The recommendations run the gamut, from stashing money in tax-deferred annuities to loading up on municipal bonds to favoring private equity over hedge funds and cleverly using trusts. The thoughtful reshaping of portfolios is happening with good reason; the tax hikes of 2013 are going to hurt.
Someone with $8 million in earnings and investment income will pay an average $450,000 this year in taxes on top of the $2.7 million paid last year, figures the Tax Policy Center. A married couple with two young kids and a combined income of $2 million can expect to pay $87,500 more in taxes than the $500,000 they paid in 2012.
The government is clawing back revenue from everywhere. The top marginal income-tax rate for couples earning $450,000 and up has increased to the well-publicized rate of 39.6%. Long-term capital gains are not only subject to a higher 20% rate, but also a new 3.8% Medicare tax for a total 23.8%. Short-term gains are taxed at the highest marginal rate plus 3.8% Medicare tax for a total 43.4%. And that's not all. Alan Kufeld, a tax advisor at Rothstein Kass, points out that a new limit on itemized deductions for top earners adds as much as 1.2% on top of each of those rates.
Unlike the 1990s tax increases under Presidents George H.W. Bush and Bill Clinton—which increased income-tax rates but lowered taxes on investment gains and income—the current assault comes from all sides. "In the past, you could arrange your income to take more in the form of capital gains at a lower tax rate," says Roberton Williams, a senior tax fellow at the Tax Policy Center. "Now you're going to pay higher taxes on just about everything; it's much harder to hide."
Not wanting to miss out on all the fun, New York, Connecticut, New Jersey, and California have been raising their own taxes. California became the highest-tax state by raising its top rate to 13.3% on earned income, investment income, and capital gains. That brings the total income-tax hit for top earners in that state to 51.9%; for wealthy residents of New York City, it's 51.7%.
But don't despair. There are things you can do to ease the hurt. Here are some tax-saving moves the best advisors are currently recommending to their clients:
POSTPONE TAXES. Pursue as many tax-deferring opportunities as possible. Certain variable annuities have no limits on how much you can sock away and let your investments grow tax deferred in underlying mutual-fund-like investments. Fee-based advisors have traditionally been highly critical of variable annuities, because they are so expensive and complex. The average variable-annuity investor can easily pay in excess of 3%—a 1.46% contract fee, 0.50% to 1.5% in annual expenses for the underlying funds, and, frequently, guaranteed-income riders typically averaging 1%.
But some annuity companies, such as Jefferson National, Symetra, and Security Benefit, have been quick to respond to the higher tax rates by launching variable annuities that are cheap, liquid, and simple; they include a broad array of investment options, including normally tax-inefficient alternative strategies. The real value of these annuities is their tax-deferment feature.
John Capets, an advisor and vice president at Harbor Capital Management in Charlotte, N.C., says he has started using the Jefferson National Monument Advisor Variable Annuity for his high-net-worth investors. It has 397 investment options, from mutual funds to alternative investments. "The alternatives portfolio can generate a lot of short-term capital gains, but inside the tax-deferred annuity it has no impact," Capets says.
Investors pay the annuity's fund-management fees and $20 a month. On the firm's average policy size of $230,000, that turns out to be an attractive 0.11% charge for the tax-deferral product, compared with the 1.46% charged by the industry's average variable annuity.
CONSIDER NONQUALIFIED deferred-compensation plans. These allow you to sock away a portion of pretax compensation and let it grow tax deferred until a specified date. These plans fell out of favor in 2008 and 2009, when many top executives lost millions in deferred compensation at the likes of Lehman Brothers and Circuit City. If your company goes bankrupt, your deferred-compensation may become subject to creditors' claims.
"That shook things up, but now that tax rates are higher and balance sheets are in much better shape, we are starting to evaluate deferred-compensation plans more closely," says Chris Zander, head of strategic wealth planning at Evercore Wealth Management. "It's very client- and company-dependent. You have to make an overall assessment of the health of your company."
Business owners and self-employed taxpayers can defer taxes by setting up a defined-benefit plan, which is like a traditional pension structured to pay a certain lifetime annuity in retirement. For 2013, the maximum benefit you can fund equates to a $205,000 per year payout for life.
So let's assume a 58-year-old wants to set up a pension for himself, with $205,000 annual payouts starting at age 65 and lasting until the final curtain comes down. For the next seven years there is no limit to how much he can pour into the plan to fund the retirement payout meant to last the remainder of his actuarially determined life under the palm trees. Even better, says Stephen Baxley, director of tax and financial planning at Bessemer Trust, is that "he gets a tax deduction every year for the amount he puts into the plan."
CONSTRUCT TRUSTS WISELY. Tax deferral and other benefits are, for example, byproducts of charitable-remainder trusts. If you intend to leave assets to charity, do so with these trusts "and in the process create your own tax-deferred retirement account," says Allen Laufer, managing director at Silvercrest Asset Management in New York.
You can set up the trust for a period that can be as long as the combined lifetimes of you and your spouse. When you fund the trust, you specify what percentage of the trust assets you want to leave to charity at the end of the trust's term; the charitable minimum is 10%, according to tax law.
