More Tax Chores for the Wealthy at Year-End

Wealth Matters

By PAUL SULLIVAN
Published: December 11, 2009

At the end of every year, there is a basic list of things wealthy people should do to put their financial houses in order. But this year, that house may be a lot messier than in years past, given the wild swings in wealth in the last 12 months and the various government programs and proposals that can change the calculus.

Sam Petrucci of Credit Suisse Private Bank says a popular tactic has been a special annuity trust to give money to an heir tax-free.

The biggest question — the one that overshadows all of the others and is still unresolved — is what will happen to the estate tax next year. While the House of Representatives has voted to make permanent the current 45 percent tax rate on all estates above $3.5 million, the Senate has yet to take up the bill. And it is not clear if it will have time to do so this year.

The uncertainty gives wealthy investors much to consider in the next few weeks. To address these concerns, I intend to discuss here what you should do before the end of the year and use the next column to look at what you should do at the beginning of 2010.

NOW OR THEN?

The mantra for year-end tax planning is usually “accelerate deductions, delay income.”

The reason is simple: to lower your tax bill in that year. But with the prospect of higher taxes on the wealthy by 2011 at the latest, the advice now is the opposite: accelerate income now and delay deductions until after taxes rise, when they could be more valuable.

“Many people are resigned that income taxes are going to rise,” said Janine Racanelli, managing director and head of the Advice Lab at J. P. Morgan Private Bank. “People are being tactical as the picture is becoming clearer.”

What is certain is the income tax for the top earners is going to be 39.6 percent in 2011, up from 35 percent now.

Yet there are other variables, Ms. Racanelli said, that could drive tax rates even higher, like surcharges on those who make more than $250,000 a year and other taxes to pay for the health care legislation.

Some of the popular types of income being accelerated are stock options, distributions from retirement accounts for people over 59 ½ and payments from deferred compensation plans. Ms. Racanelli added that business owners were looking particularly closely at paying themselves dividends from their company. Their fear is that the tax on these qualified dividends may rise to the income tax rate, from the current 15 percent.

CAPITAL GAINS DECISIONS

Also unknown is what will happen to the long-term capital gains tax rate. Many advisers suspect it will rise to 20 percent, from 15 percent, by 2011. As a result, some investors are weighing whether to sell securities now and pay the lower capital gains tax.

Stephen Horan, head of private wealth at the CFA Institute, said it might not make sense to rush to sell, even if the rate went up. He has run calculations on the impact of an increase and said that if your investment horizon was 10 years, you needed to earn just 2 percent more per year to make up for a five percentage point increase in the capital gains tax.

“It’s better to keep your money than give it to the government,” he said.

Mr. Horan said investors could actually do even better by avoiding the higher short-term capital gains tax. That rate is 35 percent and is applied to investments held for less than 12 months. Over 10 years, investors could earn 15 percent more on their money by avoiding short-term capital gains, he said.

Of course, these taxes are paid only on gains. Most investors still have substantial losses left from 2008. If losses outweigh gains, people can deduct $3,000 from their taxes each year until that loss is used up.

SHORT-TERM TRUST

For the wealthy, this was the year of the GRAT, for grantor retained annuity trust. Sam Petrucci, a director in the wealth planning group at Credit Suisse Private Bank, said he arranged more of these trusts this year than at any time in the previous decade.

GRATs are a fairly simple way to transfer money to an heir tax-free. A person puts a sum in the trust that will be paid back to him over a fixed period of time. The heir receives any appreciation in the trust above a “hurdle rate” — the interest the Internal Revenue Service requires to be paid to the person who set up the trust.

The reasons for the increased attention in these trusts were twofold: the hurdle rates were low all year, as were the prices of some securities. Mr. Petrucci said that someone who put $10 million into a two-year GRAT with the December hurdle rate of 3.2 percent, assuming an 8 percent return, would pay himself two payments of roughly $5.2 million and pass $760,000 to heirs free of gift tax.

