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The Tax Surprise

Advisors have a good news/bad news proposition for wealthy clients this tax season. The bad news is mostly for the clients. The good news is that tax season brings planning opportunities for financial advisors and insurance agents.

The bad news is that between new taxes, old taxes with new increases and existing taxes, the 2013 bite will gobble up about half the income of high-earning clients in some states. The good news, besides the business for advisors and agents, is that the chomp won’t get worse when this year’s taxes are prepared next year.

Here are some of the teeth that make up the 2013 tax bite:

  • HIGHER TOP TAX RATE: 39.6 percent bracket for incomes over $400,000 for singles and $450,000 for married couples.
  • DEDUCTION PHASEOUT: Itemized deduction and personal exemption will begin to phase out on single-filers earning more than $250,000 and $300,000 for marrieds filing jointly.
  • NET INVESTMENT INCOME TAX: The 3.8 percent additional tax is on passive investment income for $200,000/$250,000 filers.
  • CAPITAL GAINS: The increase in rate from 15 percent to 20 percent on qualified dividends and capital gains for singles earning more than $400,000 and couples over $450,000. That increases to 23.8 percent if the net investment income tax applies.
  • MEDICARE SURTAX: In case the $200,000/$250,000 crowd didn’t feel picked on enough, they get another 0.9 percent tax on their income. Clients might be confused about this in light of the 3.8 percent tax on investment income, but this tax is on earned income.

It all adds up to a whopping tax bill this year for wealthy clients, even for some who didn’t necessarily think of themselves as wealthy. The headline has been that new taxes are aimed at people making more than $200,000, but if a $100,000 earner is married to a $151,000 earner, then – blammo! – here comes the Medicare surtax on earned income over $250,000.

  • Well, maybe “blammo” would be overstating it, because it is a 0.9 percent tax on top of the 1.45 percent they would already be paying in Medicare payroll tax. It is stealthy, however, because the surtax is not deducted from paychecks.

    Lynne Stebbins said she is expecting some couples to be surprised by that tax this year. Stebbins, JD, AEP, CLU, CHFC, is a principal and senior legal consultant at Mercer H&B Executive Benefits & Private Client Life in New York City.

    “I think a lot of people haven’t recognized what the actual impact of this is going to be,” Stebbins said. “There’s no withholding for the extra 0.9 percent for the Medicare surtax.”

    That is one reason advisors can expect many startled clients this year. “Probably after this year, then they’ll figure it out and do the extra withholding next year,” Stebbins said. “But I think that’s going to be a rude awakening for a lot of people when they have their taxes done.”

    If that couple has investments that are “unearning” income, then maybe that’s the blammo. That income will be taxed at 3.8 percent.

    But, of course, taxes being taxes, it gets complicated. “There are different categories of income that get you to the net investment threshold,” Stebbins said. “It’s not the gross amount of investment; it’s a net number. So you get to match capital gains with capital losses. But when you’re a married couple earning more than $250,000 a year and you have net investment earnings, then that’s what gets hit with the 3.8 percent tax. I think this was probably aimed at the hedge fund partners, because it was very clear that some hedge fund income is a carried interest that wasn’t getting taxed. Now it is, but it is also hitting the $250,000 ordinary household.” Neither the Medicare surtax nor net investment income tax threshold is indexed for inflation, so as incomes rise, more tax will be collected.

    The bottom line is that some doing-OK-but-not-Trump-style people will be paying more in taxes.


    Don’t Forget the AMT

    Another tax trap is the alternative minimum tax (AMT), which snares more people each year because, until recently, it was not indexed to inflation. Over the years, the AMT lowered the standard on those considered wealthy but not paying their share of taxes because of write-offs.

    Stebbins said this is a particular problem in high-tax states, such as New York, because high deductions can trigger the tax.

    “Usually you deduct state income and property taxes, but all this gets added back in for the AMT, and you can count only one mortgage and few other standard deductions,” Stebbins said. “So if you live in a high-tax state, the alternative minimum tax is still going to be a problem even though Congress did fix the indexing of the deductible amount.”

