There's a one-word theme for the 2012 tax year: uncertainty. Chief among the reasons are the sky-high exemptions on the estate tax, the lifetime gift tax and the generation-skipping tax. All are currently set at $5 million, but they are headed for expiration at year's end. Most planners expect that these taxes and others - including taxes on capital gains and dividends - will be going up next year, though no one knows for sure. And that's the rub.
"The big question is whether the Bush-era tax cuts will expire at the end of 2012," says Eleanor Blayney, consumer advocate for the CFP Board. "So there's a lot of uncertainty. A lot of us assume that, one way or another, taxes will go up. And if not directly, then we may lose deductions."
After speaking with and learning from planners around the country, Financial Planning has gathered a list of top tax strategies for 2012. Quite a few of these strategies are geared specifically to this year's low-tax-rate environment. Others are tried and true, and bear repeating in any tax year. For as any good planner knows, smart tax planning is not only about choosing the right strategy at the right time, it's also about avoiding bush league mistakes, like the one that befell one high-net-worth family about five years ago.
In this instance, according to the planner involved, several children of modest means became very wealthy upon inheriting assets from their late father. Each child in turn prepared his or her own estate plan. All but one brother signed a plan. "He just never got around to it," the planner says.
About a year after the father died, the son "went to a holiday party, had a massive heart attack at age 49 and died with no estate plan in place," the planner recalls. "His sisters were literally running through the house saying, 'Did he sign the plan? Did he sign the plan?' No, he did not. His estate paid 45 cents on the dollar above and beyond the federal exclusion. More tragically, the old will still named his ex-wife and her child, his former stepchild. It was grotesque. A ton of money went that didn't need to go." All because of one critical misstep.
Planners often don't know for sure which tax strategy could end up being most critical for each client. But, as this case shows, doing something as simple as getting clients to review their estate plans can be just as important as taking advantage of a $5 million estate and lifetime giving exemption.
1. Consider the $5 million estate and lifetime giving tax exemptions.
For the rest of the year, the beneficiaries of anyone who dies won't pay federal estate taxes on the first $5 million value of his or her estate. A gift tax and generation-skipping tax exemption, both at $5 million, were designed to synchronize with the estate-tax exemption. That means that, before they die, clients can give up to $5 million to any individual, including their grandchildren or charity without paying taxes on the money. For couples, the limit is $10 million, with a 35% tax on assets above that amount. The $13,000 annual gift-tax exemption also remains in place and does not count against the $5 million thresholds. By next year, these exemptions could drop substantially.
"It will really be ugly if it goes back to [2002] when it was at $1 million," says Armond Dinverno, president of Balasa Dinverno Foltz in Itasca, Ill.
Some planners say many of their clients have already taken advantage of these exemptions. But others think they pose hidden and dangerous risks. "There are a number of things we leave to our children," Dinverno says. "They include family values, faith and work ethic. I don't think that trading a tax savings for a work ethic or at the expense of creating a trust fund baby is a good choice."
Some of Dinverno's clients have decided it's just not worth the risk to give money too soon to a child or a grandchild, even if the high giving threshold disappears next year. A multimillion-dollar gift, given too soon to someone, can strip away that individual's drive to work, he says.
Dinverno's older clients are more willing to pull the trigger. In these instances, their own children are grown, with well-established careers, families and homes, making the perceived risk lower. "For them," he says, "it's a slam dunk."
2. Channel estate transfers through family limited partnerships.
Planner Andy Berg, co-founder of Homrich Berg in Atlanta, advises his clients to combine the gift-tax exemption with family limited partnerships. "The partnerships are a tool you can use to give away a great deal of wealth, but remain in control of the underlying assets," Berg says.
One of Berg's clients, for example, owned $7 million in commercial real estate. By putting it into a family limited partnership, the actual value of the property was discounted to $4.5 million for tax purposes because it is not liquid. The gift, which fell under the $5 million gift-tax threshold, came tax- free, he says. "It's somewhat of a loophole, if you will," Berg says.
