Are Your Clients Tax Diversified?

February 15, 2012

By Sonja Hayes
InsuranceNewsNet Magazine, February 2012 

Taxes are a certainty in life, as Ben Franklin said, but here is another one: Taxes will drive you batty. That’s because taxes will increase, decrease or stay the same—and you can’t predict which route they will take.

Although we are left guessing about future rates, we do know that we are experiencing some of the lowest marginal tax rates in history. In 2013, existing tax cuts for ordinary and capital income are set to expire. But who knows what Congress will do by then.

In addition to this scheduled increase in marginal tax rates, 2013 will also have the implementation of a new tax on investment income. This is a 3.8 percent Medicare tax on investments, while Medicare taxes have traditionally been paid only by individuals and only on earned income. In 2013, this tax will be applicable to individuals and on income once it exceeds certain thresholds. For a married couple filing jointly, this threshold is $250,000 Adjusted Gross Income (AGI). And for a single person, the threshold is $200,000 AGI. Once these income levels are reached, this surtax will apply to their investment income. Similarly, this tax will apply to a trust once it has undistributed net income of at least $12,200. For a better understanding of the impact of this additional tax, let’s examine a typical middle-aged family.

Meet the Spencers, Greg and Nancy, both 45, and their two kids, John and Jennifer. Greg and Nancy have an adjusted gross income of $300,000. Of this, $250,000 comes from wages, $24,000 is from their rental home on the beach, $10,000 is interest from CDs and money market accounts, and the remaining $16,000 is derived from various stocks, bonds and mutual funds. At this income level, the Spencers will be subjected to the additional 3.8 percent Medicare surtax on $50,000, which comes to $1,900. Although this does not seem like a large number, when added to the additional ordinary and capital gains taxes that will be due, Greg and Nancy liken this to a reduction in their annual rate of return.

The Spencers are always looking for ways to reduce their tax liability, but they do not want to reduce their current income or spending. Furthermore, they want to have as much money set aside for retirement as possible. Initially they work with their financial advisor to determine their current and retirement income needs. The advisor they chose has a history of working with retirees and is licensed to sell both insurance and securities products. This exercise shows they can maintain their current lifestyle with less income. Their advisor suggests they increase their pre-tax contributions to their employer sponsored retirement accounts. By doing this, their wages remain the same; however the taxable income is reduced because traditional retirement plan contributions occur on a pre-tax basis. After increasing their pre-tax contributions to their retirement accounts, their income from wages is $240,000 and their surtax is reduced to $1,520.

At this point their advisor educates the Spencers on the benefits of incorporating tax diversification into their planning while conducting an income audit. An income audit is where incoming investment dollars are categorized into one of three categories, while the same is done with expenses. Our three income categories are taxed now, taxed later and tax-preferred. Meanwhile, they examine three common expenses, which are the mortgage, retirement and those dollars designed for estate planning. The income from the CD is an example of a taxed now asset, but the Spencers hope to leave this money to their children if they have not needed it during retirement. While the Spencers pay taxes each year on the interest that is being generated from this CD, the money itself is not now being used. Instead it is rolled over into the next CD.

There is one question to ask the Spencers: Why are you paying taxes on money today you are not using? This is the question the Spencers should be asked regarding each line of income on their tax return.

After establishing that the Spencers do not have a current need for this $10,000, our goal becomes one of removing it from the tax return. As long as the Spencers wait until the CD had matured, there are no consequences to removing these dollars from the CD and investing them elsewhere. One suggestion would be to invest in a taxed later or taxed preferred environment. Tax preferred investments are the most desirable as there is the potential for these dollars to escape taxation entirely. These investments include Roth accounts, municipal bonds and life insurance. Today, the Spencer’s income is too high to participate in a Roth IRA. They could consider making a nondeductible contribution to an IRA and then immediately converting to a Roth IRA. While there are income limits on a Roth IRA contribution, the income limits on Roth conversions were eliminated as of 2010. This strategy would enable them to fund $10,000 in a Roth each year.  If they contribute to a Roth 401(k), the income reduction we achieved above will be lost since Roth contributions occur on an after tax basis. Finally, the Spencer’s could purchase life insurance however they are already adequately insured.

This leaves the Spencers with the ability and desire to invest in the tax later category. This category includes qualified retirement plans and non-qualified annuities. Having already made the maximum contribution to any IRA and 401(k) accounts, one suggestion is to take the money from the CD upon maturity and purchase a deferred annuity. While in the accumulation or tax deferred stage there will not be a current tax implication to this investment. The result is that the $10,000 being generated by the CD will no longer be an item on the tax form. Keep in mind, once distributions from the annuity begin, all or a portion of the payments will be taxed. Following this re-investment, the total Medicare surtax will be $1,140, for a 40 percent reduction in the surtax due. While similar opportunities exist in reference to the reallocation of other investments, there could be tax consequences surrounding their reinvestment.

This income audit and the reinvestment of assets that follows positions the client in a “win-win” position, regardless of what tax rates do in the future. If income tax rates decrease, this client is in a better position with these dollars removed from their taxable equation. Likewise, with these dollars removed, the client is in a better position if tax rates increase. And finally, even if tax rates remain the same, the Spencers’ overall tax situation is improved. Until we can predict the future of income tax rates, the next best thing is to position a client so that they will always be in the most advantageous position possible.

Sonja Hayes is director of advanced planning and solutions at Prudential Annuities. She can be reached at Sonja.Hayes@innfeedback.com.

© Entire contents copyright 2012 by InsuranceNewsNet.com, Inc. All rights reserved. No part of this article may be reprinted without the expressed written consent from InsuranceNewsNet.com.


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