Upon funding the trust, you get a tax deduction based on the present value of your gift. For the term, your assets grow tax deferred in underlying investments, and you receive an annuity. The annuity is calculated to pay out all of the trust's assets, except for the amount slated for charity.
Consider funding the trust with a highly appreciated asset that you would like to sell to diversify. "If you transfer it to the trust, you can sell without any immediate tax impact," Laufer says. If, instead, you sold your position outside the trust, you would likely pay capital-gains taxes and the 3.8% Medicare tax, and reinvest a significantly smaller sum.
Let's assume a couple, ages 50 and 47, fund a trust with a $1 million stock holding that has a cost basis of $150,000. At the end of their assumed joint life expectancy of 36 years, using an 8% average annual-return assumption, they will have collected and reinvested annuity payments amounting to $7.3 million; $1.8 million would go to charity, according to an analysis by Laufer. Their heirs, meanwhile, would receive $4.38 million, net of a 40% estate tax.
ANALYZE AFTER-TAX INVESTMENT picks.Wealth advisors are making sure that individual investment choices create more tax-efficient portfolios over all. Private equity, for example, tends to be tax efficient because of its long-term holding period and capital-gains-tax treatment. Active trading inside hedge funds, meanwhile, typically triggers higher short-term capital gains—and higher taxes.
In 2012, in anticipation of higher tax rates, Citi saw net private-equity inflows of over $1.5 billion and net inflows into hedge funds of $500 million. "Four years ago, that was exactly the opposite," says David Bailin, global head of managed investments for Citi Private Bank.
Advisors in high-tax states have also been bulking up on state-issued municipal bonds. While most munis are exempt from federal taxes, if you buy a tax-exempt muni issued by your own state, you will be spared state taxes on the bond, too.
"In recent years, we had diversified out of California municipal bonds because California was going through a series of fiscal challenges," says Bruce Simon, chief investment officer at City National Asset Management. Higher tax rates and fiscal improvements mean "we've reallocated back to 100% California municipal bonds."
The 10-year California muni is currently yielding 2.25%, which is 42 basis points more than current yields in the high-grade municipal-bond market. "If you're in the highest tax bracket, to get the same after-tax yield on a corporate bond, you'd have to find a 10-year yielding 5% at a time when they're going closer to 3%," says Greg Kaplan, City National's director of tax-exempt fixed income.
Creating more tax-efficient stock portfolios is also critical, given that capital-gains taxes have gone up 59% over the past year. Harvest losses in your portfolios to offset your gains, advises Robert Breshock, managing director of Parametric Portfolio Associates.
An exchange-traded fund or index fund has low turnover, but you miss opportunities to realize losses to offset gains. Consider that with normal volatility, about 10% to 15% of the S&P 500 index is trading at a loss at any given time, but in a fund you miss the opportunity to realize the losses. If, instead, you invest $1 million in a separate account that mimics the S&P 500, says Breshock, "you'd be able to realize $100,000 to $150,000 in short-term losses to offset any short-term gains you may have." That translates to between $43,000 and $64,500 in potential tax savings.
But be aware that actively managed accounts are more expensive than index funds and ETFs. Whether it makes sense to pay more in fees depends on whether the manager outpaces his benchmark, and how much the manager is saving you in taxes by capital-gain offsets.
MOVE TO ANOTHER STATE, preferably a no-income tax state like Florida, Nevada, or Texas. The migration is already in full force, as reported in our Luxury Second-Home Survey in the March 4 issue of Penta. "Often these are people who will be selling their businesses soon for a tremendous gain, and their thinking is, 'If I move out of my state now, the state-tax savings could put a nice down payment on a nice retirement home,' " says Bessemer's Baxley.
Not all taxpayers are waiting until retirement to make the move. Seeing what was coming down the pike in the political debates of 2010, David Kotok pulled up stakes in high-tax New Jersey after almost 40 years of living and operating his financial advisory business there. His Cumberland Advisors is now headquartered in Sarasota, Fla.; he and his eight partners are enjoying an 8% or so reduction in their personal income-tax burden, he says. "And that doesn't count lower property taxes, lower sales taxes, and the fact that there is no state estate tax in Florida," Kotok says.
RETHINK TRUST PAYOUTS. The new tax climate has been particularly hard on trusts. While individuals get hit with tax increases at varying high-income thresholds, the higher tax rates, including the 3.8% Medicare tax, punitively hit trust income in excess of just $11,950. "One way to address this is rather than reinvesting income in the trust, distribute it to beneficiaries—assuming they have lower tax brackets—earlier than the trust had intended," says Jere Doyle, estate planning strategist at BNY Mellon.
Use the same principle to avoid the new Medicare tax and the 20% capital-gains tax above $11,950 by distributing the trust's appreciated asset to a beneficiary whose income is low enough to avoid the higher charges, says Mitch Drossman, managing director at U.S. Trust. To avoid both the Medicare and highest capital-gains taxes, income of the beneficiary would have to be below $200,000 for singles and below $250,000 for a couple. "Then the beneficiary can sell it at a lower tax rate or give it to charity," he says.
Of course, that also means you or your trustees could be prematurely enriching beneficiaries for tax reasons, when they aren't mature enough yet to handle the sudden wealth. Hence our final bit of advice: Whatever asset-shuffling moves you make, never let your desire for a lower tax bill override basic common sense.
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