Tax Diversification

Congress has a mountainous struggle ahead with debt. We’re already borrowing 40 cents for every dollar of federal outlays. Structural and demographic issues hardwired into the Social Security program since the baby boomers were born are about to make themselves felt – overwhelming payroll tax receipts. And Medicare is in even worse shape. Meanwhile, Congress stripped 500 million from Medicare over the next 8 years to fund ObamaCare, which we now know will cost about $800 billion more than advertised over the next ten years.

One way or another, taxes are going to go up.

What we don’t know is how. Will Congress raise taxes on Social Security income, as the Clinton Administration did in 1993? Will they raise the retirement age to 70 and beyond to balance Social Security cash flows? Will they get out of the Medicaid business and leave it in the hands of the states? Will they move to nationalize 401(k) and other pension assets, or tax their growth? Will they make Roth IRA income taxable?  Take away the homeowners mortgage interest tax deduction? Raise income tax rates or lower exemptions? Tax life insurance cash value accumulation and/or death benefits? Raise the estate tax or slash the current exemption of $5 million?

We don’t know.

You’ve heard of investment risk and inflation risk. In the bond world, you have default risk. Well, all investors in America must also deal with the presence of legislative risk: The possibility that Congress will pass laws that substantially change the present or future value of your assets, and present changes to the set of assumptions that guide your investment and savings decisions.

Tax Diversification

That’s why it’s important to spread your legislative risk among many different types of assets: Tax deferred retirement accounts, pensions, home equity, savings in taxable accounts, municipal bonds, dividend paying stocks, cash value life insurance – all have an important role to play in building a tax-diversified retirement portfolio.

We believe it’s important to divide assets among at least three “buckets,” the taxable bucket, the tax-deferred bucket, and the tax-free bucket

Taxable Assets

These are assets that don’t present an income tax bill after the year in which you receive them – at least, under the current set of laws. Instead, Congress levies capital gain taxes on any profits you make – though they may charge income tax of some kind on dividend income these sources generate.

The main benefit here is the favorable rate accorded to long-term capital gains – that is, profits on assets you held more than a year.

You can also mitigate your tax liability through techniques such as tax loss harvesting – that is, selling some losers to generate capital losses, to offset your gains (and up to $3,000 of income in any given year).

Examples of assets in the taxable bucket include most things you hold outside of retirement accounts, including rental real estate, your own home (you do get a $250,000 or $500,000 capital gains exemption on your personal residence, depending on whether or not you are married, though Congress can modify this at any time as well). CDs, bank accounts, money market accounts, bonds, mutual funds, stocks, and investment property, including collectibles, tends to fall in this category unless you put it in a retirement fund.

Tax-Deferred Assets

Tax deferred assets include things like deferred annuities, 401(k)s, SEP IRAs, SIMPLE IRAs, 403(b)s, and traditional IRAs. These assets are most vulnerable to an increase in income tax rates in future years. Congress could also begin charging for transactions within them, to some extent, though they would have some difficult questions to explain to the public about why they were changing the rules after investors had committed these funds.

Tax Free Assets

Tax free assets include assets you already paid taxes on, which current law allows to grow tax free, and generate tax free income to you. This works for you very well if you front-loaded your income taxes when rates were comparatively low – as they likely were during the Bush Tax Cut era. Congress is quite likely to repeal the Bush cuts at some point – perhaps after the economy has recovered somewhat and the Democrats retake control of the House.

Examples of assets currently inhabiting this bucket include Roth IRAs, designated accounts in 401(k)s, and cash value life insurance (funded under modified endowment contract limits).

By dividing your assets among each of these tax buckets, you can go a long way towards avoiding a severe shock to your retirement income or plans to pass on assets to the next generation.

Part of our process is looking beyond your assets and asset classes to help ensure you are diversified against acts of Congress as well as acts of God and acts of neurotic stock market players and bond players.