    That fix was in the American Taxpayer Relief Act (ATRA) of 2012, but even though the indexing pulled many people out of the firing line, millions will be hit by the tax. According to the Tax Policy Center, the number will grow from about 3.9 million people in 2013 to 6 million in 2023 because of growth in income.

    That is far lower than the 50 million people that the center estimated would have had to pay the tax in 2023, but that might be small consolation for those shelling out the extra tax. The tax is not a surprise to the upper-middle echelon of taxpayers, but a stinging “welcome” for debutants in the upper-middle class. When they meet certain conditions, either because of income or high deductions (such as multiple dependents or unexercised stock options), those taxpayers will have to figure their tax both ways and pay the higher one.

    “There will still be plenty of people who in my opinion shouldn’t get hit with the AMT but do,” Stebbins said. “It was really to get at people who were doing a lot of tax shelters in the ’80s, when there were so many tax preference items that people were paying no tax. Since then, all those tax-shelter loopholes have been legislated out of the code, but they let the AMT stand.”

    It might relieve those folks to know that although they have to jump through these hoops and cut a larger check, wealthy people avoid the 28 percent AMT bracket by playing in the elite 33 to 39.6 percent league.

    People playing in the big leagues will start seeing the bigger bite this year, said Barry Picker, CPA, CFP, and a partner in the Picker & Auerbach accounting firm.

    “Over the years, rates were fairly constant and people’s income was fairly constant,” Picker said. “Maybe they paid $20,000 a quarter in estimated taxes and that was increased to $22,500 last year. But with everything that’s happened, maybe they will end up having to pay another $5,000 to cover a shortfall and end up with a new rate of $30,000 this year.”

    Good planning will prevent almost all surprises, but some factors can sneak in. For example, with equities’ meteoric rise in value last year and dividends coupled with the capital gains tax boost from 15 percent up to 20 percent, that can pile up to a steep new bill.

    “All of a sudden you whack them with this new number and that’s when they’re going to say, ‘Whoa, what happened here?’” Picker said. “But to turn around and say ‘You can get a half a percent a year in municipal bonds’ is not cost-effective. They’re obviously better off getting a higher return and paying taxes on it rather than getting nothing on their money.”

    When Tax Avoidance Ends Up Costing More

    But some advisors are in fact suggesting putting money into municipal bonds because of another reason – they are tax-exempt. This tactic has been touted by some as a way to get income under the $200,000/$250,000 line that triggers new taxes. But besides the low return on the money, Dan McGrath said that strategy will come back to bite people in another way. McGrath is vice president of Jester Financial Technology and co-author of What You Don’t Know About Retirement Will Hurt You.

    “While you are staring at the Affordable Care Act, you are not paying attention to Medicare,” McGrath said. “Muni bonds actually count in the eyes of Medicare. So all that dividend that you created that you thought was tax-free is actually going to be used to increase your Medicare premiums, and your Medicare premiums are deducted automatically from your Social Security check.”

    This is not something down the road. McGrath said some seniors are getting hit with this now because of municipal bonds and what he characterized as misguided investment strategies.

    “There are people paying top dollar for their Medicare and not receiving Social Security checks,” McGrath said. “They are actually having to write the government a check each month. And then add the little cherry on top – they get to pay tax on the income they’ve never received because it was deducted directly for the Medicare premiums.”

    His solution might delight most InsuranceNewsNet readers: life insurance.

    “Sell them life insurance that generates cash value and, it’s amazing, the problem vanishes,” McGrath said. “What I’m starting to see small companies do is buy defined benefit plans that are wrapped in health insurance or in life insurance to benefit employees. They take the income out of the equation and just buy life insurance policies for them that build cash value.”

    McGrath said he was a financial advisor who got life insurance religion when he saw his own mother struggle with health costs. Back then, he was a “buy-term-and-invest-the-difference” kind of guy.

    “If I met myself 10 years ago, I think I would have punched myself,” McGrath said. Now he is a big believer in insurance cash value and health-care-related riders.

