It's hard to know exactly what will happen with taxes in 2013, but now is an opportunity for financial advisors to engage their clients to begin formulating a plan. While no one has a crystal ball to know how expiring tax laws will be addressed or what actions lawmakers will take, an advisor can build credibility and trust by simplifying the situation for clients and helping them explore potential portfolio adjustments.
First, help your clients understand the three potential tax scenarios they may face:
1. Tax rates will increase, particularly for the wealthy.
2. Tax deductions will be reduced.
3. Tax rates will decrease, but tax preferences will be removed.
Regardless of which scenario plays out, you may be able to help clients take advantage of short-term opportunities to become better positioned for the long run. Here are a few topics that you may want to touch on with clients:
Investment taxes: Long-term capital gains rates are scheduled to rise from 15 percent to 20 percent for most taxpayers and the tax on dividend income would go from 15 percent to ordinary income rates, which could be as high as 39.6 percent. An additional 3.8 percent Medicare investment earnings surtax is also likely to affect those with high overall incomes and investment earnings.
Possible opportunities to explore with clients:
Consider harvesting gains to take advantage of current capital gains rates. If you are considering selling your business, this may be the year to do it. Also, large stock or mutual fund positions may be sold in 2012 to generate a capital gain at the current rate. The proceeds may then be reinvested in a more tax-efficient manner or in a tax-deferred vehicle. Keep an eye on the turnover rate of the investments in a mutual fund to determine the capital gains that may be passed through to the owner.
Converting funds or investments that are currently taxable into tax-deferred vehicles may be an effective planning transaction. Consider converting existing bank CDs, money market accounts, mutual funds and other similar vehicles that result in annual taxable income into opportunities like tax-free municipal bonds, tax-deferred annuities or life insurance. These vehicles provide tax deferral on annual gains. Life insurance that is in force until death may provide tax-free death benefits to beneficiaries of the policy.
Pay special attention to dividend-paying stocks because the taxation on dividends is scheduled to increase significantly. If you really like certain dividend-paying stocks, consider owning them in a tax-deferred IRA or another type of qualified account. Consider repositioning a mutual fund portfolio to a tax-deferred vehicle like a deferred annuity, or at least look for mutual funds that are run in a tax-efficient manner. Keep in mind that mutual funds pass dividends received through to the investor and the tax liability that comes with them passes through too.
Income taxes: Expiration of Bush-era tax cuts will impact the top four marginal brackets and eliminate the 10 percent bracket -- meaning higher taxes for virtually everyone. While increases are more likely for the affluent, it's unclear if lawmakers will address this for non-affluent investors. The phase-out of itemized deductions for high income earners is set to return in 2013.
Possible opportunities to explore with clients:
To the extent possible, shift income into 2012 to take advantage of lower rates. Consider accelerating income such as salary, bonuses, receivables and stock options that can be exercised into the current tax year.
For owners of pass-through entities such as S Corporations, partnerships and most LLCs, it may be possible to accelerate receivables into the current year. Don't forget that itemized deductions are scheduled to phase out for higher income earners, so consider taking deductions while you know you still can.
This may be a good time to fund a Roth 401(k) or Roth IRA.
Consider converting traditional IRA assets into a Roth IRA -- if the clients are seeking to avoid required minimum distributions and leave an income-tax-free account to beneficiaries.
When 2013 arrives, consider maximizing deductible retirement plan contributions.
Your clients may want to consider shifting assets in taxable accounts to a deferred variable annuity to gain tax deferral. VAs allow money to accumulate tax deferred until withdrawals begin and can provide liquidity. Owners can exchange underlying investment options within subaccounts of an annuity without tax liability, and there are no limits on contributions to variable annuities.
Gift and estate taxes: The gift and estate tax exemption is scheduled to shrink from $5.12 million to $1 million in 2012, which could create new estate tax exposure for many clients.
Potential opportunity to explore with clients:
For some clients, there may be an opportunity to take advantage of the current gifting exemption amount before it expires by setting up an irrevocable life insurance trust (ILIT). Clients who want to take advantage of this opportunity may choose to purchase a life insurance policy with an immediate annuity inside the trust to pay premiums on the life insurance policy.
A key point to keep in mind as you work with clients is that when confronted with so much risk and uncertainty, tax diversification should be part of your discussion. This means allocating a portfolio to assets that are taxable now or later -- or that may never be taxed at all.
You don't need to know exactly how the tax debate will be resolved to help clients begin to put a strategy into place. By proactively engaging clients now, you can build credibility and cement relationships.
Eric Henderson, FSA, MAAA is senior vice president of Individual Products and Solutions for Nationwide Financial.
Nationwide does not provide tax advice. Tax advice should be sought from a tax professional such as a CPA.