How to Avoid 'Stealth' Taxes
There's a good chance that you are already hearing from clients who have been blindsided by taxes they were not prepared for. The American Taxpayer Relief Act of 2012 is starting to show its ugly side as clients get their first look at their 2013 tax bill.
The tax increases in question are what tax professionals for years have called "stealth taxes" - under the radar burdens that are hard to see coming. Because lawmakers don't want to admit to raising taxes, it might seem that they raise them in ways they hope we won't notice. All this makes long-term tax planning almost impossible.
Stealth taxes mostly affect higher-income clients, but there are several different income thresholds for different tax provisions. The 2014 tax planning charts at the end of the article provide the threshold incomes for a variety of provisions.
As advisors, you should go on the offensive with stealth tax management. Keep taxable income low to reduce the long-term impact of stealth taxes, including five that are making their first appearance - or first in several years - on 2013 returns: the phase-out of personal exemptions, a reduction of itemized deductions, increased tax on net investment income, increased tax on earned income and a decrease in deductible medical expenses.
In its simplest form, this management approach involves keeping taxable income as low as possible for the long term. Short-term solutions won't help; lowering income one year might cause a bump the next year and cost a client more in the long run, especially if taxes keep increasing.
Begin with the income items that are most controllable, like distributions from retirement plans and the sale of investments. The master plan is to lower taxable income by consistently moving money to tax-free territory.
This generally costs money, of course, but it's money well spent if your client's income will exceed the various income triggers. It is also essential to use the right money to pay the cost of moving funds to tax-free territory.
Doing so provides a double benefit: You can reduce assets that increase a client's exposure to higher income taxes and stealth taxes, and you can build a retirement fund that can then be accessed tax-free, so taxable income will stay low for life.
For high-income clients, it often pays to do a Roth conversion. It's true that a Roth conversion could itself trigger stealth taxes, but only for the year of the conversion. Once converted, the funds in the Roth IRA continue growing tax-free forever. (That's tax-free, not tax deferred - a big difference that's worth more each passing year.)
Roth IRAs have no required distributions during a client's lifetime, so if your client does not need the money at age 70 1/2 or beyond, the Roth IRA can continue to grow tax-free. That's a great payoff for just one year of biting the bullet.
What's more, not all of an IRA has to be converted. If the tax hit is too big if taken all in one year, then think about making partial conversions over many years.
If your clients don't do the Roth conversion, their IRA will continue to grow tax-deferred, building up a tax problem once they must pull required distributions after age 70 1/2.
Clients who don't convert to a Roth IRA have a greater chance of being hit with stealth taxes and higher income tax rates during retirement, when they need the money the most. That's not a good plan.
To fund the tax payment on a Roth conversion, consider having clients sell assets that would otherwise create more exposure. For example, it might pay to sell stocks that will produce big capital gains and/or dividends and be subject to the net investment income tax. That would increase income for the year of sale, but shield future income.
Be careful, though: Some investments with substantial appreciation might be better off held until death so beneficiaries can benefit from a step-up in basis.
One more point: With Roth conversions, for a limited time, you can get a do-over if they don't work out. Say a client changes her mind and does not want to pay the tax, or needs the money, or the investment tanked after conversion. She has until Oct. 15 of the year after the conversion to undo all or part of it for any reason.
THE WIDOW'S PENALTY
A Roth conversion can also be used to avoid a so-called widow's penalty.
When one spouse dies, the survivor generally files as a single person (unless he or she remarries), using tax brackets in which the rates rise at lower income levels than those for married people filing jointly. Many surviving spouses find they have the same or higher income as when their spouse was alive; they may also have lower expenses, especially true if there were big medical costs for the deceased spouse. A spouse could also inherit life insurance, whose proceeds will probably be invested, which would produce additional interest, dividends and capital gains.
A Roth conversion after the first spouse dies will again increase taxes in the short run, but will pay off over time by providing lifetime tax-free income.
A couple of caveats: A Roth conversion may not be advisable for someone whose income is low and taxes are not an issue, since IRA funds can be withdrawn in retirement at little or no tax cost.
And a Roth conversion is not the only effective strategy to reduce long-term exposure to higher income taxes and stealth taxes. Other approaches include leveraging with life insurance and timing investment sales.
But the Roth conversion is easily accomplished and can quickly eliminate a big chunk of the coming tax increases faced by higher-income clients.
Ed Slott, a CPA in Rockville Centre, N.Y., is a Financial Planning contributing writer, IRA distribution expert, professional speaker and author of many books on IRAs. Follow him on Twitter at @theslottreport.