.12 million. Unless Congress changes the law, the GST exemption will decrease to $1,360,000 in 2013 (subject to inflation). High-net-worth clients should be encouraged to see their estate planning attorney before year end 2012 to consider taking advantage of these 2012 opportunities.
8. Are you seeking tax deferral?
If your client is already fully utilizing the retirement plans available to them, there are options such as annuities and life insurance policies that can assist them with tax deferral. Keep in mind, the primary purpose for purchasing life insurance is the death benefit, which can provide some financial reassurance to beneficiaries that can be used for various purposes, such as paying down debt, income replacement and final expenses. A secondary reason can be for the potential to accumulate cash value on a tax-deferred basis. Any earned interest credited on both annuities and the cash value of life insurance policies is tax-deferred. Interest earned on nonqualified annuities is generally taxed as gain-out-first when the client takes a withdrawal.
If prior to age 591/2, the annuity distribution may also be subject to the 10 percent federal additional tax. Interest earned on the cash value of non-modified endowment contract (MEC) life insurance is income-tax-free if taken as a withdrawal up to the amount of the client's basis in the contract. A MEC is a policy that has been funded too quickly -- i.e. frontloaded -- and can still take advantage of the tax deferral aspects of a life insurance policy as long as it qualifies as life insurance under IRS rules. Loans on non-MEC life insurance are income-tax-free as long as the policy does not lapse while the loan is outstanding. For MEC life insurance policies, if there is gain in the contract, all cash value-taken (i.e. loans and withdrawals) is taxed as gain-out-first, and if taken prior to age 591/2, is subject to a 10 percent federal additional tax unless an exception applies. Cash values in life insurance policies can be accessed via loans/withdrawals.
Clearly, the potential for retirement and wealth transfer planning to become derailed by tax issues is significant, but providing your client with a roadmap that they can take to their tax advisor can help them chart their course to retirement in a more efficient and effective manner. At the end of the day, you may have helped your clients immensely simply by recommending they meet with their tax advisor and review these 8 important questions.
Deb Repya, JD, CLU, ChFC, is vice president of Advanced Markets for Allianz Life. In this role she is responsible for the strategic direction of the Advanced Markets group and also oversees the development, promotion and quality of the group's services.