Federal income tax rates are slated to rise next year and already many clients are concerned. "Whether the increases mean we should be looking at new strategies is the second most frequent question I'm getting this tax season," right behind how to avoid alternative minimum tax, says CPA/PFS Michael Tedone, managing director at Filomeno Wealth Management LLC, in West Hartford, Conn.
Meanwhile, financial-services companies will soon be painting the rate hikes as a great reason to convert individual retirement accounts into Roths, industry-watchers say.
And all the tax talk coming out of Washington this testy election year will certainly keep the topic in the public eye.
So advisors should expect continued questioning about the changes scheduled for 2013, even if another extension of the Bush tax cuts, sweeping tax reform or something in between could be enacted before then -- or after, depending on the outcome of the elections.
Besides higher rates on ordinary income, key rules on the books for next year include taxation of qualified dividends at ordinary rates rather than capital gains rates, a 5% jump in the top cap-gains rate, and the new 3.8% Medicare surtax on passive-investment income for joint filers with earnings above $250,000 (above $200,000 for singles), according to CPA Stuart D. Lyons, tax principal at Baker Newman Noyes, in Portland, Maine.
The skyrocketing tax on qualified dividends, from 15% currently to as much as 43.4% (39.6% new top ordinary bracket, plus 3.8% surtax), increases the allure of municipal bonds for high-income investors. "I have one client who's going to get with his financial planner to see about moving out of dividend stocks and into munis," Lyons says.
But the Obama administration's budget proposal for 2012-13 seeks to curtail the tax benefits of municipals for high-bracket investors, while enactment of the so-called "Buffett Rule" could make muni income taxable for clients making over $1 million.
Leverage For Advisors
The prospect of higher capital gains taxes could be just the ammunition you need to get clients to diversify. "I had this discussion last week with a client who has a concentrated position," says Richard Stumpf, principal at the comprehensive-planning firm Financial Benefits Inc., in Wichita.
Stumpf has long been urging the client to diversify. But he really struck a nerve by telling the client that selling after 2012 could result in higher capital gains taxes as well as the 3.8% surtax. "He has finally agreed it's time to sell," Stumpf says, although the client has yet to act.
Repositioning portfolios always demands watching out for the alternative minimum tax, but the problem is worse this year. For 2012 the exemption from AMT is lower than it's been in years, just $45,000 for joint filers and $33,750 for unmarried taxpayers. That makes it easier to owe alt min.
"We have a new client and if we restructure his portfolio like he wants us to, it's going to generate capital gains that will throw him into an AMT situation even though he doesn't have a high income," Stumpf says.
Another Chance To Market Roths
An obvious strategy in the face of rising ordinary rates is a Roth conversion. "It's pretty much a sure-win situation when the tax rate you pay on the conversion is lower than the rate you would pay at the time of withdrawal, all other factors being equal," says industry consultant and software designer Ben Norquist, whose firm, Convergent Retirement Plan Solutions in Brainerd, Minn., works with large financial-services companies. "The institutions are starting to put that message out," Norquist says.
Then again, Rep. Paul Ryan (R, Wis.) recently proposed a near-flat tax with a top rate of 25%.
"In a low-tax future environment you can lose out with a Roth," Norquist reminds advisors. "The uncertainty surrounding future tax rates is leading a lot of people to conclude that doing a partial conversion is one of the best ways to hedge their tax risk."
Given the wide range of competing tax-law proposals (none of which may ever be enacted), not to mention the fall elections, some practitioners think it's too soon to act.
Stumpf, meanwhile, is planning for the worst-case scenario - higher rates, continued low AMT exemption and the Medicare surtax.
Lyons says, "The advice I give is to assume what the law is now. Anything else is pure speculation."
--Eric L. Reiner