Tax plans not a sure bet heading into 2013

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Financial planning this year feels more like betting a wild card than a sure thing.

Financial planners are bracing clients for the coming tax increases in 2013 as the Bush-era tax cuts are set to expire come the end of December. At the same time, they can’t help thinking that the conversation on the tax cuts isn’t over and could be pushed into 2014 before a decision is made.

The possibility of another extension on the Bush tax cuts has left planners wary and anxious to move on, one way or another.

“Frustration is the thing I feel personally, of not being able to evaluate all the possibilities and try to make good informed decisions,” said Terri Roberts Munsell, UMB Investment and Wealth Management vice president, trust legal counsel. “It’s coming down to instinct — make the best decision today with what we know. Hopefully things will be put in place and we can re-evaluate them down the road when we know something more certain.”

For now, that means planning for gigantic leaps in taxes on qualified dividends, drastic changes in estate and gift tax exemptions and upticks in long-term capital gain taxes.

With three months remaining until 2013, there is a flurry of activity at financial planning offices. Some families are hoping to distribute millions to their heirs by year’s end, and some small-business owners are thinking of ways to take more dividends this year — all to beat the 2013 tax increases.

History on tax cuts

The Bush tax cuts, which were enacted in 2001 and 2003 and made sweeping changes to the tax code, changed the rate at which dividends are taxed so that they could be in line with long-term capital gains taxes. Prior to the cuts, dividends were taxed at ordinary income rates. In 2013, dividends revert back to being taxed at the ordinary income rate.

“That has the biggest impact for people in high-income brackets,” said Susan Strasbaugh, president of Strasbaugh Financial Advisory.

It also includes small-business owners, she said, who often pay themselves a salary and compensate themselves in dividends. Currently, the qualified dividend tax rate is 15 percent. Next year, it jumps to 39.6 percent.

It’s a good time for small-business owners to think about getting cash out of their business if they have the cash flow, she said.

“The best thing to do is pay a larger-than-average dividend this year,” Strasbaugh said. “We know you can pay 15 percent tax on that dividend this year.”

It’s turning tax planning on its head, she said.

“Usually, you want to push your revenue to future years and accelerate expenses into the current year,” she said. “For this year, I’d say that is exactly the opposite. You want to accelerate income right now because we know we have these lower rates.”

But, no one can predict whether the tax cuts will be extended or allowed to expire, Strasbaugh is not ready to advise clients to move dividends into individual retirement accounts or municipal bonds –something they might consider if the cuts are allowed to expire without revision.

“I’m waiting to see,” she said. “Even if we wait and make the move in February, that’s OK. You are unlikely to have much in dividends at that point. I believe, and I could be wrong … most likely the whole thing will be pushed out another year — that Congress will say, ‘Let’s figure this out next year.’”

Estate taxes uncertain

Nothing has been more tumultuous than estate taxes. Since the late 1990s, estate taxes have been chewed over and overhauled from the long-gone days of J.D. Rockefeller.

Sanity came for financial planners when the Bush tax cuts of 2001 and 2003 were put in place — that led to 10 years of stability, Strasbaugh said.

Then came an estate tax hiccup. In 2010 Congress suspended the estate tax with the expectation of bringing it back in 2011. Top financial planners proclaimed it a great year to die if you were super-wealthy.

David Mason, CPA and partner with BKD CPAs and Advisors, recalls that New York Yankee baseball team owner George Steinbrenner’s heirs didn’t pay estate taxes that year on his estimated $500 million estate.

Things won’t be looking so good for families in 2013, he said. In fact, the 2011 threshold, which had been at an all-time high of $5 million estate tax exemption — will drop to $1 million. So too will the gift tax exemption. And estates over that $1 million threshold will be taxed at 55 percent, instead of the current 35 percent.

It doesn’t take a wildly successful business to add up to greater than $2 million in net worth, Mason said. Life insurance, small businesses or a family farm can take a family past that threshold and into 55 percent taxing territory.

“You will see a lot of real estate holders — anyone who holds valuable assets — going to make a gift this year to get it out of their estate,” he said.

Some clients at UMB Bank also are rushing to give away millions to their heirs this year to beat the tax change, Roberts Munsell said.

“Between a husband and wife, they can go up to $10 million,” she said.

Mostly, however, there is utter frustration surrounding estate planning. There is a sense that Congress will make changes after the November presidential election. There are reports that President Barack Obama would like the estate tax exemption to be $3.5 million and Gov. Mitt Romney would hold it at $5 million.

“There are some, no matter how attractive the exemption looks this year, who say there is too much uncertainty — we’ll wait and see what happens in the election,” Roberts Munsell said.

Even if the Bush tax cuts are extended financial planners still will have unease about the situation, she said.

“It feels like it could be the worst situation of all,” Roberts Munsell said.

Affordable Health Care Act

While the Bush tax cuts are a wild card for long-term planning, the Patient Protection and Affordable Care Act is not. The tax increases in that bill are certain, Mason said.

There will be a 3.8 percent Medicare surtax on unearned income — dividends, rents, interest, capital gains, royalties and passive activity income. So, for those already seeing a 24.6 percent increase on their dividends, they can expect to add 3.8 percent, making their taxes go from 15 percent to 43.4 percent. The people affected most will be passive investors, Mason said.

An investor may think about becoming active in the business — for example, if a person was an investor in a real estate company he might consider getting a broker’s license and becoming an active investor in the business to avoid the Medicare surtax.

“It’s a tax that discourages investment,” Mason said. “It hits passive investors.”

Another Medicare tax has not received as much attention, Mason said. The employee portion of the hospital insurance payroll tax will increase .9 percent, from 1.45 to 2.35 percent, on wages more than $250,000 for married taxpayers.

“I don’t know what impact it will have on small businesses,” Mason said. “It is a disincentive to getting additional compensation.”

Heading into the final stretch before the 2013 tax changes, financial planners can only be certain that taxes will remain the same or increase, and tax code will revert back to pre-2001 and 2003 or be adjusted to a new level.

“It’s a terrible way to run a tax policy,” Mason said. “…I would not make book on what is going to happen.”

Ordinary income tax rates increase in 2013

Income, married joint filers

$70,700 to $142,700 from 25 percent to 28 percent

$142,700 to $217,450 from 28 percent to 31 percent

$217,450 to $388,350 from 33 percent to 36 percent

Over $388,350 from 35 percent to 39.6 percent

Long term capital gain rates

Increase from 15 to 20 percent. An 18 percent maximum rate will apply to capital assets purchased after 2000 and held for more than five years.

Source: Godfrey and Kahn 2013 Income Tax Update