Douglas Rothermich, Vice President, Wealth Planning Strategies
Tamara Telesko, Director, Wealth Planning Strategies
Following this month’s election, the continued split in power between the parties—with a Democratic president and majority in the Senate, but a Republican-controlled House—leaves us wondering which direction tax law changes may take in the months ahead. The changes that may occur in the income, capital gain, and transfer tax laws, along with a new tax on investment income under the 2010 healthcare laws, all combine to create investment and planning issues you should consider before year-end.
The challenge at this stage is determining how Congress may act, if at all, and what such action or inaction on tax matters means to you. With such uncertainty on how taxes may change further, how can you and your advisor respond or prepare now for investment or tax planning at year-end or for early 2013?
Where we stand
You have undoubtedly heard about the “fiscal cliff” that looms due to the scheduled year-end expiration of the 2001 and 2003 tax law changes. These changes lowered tax rates on all individual income tax brackets, reduced capital gain taxes, taxed dividends at the same rate as capital gains, and dramatically increased the amount of your assets that could be excluded from estate taxes. Congress currently has three options: do nothing and allow the tax cuts to expire; find a compromise; or extend the tax cuts, as Congress did in 2010, while continuing to work toward a solution. Let’s explore what each of those three options would mean for your tax planning.
If Congress fails to act during the lame-duck session, and the 2001 and 2003 tax acts are allowed to simply expire by their own terms, taxes across the board will increase.
Income taxes: The current six income tax brackets for individual taxpayers will be reduced to five:
The expiration of these tax laws will also phase out itemized deductions for higher-income taxpayers. The result for those taxpayers: a broader amount of their income will be subject to tax, and it will be taxed at higher rates.
Long-term capital gain taxes: The current 15% capital gain tax will increase to 20%. For wealthy taxpayers, as defined by the 2010 healthcare law (i.e., individuals with modified adjusted gross income over $200,000 or a married couple with such income over $250,000), starting in 2013 a new 3.8% net investment income tax will increase capital gain taxes from the new 20% rate to 23.8%. That is nearly a 60% increase from the current 15% levels.
Dividend taxation: Dividends, which have been taxed at the 15% capital gain rate for the past decade, will again be taxed as ordinary income. This change, plus the application of the 2010 healthcare law’s new 3.8% net investment income tax on dividends starting next year, will result in a substantial increase in the tax on dividends. For those in the top brackets, this could mean the tax on dividends would increase from the current 15% rate to 43.4%.
This scenario would have a number of implications for your investment planning. You may want to consider recognizing long-term capital gains in 2012 at the lower 15% tax rate. On the other hand, if a sale would result in a loss, you may want to wait until 2013 (or later) in order to offset higher tax rates that will be in effect that year and beyond.
Likewise, if you have a large percentage of dividend-paying stocks in your portfolio, you may want to consider reallocating some of your equity investments. If you have significant investments in other passive activities, such as rental real estate or royalties, that are subject to the new 3.8% net investment income tax, you may want to review those holdings before year-end.
In addition to assessing how the expiration of the 2001 tax act may affect your investment strategy, you should also consider its effect on gift and estate tax laws:
Take advantage of the remainder of 2012 to consult with your advisor about what you can do if these changes occur. If you have very significant assets and can afford to give away the current gift tax exemption without jeopardizing your own retirement income needs, consider how to use the current high gift tax exemption before the end of the year. If your estate is valued above the current or future estate tax exemption levels, consider how the dramatic drop in exemption amounts and the repeal of portability affects your estate plans. Without the option of portability, you must balance good income tax planning (having retirement plan assets payable to a surviving spouse to stretch out required minimum distributions as long as possible), with good estate tax planning (ensuring the estate tax exclusion amount of the first spouse to die is fully used through trust planning).
Given the volatility in the estate tax exclusion amount over the past several years, and the current unpredictability of where Congress may take this area of the law, it’s prudent to ensure your estate planning remains current and includes an appropriate degree of flexibility for changing laws.
