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Perspective on Tax, Trust and Estate Planning

January 2013

Piecing Together the American Taxpayer Relief Act

On January 2, 2013, the American Taxpayer Relief Act of 2012 (ATRA) was signed into law, affording welcome resolution and some “permanence” after a decade-long fight over Bush-era tax cuts. Most of the tax law changes introduced in this legislation affect higher-income taxpayers, who face the first major tax increase in 20 years. This Perspective provides helpful information related to ATRA, including a quick overview of the new tax law, some strategies to consider in light of this new legislation, and our investment insights.

THE HIGHLIGHTS OF ATRA

While income tax rates remain unchanged for most Americans, higher-income taxpayers will likely pay significantly more taxes in 2013 and beyond, primarily due to raised income and transfer tax rates, the personal exemption phase-out and limitations on itemized deductions.

INCOME TAX RATES

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Higher Ordinary Income Tax Rates
For individuals with taxable income over $400,000 ($450,000 for married couples filing jointly),* the top ordinary income tax rate will rise from 35% in 2012 to 39.6% in 2013. For individuals with income under this threshold, ordinary income tax rates remain unchanged.

Higher Long-Term Capital Gains and Qualified Dividends Tax Rates
For higher-income taxpayers whose income exceeds $400,000 ($450,000 for married couples filing jointly),* the long-term capital gains and qualified dividends tax rate will rise from 15% to 20%. While this represents a moderate increase, many had anticipated a much more significant hike. It’s also important to note that these higher-income taxpayers will, in reality, pay 23.8% in taxes on these gains and dividends because of the new 3.8% Medicare tax on net investment income. The Medicare tax applies to individuals with a Modified Adjusted Gross Income of $200,000 or more ($250,000 for married couples filing jointly).
For taxpayers below the $400,000 threshold ($450,000 for married couples filing jointly), long-term capital gains and qualified dividend tax rates remain unchanged.

Reinstatement of Social Security Tax
For all taxpayers, the employee’s portion of the Social Security tax on payroll will be reinstated to 6.2% in 2013, from 4.2% in 2012.

The Phase-Out of Personal Exemptions and the Itemized Deduction Limitation
Individuals with Adjusted Gross Income (AGI) over the $250,000 threshold ($300,000 for married couples filing jointly)* will derive less benefit from the personal exemption and itemized deductions, including the charitable deduction and mort-gage interest deduction:

  • Personal exemptions will be reduced by 2% for each $2,500 of AGI that exceeds this threshold. For example, a married, childless couple that earns $400,000 in 2013 could have their personal exemption amount reduced by $6,240.

  • Itemized deductions will be reduced by 3% of the amount of AGI exceeding this threshold. If, for example, the same married couple earns $400,000 and claims $50,000 in itemized deductions, the value of those deductions could be reduced by $3,000 as a result of this limitation. There is, however, a ceiling on this limitation—taxpayers cannot lose more than 80% of their itemized deductions.

Restoration of Tax-Free IRA Distributions
There is also favorable news if you are a taxpayer over age 70½ and take required minimum distributions from your IRA: the Act restores for 2012 and 2013 a provision allowing tax-free distributions from IRAs, up to $100,000 per taxpayer, for charitable purposes. This provision had expired in 2011.

Permanent Alternative Minimum Tax (AMT) Relief
ATRA permanently increases AMT exemptions retroactively to 2012, to $50,600 for single taxpayers ($78,750 for married couples filing jointly).* Without this retroactive increase, the AMT exemption amount for 2012 would have been $33,750 for single taxpayers ($45,000 for married couples filing jointly).

ESTATE AND GIFT TAXES 

A Modest Increase in the Maximum Estate and Gift Tax Rate and a Permanent Lifetime Exemption
The maximum estate, gift, and Generation-Skipping Transfer (GST) tax rate is now 40%, up from the 35% rate in 2012. Many families welcome the permanent extension of the lifetime estate and gift tax exemption, which remains at $5 million, indexed for inflation. For 2013, the lifetime exemption will be $5.25 million.

The Act did not affect the unlimited exclusion for educational and medical payments or the annual gift tax exclusion amount, which will increase, as scheduled, to $14,000 for 2013.

Portability
This legislation makes portability permanent, which means the surviving spouse may elect to use his or her deceased spouse’s unused federal gift and estate tax exemption, thereby maximizing both spouses’ lifetime exemptions. It’s important to note that the GST tax exemption is not portable, and portability does not apply for state estate tax purposes so if it is not used during lifetime or death, it will be lost.