But it was the prospect of Congressional action that really touched off the interest in setting up short-duration GRATs before the end of the year, Mr. Petrucci said. One proposal would require a GRAT to be at least 10 years long. If the person setting it up died in that time, the money would revert to the estate. The second proposal would require the person setting up the trust to pay a gift tax on 10 percent of what he puts in. Currently, a person can “zero out the GRAT,” which means he pays himself back the full amount and nothing is taxed.

CHARITABLE EXPIRATION

The next Wealth Matters column will discuss the pros and cons of converting your pretax retirement account into a post-tax Roth Individual Retirement Account in 2010. Meanwhile, there is one I.R.A. provision that will expire this year unless Congress extends it. It is the charitable rollover provision, which allows someone to donate $100,000 directly from his or her retirement account to a public charity. The person doing this has to be over 70 ½ and the money has to be transferred directly from the I.R.A.

Jere Doyle, wealth strategist at Bank of New York Mellon, said the donor would not get a tax deduction, which he would get if he donated the money directly. But he would get the benefit of not having to pay ordinary income tax on that amount. The transfer also counts toward the minimum distribution from a retirement account, which the I.R.S. suspended for 2009 but may reinstate next year. “It’s a good way to clean out your I.R.A.,” he said.

HOUSING ISSUES

Two property-related benefits also need to be considered. The Mortgage Forgiveness Debt Relief Act was scheduled to expire at the end of the year, but it has been extended until 2012. Normally, a person has to pay ordinary income tax on the part of a mortgage the bank forgives. Under this law, up to $2 million will continue to be forgiven tax-free on a person’s primary residence.

The second issue is conservation easements. The wealthy use these to give part of their property to a local conservancy and get a tax break. Mr. Doyle said this is probably the last year that people can deduct an easement worth up to 50 percent of their adjusted gross income.

Year-end tax moves to make now. Right now

Be sure to take advantage of these money-saving gems – before time runs out.

By Carolyn Bigda, Money Magazine

October 27, 2009: 4:43 AM ET

(Money Magazine) — There’s plenty to distract you from financial planning this time of year, from cheering on your favorite football team to daydreaming about Thanksgiving dinner. But you don’t want to let some end-of-year deadlines slip by without taking steps to minimize taxes and maximize savings. Especially in this economic climate, a little extra cash can go a long way.

And there’s more cash on the table than usual this year. The government’s stimulus package is loaded with incentives to motivate people to make certain big-ticket purchases — but the deals will run out soon.

So if you were thinking of buying a car or appliance, it might make sense to move those purchases up a few months. In terms of the savings, “it’s now or never,” says Bob Meighan, vice president of TurboTax.

DVR the game, and take a bit of time to make these moves now. You’ll start 2010 with more to be thankful for.

Snag tax breaks

If you’re in the market for — or have already bought — a car or a home, don’t miss these tax incentives courtesy of the stimulus package.

New-car sales tax deduction. You can deduct state and local sales tax paid on a new set of wheels purchased this year (between Feb. 17 and Dec. 31), regardless of whether you itemize. The deduction is limited to the first $49,500 of a vehicle’s price, and the break begins to phase out for singles with modified adjusted gross income of $125,000, or couples with $250,000. If you buy and register a 2010 Honda Accord in Chicago for a base price of $21,055, you would reduce your taxable income by $1,948 (based on a 9.25% sales tax).

First-time homebuyer credit. Since a credit is directly subtracted from the taxes you owe, the first-time homebuyer credit could put up to $8,000 back into your pocket if you bought a house this year. To qualify, you must not have owned a principal residence in the past three years.

Your modified AGI must be $75,000 or less if single, $150,000 or under if married. Plus, closing and title transfer must be completed by Nov. 30. (If you can’t make the deadline, you may have another shot; bills to extend the credit have been introduced into the Senate.)