Year-End Tax Tips – 2012 Edition

I don’t remember a time when there was more uncertainty over the tax scheme in the years ahead. Both parties have very different visions about where they want this country’s tax code to go – and they are at variance with the current law, which will automatically enact a substantial tax increase in January that nobody wants. But the two sides may not be able to come to a year-end agreement – particularly if the opposition party wants to hamstring whoever wins the White House this year by sticking them with the sequestration tax increases, spending cuts, and probable recession that would result.

Despite the uncertainty, though, there are some moves I’m comfortable suggesting:

• Harvest those tax losses. If you have an investing portfolio with both winning positions and losing positions in it, you can use your losses to cancel out your gains – reducing or eliminating your capital gains tax for the year – a technique called “tax loss harvesting.” If you have more losses than gains in any given year, you can deduct those losses against future capital gains. If you have no capital gains to deduct them against in the following years, you can use those losses to cancel out up to $3,000 of income per year.
• Sell winners. Consider doing so even if you can’t offset capital gains with losses: Taxes on capital gains are set to increase by as much as 33 percent come January 2013, when the tax on long-term gains will increase from 15 percent to 20 percent.
• Close out any sales of closely-held businesses you’re trying to put together, for the same reason. If you sign over appreciated stock in your own corporation, or assets at a profit, delaying the transaction from December to January could be very expensive.
• Remember the 3.8 percent surtax on capital gains. If you make more than $200,000, or $250,000 as a married couple, it’s even more important to move gains into this year to avoid the 3.8 percent tax on capital gains imposed by the Affordable Care Act. That’s in addition to the across the board capital gains increase.
• Careful with mutual funds. Are you considering a mutual fund? Look up the funds’ distribution date, which often falls in November. If the fund has a lot of embedded capital gains, you could get stuck with a big taxable distribution. That means you will have to pay capital gains tax on money other people made. That doesn’t mean mutual funds don’t make sense. Just go in with your eyes open.
• Do you control a C corporation? Take as much dividend income as you can this year. If you wait until next year, you could wind up paying 39.6 percent on those dividends, rather than the 15 percent on qualified domestic dividends you get this year.
• Oops… did I say 39.6 percent? Add the 3.8 percent Medicare surtax to that figure if you wait until next year. That’s what will happen under current law, unless Congress intervenes. I suspect it will… I don’t think either Republicans or Democrats want a full sunset of the Bush tax cuts, plus the Medicare surtax to hit all at once. But Congress has done dumb things before – and you can’t ignore what the law on the books says now.
• Self-employed? Try to push income to 2012 rather than take in 2013, if possible. That will save you 2 percent on your self-employment tax, since the employee’s share of the tax is increasing by 2 percent as of January 1, from 4.2 to 6.2 percent.
• Schedule an AMT review with your tax advisor. You may need to make some moves with stock options, or push certain deductions to a non-AMT year. You may also want to accelerate income to the current year, or hold off on constructive receipt of income until 2013, depending on your overall situation. Everyone is different when it comes to the AMT.
• Do you itemize? Schedule a Pease limitation review with your tax advisor. You might want to push deductions to this year rather than risk losing the ability to take certain deductions next year

These are just the basics. There is a lot to discuss when it comes to taxes as we come to the end of the year. We’ll certainly be covering them, looking at these in more detail and digging into other year-end tax planning issues, too. Keep tuning in to my blog Penge Snak!

The Oregon Estate Transfer Tax – What You Need to Know

And so we have an estate tax at the federal level. Most people who have enough assets to have the lucky burden of worrying about it are familiar with it. But Oregonians should know that the Salem imposes an estate tax of its own, on top of the federal estate tax. Lots of affluent folks forget all about the state level taxes until it’s too late to do much about them.