    “With a small business owner out of Manchester, N.H., I’m working with, he and his wife are making over $250,000 and they know they are going to be paying big taxes,” McGrath explained. “So, he is taking less income and he’s putting the surplus in a life insurance policy as his defined-benefit plan. He is putting a long-term care rider or critical care rider on it.”

    So, not only is the business owner avoiding the tax triggers, he is also covering the medical care costs that slam so many seniors. On top of that, he has the inherent insurance and cash value in the policy.

    “Once again, the solution to everything is going to end up being life insurance,” McGrath said, also warning of the potential health-cost impact from common financial advice. “Just do what the financial planners tell you to do and everything should be all set. You will lose everything you have.”


    Planning with Insurance

    Stebbins also advocates insurance solutions but in a different way.

    “We’ve seen an upsurge in the use of private placement life insurance and annuities,” she said, “because if you have 10 large holdings, you can monetize those, dump them into a private placement life insurance contract and not have to worry about the net investment income on any of those earnings.”

    Private placement insurance contracts are variable universal life vehicles that are custom-made for the owner in collaboration with the insurance company. They are typically single-paying contracts done for income tax purposes, so the object is to fund them significantly to protect earnings. Stebbins said the strategy is likely to become more popular as taxes grow, particularly in hightax states.

    It is a strategy that also works with annuity distribution, some of which is added to a net investment earnings calculation.

    “Whether it’s private placement or just a shelf product that they single pay just to get out from paying the extra 3.8 percent tax on those earnings, they can be very helpful,” Stebbins said. “It’s especially true if those new funds were going to be earmarked for the next generation anyway. Why not wrap it in with life insurance contracts, slap it in the irrevocable trust, have less income tax during your lifetime, have a tax-free payment to the trust and then ultimately to the beneficiaries?”

    Another strategy likely to become more popular would involve charitable remainder trusts and charitable lead trusts, because they not only support a favorite charity, but they also divert taxable income.

    A charitable trust is especially helpful if a client has a large asset that would be subject to a large capital gains tax. The tax-exempt charity can sell the asset and not be liable for the capital gains tax. Then it can pay the client an income for life.


    Using Insurance’s Tax Benefit

    Then there are insurance products themselves, with their tax-favored status. If clients are worried about gains boosting their taxable income, many varieties of products offer the buildup under the insurance umbrella: universal life insurance, indexed annuities, variable annuities, for example.

    Doug Wolff is president of Security Benefit Life, which is marketing lowcost variable annuities as a way for clients to get equity excitement in insurance tax-protected security.

    “The challenge for advisors right now is to get clients more income to cover a higher tax burden,” Wolff said. “They either have to stretch for extra risk for return or use traditional methods of harvesting tax losses.”

    Older clients who have a relatively fixed amount of savings are not necessarily wanting to bet on the unpredictable stock market, but Wolff suggested that the second option is also not sustainable.

    “We don’t think tax harvesting is all that scalable,” Wolff said, “and many people don’t have a lot of risk tolerance after the two historic sell-offs that we had recently.”

    A VA can have the “look, smell and feel” of mutual funds without the annual 1099, Wolff said, who added that his company’s VAs are low in cost because they are stripped of bells and whistles such as riders that other companies are offering.

    Others argue that the riders, such as long-term care and others, make annuities and insurance an even more essential product because, as McGrath said, seniors are seeing their life savings being drained by health care costs.

    Whatever the strategy or product, taxpayers across the spectrum are grappling with multiple challenges at tax time. This year that is particularly true at the upper end of the scale where new taxes introduce themselves.

    “It is up to advisors,” Wolff said, “to help people fight a rising tide of income tax.

    Steven A. Morelli is editorin- chief for InsuranceNewsNet. He has more than 30 years of experience as a reporter and editor for newspapers, magazines and insurance periodicals. He was also vice president of communications for an insurance agents’ association. Steve can be reached at [email protected]

Steven A. Morelli is editor-in-chief for InsuranceNewsNet. He has more than 25 years of experience as a reporter and editor for newspapers, magazines and insurance periodicals. Steve may be reached at [email protected] Follow him on Twitter @INNSteveM. [email protected].

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