Replace old appliances

Thinking about buying a more energy-efficient furnace this winter? Congress has earmarked nearly $300 million in rebates for new “green” appliances. The rebates will typically range from $50 to $250 and take effect as early as the end of this year (dates, amounts, and method of redemption will vary by state).

While there’s no deadline per se, the offer operates like this year’s “cash for clunkers” program. “When the money is gone, the program will be over,” says Meighan of TurboTax. To find out when rebates start and what they’ll cover, go to energystar.gov (click on Tax Credits for Energy Efficiency).

Reap your losses

Even with the market’s rally this year, the S&P 500 is still down 32% from its 2007 peak. So you probably still have losses in your portfolio. Take advantage of them and the chance to get rid of deadbeats.

If you sell a stock, bond, or fund in a taxable account for less than you paid, you can use the losses to offset your gains. Have more losses than gains? The IRS lets you deduct up to $3,000 in remaining losses from ordinary income. The rest can be used on future returns.

You can’t buy the same investment or one that is “substantially identical” within 30 days before or after the sale. (Otherwise, it’s considered a “wash sale,” and the loss is disqualified.) So you can’t, for example, swap S&P 500-tracking funds. But you can switch to a fund following another index (even a total stock index), and trading one actively managed fund for another is okay. “Presumably, the managers don’t pick the same stocks,” says wealth manager Chuck Roberson of Old Tappan, N.J.

Prep for the AMT

For once Congress passed its alternative minimum tax (AMT) “patch” early in the year, raising the income exemption on this parallel tax structure to $46,700 for singles and $70,950 for marrieds. Generally, higher earners must compute their tax bill using both the traditional code and the AMT, which disallows certain deductions and credits — then pay the higher. The patch is necessary because the AMT, which was intended to keep the wealthy from abusing tax breaks, is not tied to inflation.

The new exemption levels are similar to those for 2008. So if you were stuck last year, you’ll probably be stuck this year, says New York City CPA and tax attorney Alan Straus. It’s not easy to get out of the AMT trap, but some strategic end-of-year moves may help.

Since big deductions can tip you into the AMT zone, limit what you plan to write off. For example, don’t prepay fourth-quarter estimated taxes to your state, which you can deduct on your federal returns, in December. Wait till January.

Also, try reducing your income in order to make the most of your exemption: Max out your 401(k)s. Ask your boss to put off any bonus (ha!) until early next year. And if you’re self-employed, hold off on sending invoices.

(And if what you do now fails to get you off the hook, there’s still some potential for relief: As part of the stimulus package, Congress is allowing AMT payers this year to take tax breaks normally disallowed, such as child- and dependent-care credits.)

Give gifts

As always, send in donations to charitable organizations by the end of December if you want to deduct the gifts on your 2009 tax return. Also, this is the last year you can do a direct rollover from an IRA to a tax-exempt organization.

The 2008 Emergency Economic Stabilization Act lets you give up to $100,000 if you’re 70½ or older. You won’t owe federal income tax on the money (though you can’t take a deduction).

Speaking of estate-minimizing strategies: Remember that you can give up to $13,000 per recipient tax-free this year (a couple can give $26,000). That should make somebody’s holidays especially happy.  

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Here are some tax breaks that are set to expire in 2009.

•  If you claim the standard deduction for 2009, you may also claim an additional deduction for real estate property taxes.

 

•  Whether you claim the standard deduction or itemize your deductions for 2009, you can deduct the sales tax you pay on a car or truck purchased by December 31, 2009 (but the deduction is phased out if your income is too high).

 

• If you itemize your deductions for 2009, you can choose to deduct state and local sales taxes instead of claiming a deduction for state income taxes.

 

• If you buy a principal residence by December 1, 2009 and haven’t owned a home during the prior three years, you are entitled to a tax credit of up to $8,000 (but again, there is a phase-out if your income is too high).

 

• If you are age 70 ½ or over and own an IRA, you don’t have to withdraw any funds from your IRA in 2009 unless you wish to.