Tax Strategies You Might Consider

Rising taxes means it’s important, particularly for higher-income taxpayers, to ensure investment and transfer tax plans take into account the changing tax laws. Here are some strategies to consider:

Review Your Estate Plan: Since there is now “permanence” regarding the federal estate tax exemption, now might be a good time to review your estate plan. For example, many wills are drafted using formula clauses pegged to the maximum estate tax exemption—a figure that has fluctuated significantly over the years. You might also consider a strategy to ad-dress the fact that the federal estate tax exemption amount greatly exceeds most states’ exemption levels.

If You Are 70½ or Older, Consider Making a Charitable Contribution from Your IRA: The new legislation allows tax-free transfers up to $100,000 of your required distributions from an IRA to a charitable organization. In fact, a special rule per-mits retroactive distributions. For example, distributions made in December 2012 may be considered a tax-free transfer, assuming the transfer is made to a charity before February 1, 2013. Another special rule permits taxpayers to deem distri-butions made to charities in January 2013 as made in 2012.

Understand the Benefits of Roth IRA Conversions: It might be worthwhile to consider the tax advantages of rolling assets over from your 401(k) plan into a Roth IRA. Although conversions from your 401(k) are subject to applicable taxes, in-vestments in a Roth IRA will then grow tax free and distributions taken in retirement are tax free.

Consider “Topping Off” Gifts: If you already gifted up to last year’s maximum lifetime gift tax exemption of $5.12 million, consider gifting $130,000 this year, so you take full advantage of the increased exemption.

Piecing Together ATRA'S Impact on Your Investments: Yet Another Question Put to Rest

The high-suspense, last-minute ATRA legislation settles some long-standing questions, lending a sense of certainty to the tax implications of investing in our financial markets.

A Clear Picture of Tax Implications Emerges
Many investors were relieved to find ATRA didn’t cut as deep as expected. For example, clarity around the maximum dividend income tax rate, now set at 20%, is a welcome relief to many equity and mutual fund investors. Since interest income is taxed at the ordinary income tax rate, qualified dividend-paying stocks offer an attractive profile of after-tax income to a broader swath of investors.

The fiscal cliff deal is also good news for municipal bond investors because these securities’ tax-favored status remained untouched by the legislation. In addition, the marginal tax-rate increases for top-income earners make municipal bonds’ tax-free income even more attractive.

Some Additional Uncertainties Are Now Settled
Over the past few months, a degree of clarity has emerged around some important questions: China’s leadership appears settled and its growth is re-accelerating; Europe demonstrates signs of slow progress; and, here at home, the Presidential election is behind us and important tax rate decisions are now codified. While higher U.S. taxes are headwinds to consumption, we believe the picture coming into focus is cause for cautious optimism within the financial markets.

Our Outlook is Cautious and Confident 
With all of this in view, we believe a recovery is sustainable, and may even be gathering momentum. This is substantiated by on-going gains in employment and hours worked, elevated housing sales and prices and higher auto sales.

In September we reduced portfolio risk by lowering exposures to international equities. It is now time, in our judgment, to re-deploy some of the cash we had sidelined in order to capture the growth potential evident in many economic measures. We are doing this by making measured purchases of emerging market and U.S. small cap equities as attractive opportunities appear. These asset classes should perform well as economic recovery growth spreads.

Our view of fixed income remains largely unchanged—we anticipate most fixed income asset classes will likely return their coupon but little else given the strong returns bonds have delivered as the Fed and fellow central banks suppressed interest rates. We appear to be nearing the end of a prolonged period of fixed income strength stimulated after 2008 by central bank policies to combat the effects of the great recession and a world-wide bias toward deflation. As growth becomes more widespread and discussed fears of deflation give way to anxiety over inflation, bond prices may be threatened. Our current bond exposures recognize this transition by being of shorter maturities, opportunistically placed in higher yield or high quality credit and, among municipals, in highly rated and essential service issuers.

*These amounts will be inflation adjusted for tax years after 2013.

 

 

This communication is intended to provide general information. The information and opinions stated herein are as of January 2013, unless otherwise indicated, and do not represent a complete analysis of every material fact. We undertake no obligation to update this information. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual tax or investment advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. You should seek advice based on your particular circumstances from your tax advisor.

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