Find a compromise
When Congress extended the Bush-era tax laws for two more years in December 2010, it seemed that we might see some compromises to replace or modify those income, capital gain, gift and estate tax laws. In the two years since, however, the parties haven’t often found common ground on this topic.
For income taxes, the parties seem to agree on keeping the current rate structure for the bottom four brackets, but the debate on how the top two brackets should either stay as they are or revert to pre-2001 levels has been a point of serious debate and contention. Likewise, for most taxpayers, the parties agree on leaving capital gain and dividend taxes as they are, but for higher-income taxpayers (those above the threshold of $200,000 for a single person or $250,000 for married couples), the parties have opposing views.
In the estate and gift tax area, neither political party today is advocating a return to estate tax exemption amounts as low as $1 million, nor is either advocating tax rates as high as 55%. There is also some bipartisan agreement that portability makes estate planning for married couples easier and fairer. Although neither side seems fond of where the estate tax laws will revert if the current laws expire, it’s unclear if they can agree on an alternative. Many Democrats would prefer a return to the 2009 levels (with an estate tax exemption level of $3.5 million). Republicans often advocate for a complete repeal of the estate tax laws.
If the parties fail to compromise, the default scenario is a return to the $1 million exemption, which neither side wants. That shift could dramatically impact many TIAA-CREF participants who under the current levels haven’t had to focus heavily on federal estate tax planning within their estate plans.
The parties could use a compromise in the estate tax area as a bargaining chip for agreement on income and capital gain taxes. That clarity would be good for estate planning needs, and this is an area that you and your advisor will want to watch closely in the coming months.
Extend the tax cuts
Some members of Congress have advocated a short-term extension of the 2001 and 2003 tax acts to allow sufficient time for a new Congress to address more fundamental tax reform.
In that scenario, you may want to see if a Roth conversion is appropriate in your situation. Generally speaking, Roth conversions make sense when your income tax rate at the time of the conversion is lower than you anticipate it will be when the assets will otherwise come out of the account (as payments to you in retirement or to your beneficiaries following your death). An extension of the current income tax rules allows you to capture the lower rates. You will pay income taxes on the full amount you convert, but there is no income tax due on future distributions from the Roth account. Roth accounts are also not subject to the minimum distributions rules applicable to your traditional retirement accounts or IRAs.
Additionally, with any Roth conversion, you can “re-characterize” the conversion up to the time when the income tax return for the year of conversion is due (with extensions). A re-characterization simply means you are undoing the conversion, and for income tax purposes you are treated as having never made the conversion. The account assets are put back into a traditional account from the Roth account.
For a January 2013 Roth conversion, you could have until October 15, 2014 (with an extension of your income tax return), to decide if you want to re-characterize your conversion. During that roughly 20-month period, you could then see if post-conversion the market and your account performed well or if tax rates rose. If tax legislation is passed and rates rise during that period, your conversion may be very well timed. If taxes are not increasing or are actually lower by October 2014, you can re-characterize the conversion—effectively giving you a long, free look at whether this form of tax planning makes sense and to see if Congress actually moves forward with tax changes.
Likewise, if the account performance is poor during that same re-characterization period, you may regret converting and paying income tax at the higher (January 2013) conversion values when the account has declined to lower levels. If there is a strong market correction and your account declines considerably post-conversion, you would have the re-characterization period to decide if you want to keep the conversion, or if you want to undo it and return the assets to your traditional 401(k), 403(b) or IRA account —avoiding the income tax on the higher converted values.
An uncertain future
The multiple paths Congress could take in addressing the expiration of the current tax laws does not provide a clear picture on how it may affect your investment and tax planning. But late 2012 and early 2013 are ideal times to meet with your TIAA-CREF and tax advisors to ascertain what steps may make sense for you. Doing so may assure you that as tax laws inevitably do change, you have positioned your portfolio and your tax planning well in this uncertain and volatile environment.
You should consult a qualified tax advisor for questions regarding your particular situation.
TIAA-CREF Individual & Institutional Services, LLC, distributes securities and provides additional brokerage services in its capacity as a registered broker/dealer, member FINRA. TIAA-CREF Trust Company, FSB provides investment management and trust services.