In this strategy, the giver can remain a general partner owning just 1% of the property in the trust, but keeping all decision-making to himself or herself. The other 99% is owned by the recipient and limited partner. "But the limited partner would have little or no say in the management of the assets," Berg says.
When the grantor dies, the recipient pays a capital gains tax on the difference between the basis of $4.5 million and any appreciation. "Let's say it appreciated to $10 million," Berg says, "but who cares." The grantor, he says, "got $7 million out of their estate, tax- free, and the kids already own it."
3. Open a donor-advised fund
A donor-advised fund allows a person to contribute any amount he or she wants to charity, without having to name the charity right away. Once the money is in the fund, it has been gifted from the perspective of the IRS, but the client can take his or her time in deciding who will get it.
Planners say it gets the money out of the income tax column while buying time for clients. "Part of many people's identity is how closely tied they are to a charity," says planner Jeff Fishman, a former lawyer and the founder of JSF Financial in Los Angeles. "So even if they have a couple of bad years, they can keep up with their giving commitments."
4. Use highly appreciated stocks for charitable giving.
Lori Flexer, a chartered financial analyst with Ferguson Wellman Capital Management in Portland, Ore., says that, whenever possible, she urges her clients to give highly appreciated stocks, instead of cash, to their charitable causes. That allows them to both keep up with their giving and to avoid paying capital gains taxes on low-basis-cost investments.
5. Consider Roth IRA conversions.
When it comes to contemplating Roth conversions, "proceed with extreme caution with your CPA by your side," Flexer cautions.
But in the right cases, planners say, Roth conversions make sense. (See "Betting on Roth Conversions" on page 61.) Flexer offered the example of an executive who retired the previous year but is not yet 701/2 years old. For this tax year, he has no earned income and is not taking Social Security. His only income is capital gains. "He knows that 10 years from now he is going to be taking out six-figure distributions (from deferred-tax retirement accounts). So maybe he does a Roth conversion of $50,000 or $60,000 at the lowest state and federal tax rates. He pays those taxes now and that money will grow tax-deferred forever."
Another advantage: Roth accounts aren't burdened by mandatory distribution requirements.
6. Direct annual $13,000 gift- tax exemptions to 529 plans.
Several planners say they urge clients to put annual tax-free gifts of $13,000 to each child or grandchild directly into 529 accounts. These accounts allow tax-free accumulation of investments in savings accounts earmarked to pay for higher education expenses.
7. Watch the Foreign Account Tax Compliance Act
Many American citizens who live abroad or keep assets overseas are not aware of the Foreign Account Tax Compliance Act, which passed Congress in March 2010. Planners should inform any clients who might be affected by it.
The act will require all foreign banks and institutions to report to the IRS all U.S. citizens with investment accounts of $50,000 or more. Institutions that fail to comply will have 30% of their earnings on their U.S.-based investments (from mutual funds to municipal bonds to real estate) withheld.
It remains to be seen how vigilantly the rest of the world complies with this expanded jurisdictional move by U.S. tax collectors, but citizens who haven't already reported the existence of these accounts may find that their foreign banks are doing it for them.
8. Invest in municipal bonds.
Some planners believe there is tremendous value to be found in the best municipal bonds, which remain one of the few tax-exempt investments and sources of cash flow. The interest on such bonds is exempt from both federal and state taxes as long as the bond is issued in a state where a client is a resident.
For high-net-worth individuals, the tax-adjusted returns for municipals can be superior to those on alternative fixed-income instruments like Treasuries. Some planners think that if you believe taxes are headed up, then munis become even more attractive.
9. Look at investment interest expenses for deductions.
Susan Colpitts, a planner with Signature in Norfolk, Va., analyzes her clients' returns to see if they can deduct interest expense that they paid on their investments. "For any investor, I would look to see if this is optimized," she says.
The determination of when this is possible is somewhat complex, Colpitts says, but planners can check IRS Form 4952 and use tax software to do the calculation. If a planner doesn't want to tangle with tax forms herself, she can recommend that they go to the client's CPA for help.
