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Divers

THE YEAR OF THE SPREADSHEET

For the last two years or so, we have anticipated that the U.S. Congress will increase capital gains rates.  We have advised our clients with investment portfolios subject to United States tax jurisdiction to ignore the time-honored mantra of “defer, defer!” and instead to consider selling – to pay tax now at lower rates, rather than to delay and pay at high rates later.  Today, we are even more confident that a rate increase is imminent, and we now suggest, even more strongly, that taxpayers who are subject to U.S. jurisdiction look seriously at monetizing assets.  While Congressional action is difficult to forecast, legislation is now pending that would increase both the nominal and effective rates of federal income tax, especially for those taxpayers with incomes of more than about $250,000.  Meanwhile, some of the tax cuts enacted in the last ten years are due to expire.  Based on the current trajectory, we make the following predictions:

•    Rates for the highest tax brackets will increase. The top 35% bracket will increase to 39.6% and the 33% bracket to 35%. This represents a considerable tax increase for taxpayers in these brackets (currently adjusted gross incomes [AGIs] of $208,850 and up). Although the thresholds for the tax brackets may also change and some new tax cuts are also expected, the effective marginal tax rate will likely increase for most joint filers with AGIs above approximately $270,000 (or about $225,000 for single filers).

•    An additional tax will be imposed on the wealthiest taxpayers to cover the cost of health care reform. This will be in the form of a 5.4% “surcharge” to the existing income tax, which would be imposed at AGI levels at or above $1,000,000 ($500,000 for single filers).

•    Congress will act to increase the maximum rate on capital gains from 15% to 20% for most taxpayers. (The 15% rate will be retained only for lower-income individuals.) Note that even if Congress does not act, capital gains rates will return in 2011 to their pre-2003 levels (generally 20% for most taxpayers).

•    The benefit of the mortgage interest deduction will be phased out more severely at higher income levels.

•    Current limitations, generally 50% of AGI, on charitable giving will be tightened.•    Carried interests on investment partnerships, currently taxed at capital gains rates, will be taxed as ordinary income.

We expect that most of these (or similar) predictions will come to fruition in the next several months, and if so, they will likely be effective for the tax year 2011. This means that taxpayers should have a full year to plan for the changes.

Although the future tax picture is still being painted, we have enough of an outline at this point to build effective models, and we can predict the effects of different alternatives. Taxpayers may want to develop strategies for accelerating income into 2010 that otherwise might accrue in 2011 and, conversely, postpone activities that would generate deductions. Any tax strategy is complicated by the alternative minimum tax (AMT), and in many cases the AMT will limit the benefit of income acceleration. Under the administration’s current proposal, the AMT will continue at essentially the same exemption amount as in 2009, indexed for inflation, through the next ten years. Our financial models can take this into account. Similarly, we can account for the effect of past losses; many taxpayers have carryforward capital losses from the last few years, which will allow them to realize significant capital gains in 2010 free of tax.

Future tax historians looking back may dub 2010 as the “year of the spreadsheet,” the year when financial modeling came into its own as a key tool for tax planning.

ROTH IRA CONVERSION— A FLOOD TIDE OPPORTUNITY

Shakespeare may have had taxes in mind when he wrote, “There is a tide in the affairs of men which, taken at the flood, leads on to fortune.” For anyone who has a retirement account— whether a qualified employer plan, a 401(k) plan, or a traditional IRA—the year 2010 may offer a flood-tide tax planning opportunity. Congress has decreed that starting January 1, 2010, taxpayers may convert their traditional retirement accounts to a Roth IRA regardless of their income level. Especially for high-bracket individuals (and even more especially for low-bracket individuals who expect to be in a high bracket during retirement), this conversion can produce significant tax savings.

Roth IRAs offer several advantages over traditional IRAs and other retirement accounts. Under current law, taxpayers can convert these accounts to Roths only if their modified adjusted gross income is $100,000 a year or less. Starting in 2010, however, the $100,000 limit is being removed.

Traditional IRAs begin with taxdeductible contributions, amounts which will be taxed later when the taxpayer retires and (in theory) will be in a lower tax bracket. In contrast, Roth IRAs are funded with tax-paid contributions, which can be withdrawn later tax-free. Both types of accounts avoid current taxation on earnings; but whereas traditional IRAs only defer taxes on earnings, Roths eliminate taxes on earnings forever. Hence, as long as some (fairly liberal) timing requirements are met, money can be withdrawn from a Roth tax-free, regardless whether the withdrawn funds represent the original contribution or later earnings. In contrast, all amounts withdrawn from a traditional IRA are taxable (and generally taxable at full ordinary rates, even though some of the earnings may have represented capital gains). Another advantage of Roths is that the taxpayer is never forced to make withdrawals during the taxpayer’s lifetime; in contrast, traditional IRAs require that minimum withdrawals begin at age 70½.

Conversion from an IRA to a Roth is a taxable event because the taxpayer is changing his or her tax-deductible contributions into tax-paid contributions. Despite the immediate tax hit, many taxpayers will find it advantageous to convert and pay this tax now (rather than later) for several reasons. First, rates are expected to increase, so paying now locks in a lower tax rate.

Second, the balance of the account may be relatively low (due to the poor-performing markets of the last couple of years), so the tax base is now smaller and the overall tax is therefore less. Third, the amount of tax paid is removed from the taxpayer’s estate, which will reduce the estate tax at death (unless the estate is sufficiently small that no tax would be imposed in any case). Fourth, as a special incentive, Congress is allowing Roth conversions to be performed in two installments, which in effect allows the tax to be paid over two years (that is, a 2010 conversion will generate tax that is payable half in April 2011 and half in April 2012).

The conversion to a Roth IRA will make the most sense for taxpayers who (a) are young and therefore have lots of future earnings that would be made tax-free by the conversion; (b) are in a lower bracket now than they expect to be at retirement; (c) will be in a high bracket at retirement and expect rates to increase; or (d) have a net worth exceeding $3.5 million and therefore expect to pay estate taxes at death. These taxpayers should review their account balances and tax situations now and determine if converting in 2010 is advisable. “On such a full sea are we now afloat, and we must take the current when it serves” (William Shakespeare). 

Contributed by Avi M. Lev, Esq., Davis, Malm & D'Agostine, P.C., Boston, Massachusetts.
 

Pour plus d'information contactez: Sophie Migliazzo