With the enactment of tax legislation at the end of 2010, the federal government extended favorable tax laws for 2011 and 2012, but we believe this extension of lower income tax rates—and modifications to the transfer tax system—will be temporary. Therefore, we recommend that clients consider the opportunities currently available in this low tax environment.
Income Taxes
Here are some strategies to consider for 2011:
Don’t feel pressure to accelerate income into 2011. Unless you are trying to use an expiring deduction (such as charitable deductions) or loss, we generally are not recommending accelerating income into 2011. Executives, directors or employees who have received non-qualified (NQ) stock options (where the difference between the grant price and the market price is considered taxable or ordinary income, recognized upon exercise) should consider an early exercise of those options in 2012 to the extent the current low tax rates are not extended.
Realize that you do not need to accelerate capital gains if you are contemplating sales in 2011—but that won’t be true in 2012. The federal income tax rate on long-term capital gains is scheduled to remain at 15% for 2012 but will likely move higher and will further increase when the Medicare surtax of 3.8% on investment income (a feature of the health care legislation) is imposed in 2013. Accelerating gains should be considered only to the extent that you would benefit from any expiring deductions or losses.
Re-examine asset allocation. Investments producing taxable income—interest, rents, etc.—will likely be subject to a higher tax rate in 2013 and will become less attractive when held in fully taxable entities. Investors should consider relocating income-producing assets to tax-deferred vehicles over time. This can be accomplished by allocating bonds, hedge funds, REITs or other tax-inefficient investments into your IRA or other deferral vehicles (such as 401(k)’s and other pension plans).
Make all but large charitable donations before December 31, 2011. By making charitable donations this year, you are locking in these deductions to be used currently and in future years. The use of appreciated stock held for over one year is the best source for making these contributions. You also can consider using distributions from your IRA for these payments (up to $100,000) if you are older than 70½. Timing of these contributions is important, and the rules are different as to whether you make payments to charities by check or in kind. The effective date of contributions is listed below:
Defer large charitable deductions. While the normal pattern of charitable giving should continue as planned, larger gifts (outright or in split-interest trusts) should be reviewed for optimal tax timing, if that is a primary consideration of the gift. To the extent that income-tax rates increase, the deferral of these large deductions probably will have a greater tax-savings benefit. The possible exception would occur in the event of an outsized income-realization event when these deductions could reduce tax burdens.
Harvest losses before December 31, 2011. Although there may be fewer unrealized losses in most portfolios than in recent years, investors should review these positions before the end of the year for any opportunities that remain to offset pending tax liabilities. Any realized losses that remain unused will be carried forward to future years until exhausted. Pay estimated state income tax before December 31, 2011, rather than in January 2012. Individuals should review their year-end regular and alternative minimum tax calculations with their advisors to determine if it would be advantageous to accelerate to December the payment of their estimated state income tax, which is usually due in January.
Consider a Roth IRA conversion. Beginning in 2010, investors could convert traditional IRAs to Roth IRAs without regard to the income limitations that had existed in prior years. Conversion amounts currently are taxable, but for taxpayers who are able to pay the tax due with outside assets, a net benefit is produced, even without assuming higher income tax rates in the future. Because you are not required to receive annual distributions from Roth IRAs (referred to as “minimum required distributions”), you receive the additional benefit of retaining funds invested in a tax-free environment.
Estate Taxes
For those interested in transferring wealth to heirs, there are a few advanced-planning ideas that could create significant transfer tax savings if executed in 2011 and 2012. Consider making gifts to children and grandchildren. For gifts completed in 2011 in excess of the annual exclusion ($13,000 per individual) and lifetime gift exclusion ($5 million), a gift tax rate of
35% applies, the lowest tax rate since 1934. This rate will increase to 55% in 2013 under the current law. Consider alternative gifting strategies. Today’s interest rates are historically low. Many alternative/deferred gifting strategies incorporate current interest rates in determining the value of the grantor’s ongoing interest before the gift is fully realized. There are several ways to take advantage of today’s low rates:
- Loans - Long-term loans to family members can be accomplished for under 3% (close to an historic low) and loans for shorter periods yield even lower rates. Future appreciation beyond the interest payments due is realized by the borrower. Today’s long-term rates may also be attractive when privately financing a mortgage for a child.
- Sales - Sales of assets between family members (or family entities) that are supported in part with a note also can take advantage of these low rates. To the extent that the assets
sold exceed the interest payments due on the note, the appreciation stays with the buyer (typically children, grandchildren or trusts for their benefit).
- GRATs - Grantor Retained Annuity Trusts also use interest rates to determine the value of the annual annuity due to the grantor. Again, to the extent that growth of the assets transferred to this type of trust exceeds the interest rate, there is a tax-free gift of the appreciation to the trust’s remainder beneficiaries (typically children or trusts for their benefit). Future legislation may restrict the use of short-term GRATs.
Conclusion
While the timing of tax law changes could extend beyond December 31, 2011, we believe that plans should be formulated with the assumption that rates will rise in 2013 (if not sooner). We recommend that you consult your tax and investment advisors to determine what, if any, changes should be made to your income tax, transfer tax and/or investment strategies. We encourage you to speak with your team at Brown Advisory, who can help tailor your portfolio to your particular circumstances.
The Strategic Advisory Team
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