Putnam Investments: Ten income and estate tax planning strategies for 2012

Unless legislative action occurs, 2012 marks the last year of a historically low tax environment. Beginning in 2013, income taxes are scheduled to increase – for some taxpayers in higher tax brackets that increase will be substantial:

Tax rates reflect highest marginal rate and incorporate additional taxes related to the health-care reform law. Health-care-related taxes include a surtax of 3.8% on net investment income and additional .9% payroll tax affecting single filers with income in excess of $200,000, and joint filers with income in excess of $250,000.  Assumes employee payroll tax rate of 4.2% is extended for tax year 2012.  If no extension occurs, the employee portion of the payroll tax will be 6.2% in 2012.

Additionally, the federal exemption amount for estate and gift taxes is scheduled to revert to $1 million in 2013 (from $5 million in 2012).

Ten tax-smart strategies to consider in 2012:

1. Accelerate income where feasible

Taxpayers who expect to remain in higher tax brackets going forward may want to consider reporting more income on their tax return in 2012.  This can be accomplished through a number of methods including converting Traditional IRA assets to a Roth IRA, realizing more income from a  business or partnership, or exercising certain stock options.

2. Complete large financial transactions

Rising long-term capital gains rates and a new Medicare surtax of 3.8% on net investment income may prompt investors to consider completing large financial transactions – the sale of appreciated stock, real estate, or businesses – before 2013 to take advantage of the low 15% tax rate.

3. Accelerate tax deductions into 2013

With the return of income phase-outs on itemized deductions in 2013, clients in higher tax brackets should consider accelerating certain tax deductions into 2012 if possible.  Examples include prepaying mortgage interest, prepaying local property taxes, and expediting elective medical procedures that may result in significant out-of-pocket expenses.  However, taxpayers should be aware that, if subject to the alternative minimum tax (AMT), some of these deductions will be reduced or negated.  For example, the deductions will be reduced or negated.  For example, the deduction for local property taxes is negated if AMT applies while the mortgage interest deduction is still available regardless of AMT status.

4. Gift appreciated assets to family members in lowest tax brackets

In 2012, taxpayers in the lowest two brackets (10% and 15%) benefit from a 0% rate on long-term capital gains and qualified dividends.  Investors contemplating gifts to family members may be well served to gift appreciated stocks or mutual funds instead of cash.  If the recipient is in one of the lowest tax brackets, the asset could be subsequently sold without any capital gains tax (before the end of 2012).  Note that this strategy is limited depending on the size of the capital gain.  For example, if the gain is large enough, that amount may “push” a taxpayer above the 15% income tax bracket where the higher 15% capital gains rate will apply.

For reference, the 15% bracket begins at income levels of $35,350 for single filers and $70,700 for joint filers.

5. Maximize retirement plan contributions

As federal budget deficits have worsened, there is increased scrutiny on tax benefits, including the preferred tax treatment of retirement plan contributions.  Plan participants may not want to assume that these tax benefits will be in place forever.  In fact, there has been recent congressional testimony on deficit reduction efforts that would reduce retirement plan contributions to certain levels based upon a percentage of income.

6. Review estate planning documents and strategies

It is critical for investors to review estate plans in conjunction with changes in the tax environment.  For example, as the federal exemption amount increased to $5 million in 2010, in many cases trust provisions had to amended to ensure that potential unintended consequences were avoided.  Additionally, investor’s estate plans may be well positioned for the federal estate tax, buy may not be designed effectively to avoid the impact of death of inheritance taxes at the state level.

7. Consider significant charitable gifts

Affluent clients considered gifts may wish to move forward in 2012 while generous tax benefits still exist.  Given escalating federal budget deficits and increased costs for entitlement programs, the deduction for charitable giving has faced scrutiny from lawmakers.   Additionally, it is reasonable to assume that the estate tax environment could get worse in the future as the federal government looks to generate more tax revenue, so removing assets from estates now may have advantages.

8. Make lifetime gifts

Individuals can gift up to $5 million over their lifetime without incurring federal gift tax.  With this limit reverting to $1 million in 2013, removing assets out of larger estates by making large gifts now may make sense.  Another reason for lifetime gifting is that appreciation of transferred assets post gift is also outside of the estate.  That makes gifting assets that may have depreciated in value due to the current economic environment, such as real estate or stocks, an attractive option.

9. Consider advanced wealth transfer strategies

Individuals and families with more complex estates should consider advanced strategies to transfer wealth efficiently.  Examples include Family Limited Partnerships (FLPs) or Grantor Retained Annuity Trusts (GRATs).  GRATs are especially attractive currently as a result of low IRS interest rates.

10. Explore options with life insurance trusts to create liquidity at death

With the possibility of estate taxes increasing, families with sizable assets may want to explore life insurance as a means to create liquid assets at death to pay estate taxes.  Proper planning with life insurance can help families avoid liquidating other, non-liquid property such as real estate or family-owned businesses during less-than ideal personal or economic circumstances.

Consult a qualified tax or legal professional and your financial advisor to discuss these types of strategies to prepare for the risk of higher taxes in the future.  Personal circumstances vary widely so it is critical to work with a professional who has knowledge of your specific goals and situation.

This information is not meant as tax or legal advice.  Please consult with the appropriate tax or legal professional regarding your particular circumstances before making any investment decisions.