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.