What’s more, the rules governing estate taxes in Oregon changed this year. So if you stand to inherit wealth, or if you have amassed wealth you’d like to pass on, you should be aware of the new rules:

If someone in your family died in 2012 or later – or is still alive, but isn’t buying green bananas anymore – that individual or estate must file an OR Form 706 with the Oregon Department of Revenue. Note that the State updated the form in July, so if you’ve been keeping an old form around, be sure to download the new one at the link. The form must be filed if all the assets belonging to the decedent anywhere in the world add up to $1 million or more.

It isn’t just for the wealthy

Note that that’s a very different amount than the federal government exempts. As of 2012, the federal estate tax exempts $5.12 million per spouse. That’s not Mitt Romney and Warren Buffett money. But the federal version of the estate tax is pretty much just a worry for the very wealthy.

The $1 million exemption available to Oregonians is a different story. If you bought a home and saved diligently in a retirement plan for an entire career, or you have a rental real estate portfolio with the mortgage paid down, or a good-sized small business that kicks off around $200,000 per year in profits (justifying a $1 million purchase price at a 5x earnings multiple), then you need to be very aware of how this tax will affect your heirs.

More background information is available here:

A few observations:

• The State of Oregon wants its money no matter where the assets are. You can’t simply park assets in a state with no inheritance or estate tax, or offshore, to avoid the Oregon Estate Transfer Tax.
• Registered domestic partners get the same tax breaks for this purpose that married couples do, under Oregon law. Same-sex couples, for example, cannot qualify for the federal unified exemption that allows assets to pass on to a surviving spouse tax-free. But they can qualify for the Oregon version.
• The estate has nine months from the decedents date of death to file the return. Your tax payment is due at the same time, unless you get an extension from the Oregon Department of Revenue. If you don’t make it, a 5 percent tax will apply. If you are 90 days late, the State will add a 20 percent additional penalty – for a total of 25 percent.
• As it stands, the estate transfer tax in Oregon is among the highest in the country.
• As currently structured, the estate transfer tax is very much a tax on the middle and upper middle class.

What’s the tax?

Oregon imposes a sliding estate tax scale beginning at 10 percent of the total estate in excess of $1 million. That percentage gradually increases to 16 percent for any taxable estates worth over $9.5 million.

The family does get to deduct some things from the estate. The decedent’s debts, of course, to include mortgages and liens, estate and administrative expenses, bequests to surviving spouses (or domestic partners), charitable gifts and funeral expenses.

What can you do about lowering it?

There’s quite a bit you can do, actually. You can move to a state that doesn’t have an estate tax at the state level, and reestablish a domicile in another jurisdiction.

You can vote to kill it this year, by voting for Measure 84 on the 2012 ballot. Actually, that would have the estate tax phase out by 2016 if it passes. The State would presumably make up the revenue with some other source of revenue – I don’t foresee it spending less any time soon. There are downsides to passing the measure, but I’ll let the political types make the pro-and-con arguments.

Spend your money before you die. After all, the sales tax is lower than the state estate tax – and is a lot more fun to encounter along the way! Money you spend now won’t be subject to the estate tax later.

Set up a trust. A special kind of trust called a credit shelter trust can enable you and your spouse to effectively add your exemptions together, rather than split one. Your attorney can help you draft the documents appropriate for your specific situation. If you don’t have an attorney I can refer you to one who’s very affordable.

Establish a strategic gifting program. You can give away up to $13,000 per year to any given family member, or anyone else you designate, tax-free, up to a certain lifetime amount, which varies over time depending on how much you have already given away. If this is a concern to you, I’d sit down with a tax expert to figure the lifetime gift tax exemption that applies in your personal situation as well. The general principal is this, though: Moving assets out of your estate means they will not be subject to the estate tax when you pass on. So if your children and grandchildren will be inheriting the money anyway, you might consider giving them an advance on your will. College funding is a great potential way to transfer money into other family members’ names, for, say, a Section 529 plan. Be careful about whom you give this money away to, though – if the student has too much assets in his or her own name, it could affect eligibility for need-based financial aid under the federal system.

If you have questions about estate planning or any other financial concern, give us a call! We look forward to hearing from you.