Obama’s Proposals Reminds Us To Reduce Our Legislative Risk Through Tax Diversification

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By Senior Attorney Dan Vu

We have all heard of the saying, “Don’t put all your eggs in one basket.” In the investment world, this means don’t put everything you have into one stock. Apple might be doing great now, but no advisor would want your entire portfolio to consist of Apple stock alone. The reason is obvious: one bad iPhone release and your retirement nest egg goes down the toilet. However, what is not as obvious, is that many retirees do have all of their eggs in one basket because they heavily rely on a single tax type of investment, the pre-tax retirement account. Too many have the overwhelming majority of their investments in pre-tax retirement accounts like IRA’s, 401K’s, and 457’s (Deferred Compensation). These accounts are very popular because they went in pre-tax and earn interest compounded and tax deferred. However, when you take money out is when you feel the pain. You will pay tax on the amount you withdraw at your ordinary income tax bracket rate. You also need be careful that the amount doesn’t push you into a higher tax bracket, increase taxes on your Social Security or increase your Medicare premium.

Now this is NOT advice to stop using pre-tax accounts altogether. They obviously have their tax advantages and they can be enormously beneficial. Instead, the advice is to take a second look at the allocation of your investments – but with a tax diversification lens. Tax diversification means balancing the use of traditional IRAs with Roths, which grow tax free on after tax money, along with investments taxed at the capital gains rate, and investments that are bought with after-tax money but are tax deferred like certain annuities. Tax diversification is important because it allows you to more effectively manage your legislative risk. That is, the risk we all have when politicians decide to change the rules on us mid-game. Pre-tax retirement accounts are more at risk of being attacked than other types of investments because of the sheer size of un-taxed dollars that could be available to our legislators.

According to Jeffrey Levine from The Slott Report, Americans currently hold well north of $20 trillion dollars in retirement accounts. “To put that into perspective, the National debt is ‘only’ about $18 trillion. The overwhelming majority of the $20+ trillion that’s held in retirement accounts is pre-tax money, meaning that it has yet to be taxed. To a broke government, it would be hard not to look at these accounts as a big, juicy steak.”

The President's proposalsProposals attacking the benefits of pre-tax retirement accounts have been passed around before. More recently, we were reminded of the importance of reducing your legislative risk through tax diversification, when President Obama announced his 2015 budget proposals. The President’s proposals attack some of the pillars that many have relied on when deciding to heavily invest in pre-tax retirement accounts.

The First Pillar – Ability to “Stretch the IRA”

The first and arguably the most important pillar, is the ability for heirs to “stretch” inherited retirement accounts. Currently, if your child inherits your IRA, he/she will not have to pay taxes on the entire amount in one lump sum. Rather, they can choose to take only the annually required minimum distribution based on the their own life expectancy. This is an incredible amount of tax savings for your child and it allows you to leave your retirement accounts to your child without an overwhelming tax burden. The President proposes the death of this stretch rule. With Obama’s proposal, a child inheriting a retirement account would have to withdraw the entire amount and pay taxes within 5 years! Imagine the tax hit on a single child inheriting $500,000 in retirement accounts. It would almost certainly propel that child into a higher tax bracket for the next 5 years and could cost them close to 45% of the inheritance in State and Federal income taxes.

The Second Pillar – Ability to take a NUA deduction

The President also proposed eliminating the NUA deduction (net unrealized appreciation). This deduction allows those with employer sponsored plans to pay the capital gains rate on company stock. Since the capital gains rate is lower than the tax payers ordinary income, the deduction can be a significant amount. The loss of the NUA deduction simply means higher taxes for all employer sponsored plans that also provide company stock.

The Third Pillar – Ability to Preserve a Roth IRA for Life

When you turn 70 ½ you must start drawing your RMD (required minimum distribution based on your life expectancy) on your pre-tax qualified accounts. Roths have never been subject to this requirement and it is the main reasons why tax payers have converted their IRAs to Roths. With this rule change, Roths would also be subject to the RMD rules like traditional IRAs. This ultimately means less tax savings and less tax-free inheritance being left to spouses and children. It is also another reminder not to rely on a single type of taxable investment -not even Roths.

Other proposed changes include placing a cap on contributions to retirement accounts and a cap on the deduction that certain tax payers would receive when making this contribution. All of these proposals amount to one idea: let’s attack the savings of retirees to help close the massive gap in our national budget. Certainly most of the proposals, if not all, will never see the light of day. The President and Congress are at odds on almost every subject, but all laws began as a simple proposal, sometimes decades before they became law. These proposals are a reminder to us, that tax diversification is key to reducing the risk of a change in the law.

So what if you are already heavily invested in pre-tax retirement accounts? Consider, converting them into other types of taxable investments. Of course consult with a competent tax and financial advisor. A blind conversion can cause unintended consequences, like increased tax on Social Security, higher Medicare premiums, and a spillover to a higher tax bracket.

How Can You Reduce or Avoid High Trust Taxes?

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By Sandra K. Dennison, CPA

A recent article in the Wall Street Journal describes a strategy to avoid taxes when you put money into a trust and when you take it out. Here’s a summary of how it works:

Distributes net income to lower tax bracket beneficiary

In cases where Mom & Dad’s trust has a higher tax bracket than their beneficiary’s, there is an opportunity to save tax dollars. Trusts have fewer tax brackets and higher tax rates than individuals who have more tax brackets and lower tax rates. Consider that a trust with as little as $12,150 in assets pays the maximum tax rate – 43.4% while individuals can earn over $400,000 before they pay 43.4%. It seems clear that paying at the individual tax rate is better than paying the trust rate, in most cases.

You also have the option to look at which tax strategy (trust or individual) makes the most sense – if you get it done in the first 65 days of the year. This extended “decision time” is only available to trusts and beneficiaries.

Although appealing, distributions should not be made just for the sake of tax saving and certainly not without expert counsel. Distributing funds from a trust could produce negative consequences that far outweigh the tax savings. Respect for the purpose of the trust is more important.

Read more at: “How a Trust Can Cut Taxes” written by Arden Dale for the Wall Street Journal.

You’re 70 ½ and beginning to take your Required Minimum Distributions (RMDs)

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By Robin Crouch

All the hard work you put into saving for retirement is starting to pay off. How long will your nest egg last? Retirement planning doesn’t end when you retire.

It’s April 2014, so many of you are have had your taxes prepared for 2013. Maybe you had your taxes done by a professional tax-preparer, or maybe you’re doing it yourself – hello Turbo Tax! [Read more…]

2014 Federal Gift and Estate Tax Update

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By Attorney Ted Brown

Effective January 1, 2014, the unified federal gift and estate tax exemption was increased to $5.34 million dollars. This change reflects an adjustment for inflation from last year’s 5.25 million exemption amount. In January 2013 as part of the “fiscal cliff “ negotiations, Congress established the limit at $5.25 million to be adjusted annually for inflation.

What this change means is that an individual can now give up to $5.34 million during their lifetime, or pass away with an estate valued up to $5.34 million dollars, without paying any Federal gift or estate tax.

The annual gift reporting limit remains at $14,000 per person. Total annual gifts less than this amount do not need to be reported and are not subject to gift tax. Total annual gifts in excess of this amount count against the donor’s $5.34 million lifetime gift exemption.