Although the Obama administration released its 2013 revenue proposals on Feb. 13, 2012, no legislative action has been taken to make these proposals binding law. Without some action from Congress before year-end, tax rates are poised to increase for income, estate, gift, and generation-skipping taxes on Jan. 1, 2013. Despite this uncertainty, planning opportunities may need to be implemented prior to year-end to minimize taxes and preserve your wealth.
Income tax changes on Jan. 1, 2013
Specifically, we will see the following income tax increases and changes:
- A 13 percent increase in the highest individual income tax rates to 39.6 percent from 35 percent, and it becomes a 24 percent increase when taking into consideration the additional 3.8 percent surcharge for those individuals subject to the new Medicare surtax on unearned income (see income thresholds indicated in the chart below)
- A 33 percent increase in long-term capital gains taxes to 20 percent from 15 percent
- A 164 percent increase for dividend rates to 39.6 percent from 15 percent
Of additional importance is the reappearance of limitations on certain itemized deductions, such as charitable contributions, for taxpayers whose income exceeds certain thresholds. The chart below summarizes the changes scheduled to take effect on Jan. 1, 2013, as well as what the rates would be under the proposals that the president recently submitted to Congress.
|Tax rates |
|2012 ||Current 2013* ||Obama proposal 2013 |
|Ordinary income |
|35% ||39.6% ||39.6% |
| ||33% ||36% ||36% |
| ||28% ||31% ||28% |
| ||25% ||28% ||25% |
| ||15% ||15% ||15% |
| ||10% ||15% ||10% |
|Alternative minimum tax ||26% / 28% ||26% / 28% ||26% / 28% |
|Dividends || |
|39.6% ||20% |
|Long-term capital gains |
|15% ||20% ||20% |
| ||0% ||10% ||10% |
|Limitations on deductions ||None ||Restored || |
|Minimum tax on income |
> $1 million
|None ||None ||Proposed |
*Medicare surtax (beginning in 2013): 3.8% on "unearned income" on taxpayers with taxable income over $200,000 (single) and $250,000 (married filing joint); 0.9% tax on wage and self-employment income
Income tax planning opportunities through year-end
With looming increases in income tax rates and the addition of the Medicare surtax, income tax planning may be somewhat counterintuitive this year. Generally, accelerating income at current lower rates may make more sense versus deferring income. Furthermore, deferring deductions may make sense where the offsetting benefit may be greater against a higher tax rate (keeping in mind the implication of the limitation of certain itemized deductions and any provisions expiring at Dec. 31, 2012).
Given these general trends, some planning strategies to keep in mind:
- Convert traditional IRAs to Roth IRAs in anticipation of higher tax rates and brackets in the future
- Discuss your investment portfolio with your investment advisor to understand the impact on your total return and after-tax income of dividend rates increasing to ordinary income tax rates from the current 15 percent rate
- Consider maximizing contributions to qualified retirement accounts (IRAs, 401(k)s, etc.) to defer income tax and reduce unearned income that would be subject to the Medicare surtax
- Consider the use of annuities to defer income tax and reduce unearned income that would be subject to the Medicare surtax
- Consider the use of life insurance for its tax-deferred or even tax-free benefits and to reduce unearned income that would be subject to the Medicare surtax
Finally, where practical, consider accelerating the sale of investments that will generate long-term capital gain at the 15 percent rate in effect through year-end. There is a cost benefit to selling at today’s lower rates as illustrated in the example below which demonstrates the additional return necessary to recoup the cost of selling in a higher capital gains tax environment.
You need additional return to compensate for higher taxes
Comparison of additional return required for sale at 20% long-term capital gains rates vs. sale at 15% long-term capital gains rates with 6% after-tax return
Estate, gift, and generation-skipping changes on Jan. 1, 2013
Specifically, without legislative action, we will see the following estate, gift, and generation-skipping tax rate increases and exemption decreases:
- A 57 percent increase in the highest estate, gift, and generation-skipping tax rate (top rate once again 55 percent)
- An 80 percent decrease in the estate and lifetime gift tax exemptions (total exemption $1 million)
- A 73 percent decrease in the generation-skipping tax exemption (total $1.36 million, which will be indexed for inflation)
The chart below summarizes prior, current, and future law, as well as the president’s proposal:
|Estate tax exemption ||Basis method ||GST tax exemption ||Top estate/GST tax rate ||Gift tax exemption ||Top gift tax rate |
|$3,500,000 ||Step up in basis ||$3,500,000 ||45% ||$1,000,000 ||45% |
|2010 ||- 0 - ||Modified |
|- 0 - ||0% ||$1,000,000 ||35% |
|$5,000,000 ||Step up in basis ||$5,000,000 ||35% |
|2011 || |
|Step up in basis ||$5,000,000 ||35% ||$5,000,000 |
|2012 ||$5,120,000 |
|Step up in basis ||$5,120,000 ||35% ||$5,120,000 |
|$1,000,000 ||Step up in basis ||$1,360,000 ||55% ||$1,000,000 ||55% |
|2013 proposed ||$3,500,000 ||Step up in basis ||$3,500,000 ||45% ||$3,500,000 ||45% |
A note on the portability election for a married individual who died in 2011 or dies in 2012 with an estate not exceeding these thresholds: Normally, an estate tax return is not required. However, if the deceased spouse’s estate does not use the full exclusion amount, the executor can elect to pass the unused amount to the surviving spouse, which can only be done through filing a complete estate tax return. This is an additional administrative burden and expense for the estate, but it is the only way of ensuring that the unused exemption is able to be utilized fully.
The Obama administration proposal also includes the following provisions relating to estate, gift, and generation-skipping tax:
- A permanent portable estate tax exclusion
- Basis reporting requirements for donated and inherited property
- Limitations on availability of valuation discounts for transfers made between related parties
- A 10-year minimum term for grantor retained annuity trusts (GRATs) and requirement for the remainder interest to have a value greater than zero at the time the interest is created
- Elimination of tax benefits associated with the sale of an intentionally defective grantor trust (IDGTs)
- Limited duration of generation-skipping transfer tax exemption
Estate planning opportunities through year-end
In addition to the current lifetime gift exemption of $5 million available only through the end of the year, interest rates and asset values are at historic lows, providing opportunities for lifetime giving. Furthermore, with the potential for legislation to limit some of the beneficial planning strategies now available, acting before year-end to take advantage of the wealth transfer environment may be very beneficial. In particular, you may to consider using the lifetime gift exemption of $5 million this year.
This exemption can be further leveraged by either giving assets with a valuation discount and/or giving assets to a generation-skipping trust. Implemented separately or together, the strategies can maximize available benefits. If you give assets with a valuation discount, this allows you to transfer additional value. For example, if you give an asset discounted by 20 percent for lack of marketability or lack of control, you would be able to give $6.25 million of assets, while only using your $5 million lifetime gift exemption.
Giving assets to a generation-skipping trust allows you to avoid not only gift and estate tax, but also generation-skipping tax. Additionally, consider using freeze strategies such as the aforementioned GRAT or IDGT to take advantage of low interest rates, so long as these strategies are still available.
Whatever your situation, we recommend discussing your personal financial planning goals and objectives with an advisor to help you prepare for the impending changing tax environment and best preserve your wealth.
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