In particular, when the markets are down, there are several tax planning strategies that can be utilized which, when designed and executed properly, can create and/or shift a considerable amount of wealth in the future.
I spoke about these and other year-end tax planning techniques at today's session of the Financial Advisor Webinar Series. You can see a replay and download the presentation slides here.
Loss Harvesting
Taxpayers should generally offset as much of their 2011 capital gains as possible by selling off loss assets, particularly stocks. If the taxpayer thinks the loss stocks are a bad investment, there are no special planning considerations. The taxpayer simply sells the stock and is glad to be rid of it.
If the taxpayer considers the stock desirable, however, and wants to repurchase the shares that are sold, it is necessary to plan around the wash-sale rules of Code Sec. 1091. Under these rules, losses on a sale of stock or securities are not deductible if, within 30 days before or after the sale, the taxpayer acquires substantially identical stock or securities. The rationale for the rule is that taxpayers who sell stocks and repurchase them a short time later haven’t really cashed in their investment.
Taxpayers who are really bullish on a stock, however, do not wish to be out of the market for the 30-day period. A number of strategies have been developed to address this problem:
(1) Buying stock of a similar company
(2) Doubling-up and waiting for 30 days
(3) Buying a call option at the money at least 31 days before the sale of the loss stock
Roth IRA Conversions
In the world of IRAs, there are basically two types: traditional IRAs and Roth IRAs. Traditional IRAs are the most common and usually allow most taxpayers to deduct contributions in the year of funding. Over time, all income and capital appreciation generated within the traditional IRA compounds in a tax-free environment. However, when future distributions are taken from the traditional IRA, they are generally fully taxable (as ordinary income) to the taxpayer.
Roth IRAs, on the other hand, do not allow a taxpayer to deduct contributions to the account. In addition, for those who transfer traditional IRA funds to a Roth IRA (i.e., convert), this will result in taxable income to the taxpayer. Nevertheless, all subsequent income and capital appreciation attributable to either a contribution or conversion will compound within a tax-free environment. Furthermore, provided certain tests are met, future distributions from the Roth IRA will be exempt from income tax.
With the elimination of the income qualification limit, virtually every taxpayer will be allowed to convert his/her traditional IRA to a Roth IRA. For many affluent taxpayers, this will provide a significant opportunity to move funds from a tax-deferred environment (as is the case with traditional IRAs) into a tax-free environment (as is the case with Roth IRAs) at a relatively reasonable current income tax cost.
Right now, because of current volatility in the stock market, one of the most important reasons why a taxpayer may want to consider converting to a Roth IRA is the ability for him/her to “recharacterize” a prior Roth IRA conversion. In essence, under the tax law, a taxpayer has all the way up until October 15 of the year following the year of a Roth IRA conversion to “recharacterize” (i.e., undo) the prior year Roth IRA conversion.
Although, in the past, recharacterizations were primarily used to undo Roth IRA conversions because a taxpayer failed to meet certain qualifications, recharacterizations are now being used as a strategy to enhance the effectiveness of Roth IRA conversions. This is incredibly important to taxpayers in that recharacterizations allow taxpayers the benefit of hindsight. Furthermore, recharacterizations protect taxpayers from paying income tax on assets that no longer exist (in the case where the value of the Roth IRA declines from the time of conversion).
While the ultimate decision of whether or not to convert to a Roth IRA will require thorough quantitative analysis, at least the initial decision to convert will carry far less risk to taxpayers because they are afforded the ability to recharacterize.
Grantor Retained Annuity Trusts (GRATs)
A Grantor Retained Annuity Trust (GRAT) is a mechanism that allows an individual to transfer a portion of the growth on property expected to produce high future returns tax-free. A GRAT essentially works in the following manner:
Ms. Smith transfers property to a trust for the benefit of her beneficiaries (e.g., children) while retaining the right to receive annual annuity payments from the trust for a term of years. At the end of the trust term, the property remaining in the GRAT passes to the Smith children. Ms. Smith’s interest is referred to as the lead interest and the children’s interest as the remainder interest.
At the time the trust is created, the grantor pays gift tax on the present value of the remainder interest of the GRAT. There is no gift tax payable on the annuity (lead interest) because the grantor is not transferring that portion of the value to anyone, but keeping it for himself. Thus, the amount of the taxable gift is the value of the property transferred to the trust minus the present value of the annuity interest that the grantor retains.
In valuing the lead interest, the IRS assumes that the trust assets produce a return equal to the Internal Revenue Code Section 7520 rate. This rate varies and is equal to 120% of the applicable federal midterm rate. It is currently set at 1.4%. If the actual return on the trust assets is equal to the Code Section 7520 rate, the gift will be fairly valued. If the actual return is higher, however, the gift will be undervalued.
It is possible to set the value of the lead interest equal to the full value of the property transferred to the GRAT. When this is done, the value of the remainder (gift) interest is zero. There is no taxable gift and the grantor doesn’t even use any of his unified credit. A GRAT structured in this way is said to be “zeroed-out”.
All gift tax consequences in a GRAT are fixed at the time the trust is created. At the end of the trust term, any assets remaining in the GRAT pass to the children with no further tax consequences. Since there is no taxable gift with a “zeroed-out” GRAT, all amounts remaining in the GRAT at the end of the trust term are transferred tax-free to the remainder beneficiaries. A GRAT, therefore, can be a valuable tool to transfer highly appreciating assets to future generations without incurring a gift tax.
Income Acceleration in 2011 and 2012
Beginning in 2013, ordinary income tax rates are scheduled to increase to their pre-2001 levels. Consequently, taxpayers should consider accelerating certain types of ordinary income (e.g., bond interest, annuity income, traditional IRA income, compensation income) into 2011 and 2012 to the extent that they expect to be in the same tax bracket or higher in future tax years.
2011 Year-End Tax Planning Webinar
As the end of 2011 is fast approaching, there are several key issues that tax advisors need to keep in mind when meeting with their clients to do year-end tax planning to potentially reduce current and future taxation.
I spoke about these and other year-end tax planning techniques at today's session of the Financial Advisor Webinar Series. The webinar is eligible for one continuing education credit from the CFP Board of Standards and the Investment Management Consultants AssociationSM(IMCA®).You can see a replay and download the presentation slides here.
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