When it makes sense, investors can gain the right to deduct all of their investment interest expense by electing to have a portion of their qualified dividends or long-term capital gains taxed at their top tax rate, she says. For example, a couple in the 35% tax bracket with a taxable income of more than $379,000 could save $7,500 by taking this election, she calculates.
"We would recommend a taxpayer do this in the case that they have nondeductible investment interest expense year after year," she says. "If, on the other hand, it is an unusual circumstance for the taxpayer and they can likely take the full interest deduction in another year without making the election, we would suggest that they would not make it."
10. Invest in an independent film.
It's little known outside of Hollywood, but Section 181 of the IRS code allows people to take a tax write-off for investing in an independent film. "It's pretty popular among my clients," says Fishman, the L.A.-based planner.
A client can take the write-off as long as the total budget on the production is less than $15 million and as long as 75% of the film is produced in the United States. Now you know why there's no shortage of independent films debuting every year, even though fewer people are going to the movies.
11. Feel free to use 401(k) catch-up contributions for older clients.
Several planners say they are surprised to discover how few of their clients are aware that they can contribute more to their 401(k) plans once they turn 50 years old. The maximum annual amount that anyone younger than 50 can contribute to a 401(k) or IRA is $17,000 for 2012.
But for people older than 50, the IRS has provided a catch-up provision allowing them to contribute $5,500 more, bringing their total annual contribution to $22,500. Clients who walk away from a 401(k) match are walking away from a dollar-to-dollar return if their employer matches their contribution, and from potentially getting themselves into a lower tax bracket.
12. Revisit estate plans frequently.
No one likes contemplating his or her own demise. But because estate-tax laws are changing so frequently, planners need to advise their clients to do so - in some cases, annually.
"It does make people really uncomfortable," Flexer says, "but I try to encourage them by saying, 'You have some clear intentions for this wonderful wealth that you've spent your lifetime building. If you choose not to do this, the government is going to take a crazy amount of the money that you've worked so hard to earn.'"
When one of her clients came to her fuming over a $4,000 bill she got for revising her estate plan, Flexer reminded the client what the government could take if she hadn't done that work. That bill "was expensive compared to what?" the planner says she asked her client before adding, "I love you, but you get no sympathy from me."
13. Work to avoid the alternative minimum tax.
Originally, the alternative minimum tax was designed to ensure that people whose income came mainly from dividends and interest paid their fair share. Instead, planners say, the AMT rules subsequently were changed, making it highly complex and expanding its reach.
"There isn't a rule of thumb except that more and more people are subject to it, which wasn't the original intention," says Deb Wetherby, a planner and former CPA with Wetherby Asset Management in San Francisco. "Once they changed the way it worked, it captured more taxpayers."
Many planners say it's critical to watch the AMT like a hawk to try to keep clients from becoming subject to it. At that point, clients lose the benefit of many deductions.
For example, Fishman says, some of his clients in Los Angeles have bought multimillion-dollar homes, expecting to write off the mortgage interest. But those who became subject to AMT were shocked to discover they lost those deductions. "We call it a stealth tax," he says.
14. Team up with clients' CPAs.
A surprising number of planners neglect to review their clients' income tax statements, their colleagues say. Or they rarely confer with their clients' CPAs. The first order of good tax planning, many planners maintain, is for planners to make a habit of working closely with their clients' tax preparers.
"Planners ought to be asking for copies of income tax returns," says Colpitts, who is a former CPA herself. "CPAs are so busy that, unless you ask them for planning ideas, they don't offer them. Sit down with a CPA to talk about opportunities. Have the conversation between the time the CPA prepares the draft and files the return."
Ann Marsh is a senior editor and the West Coast bureau chief of Financial Planning.
Correction: An earlier version of this story included a strategy, No. 5, that stated incorrectly that a tax relief measure regarding required mandatory distributions from IRAs was still in effect for 2012. The item also reported incorrectly that distributions could be gifted under the measure; the rule applied only to charitable gifts.
