With 2010 a few days away, there are several tax matters that wealthy investors need to consider next year. The two at the top of the list are whether they should convert their taxable retirement account to a tax-free Roth individual retirement account and how to deal with the uncertainty over the estate tax.
“There is frustration due to the legislative uncertainty,” said Daniel Kesten, partner in the private client services group at Davis & Gilbert, a tax firm. “Congress had eight years to address this, but they waited until the last year when two wars and health care interrupted their thinking.”
That leaves the wealthy with decisions to make about two of the biggest financial events of their life: retirement and death.
ROTH CONVERSION Starting in 2010, there will no longer be an income limit for Roth I.R.A.’s, which allow people to contribute post-tax money that can appreciate tax-free. The income limit has been $100,000 a year for individuals. The question is whether converting an existing I.R.A., the proceeds of which are taxed when distributed, into a tax-free Roth I.R.A. makes sense.
While Congress approved the change in 2006, the opportunity to convert seems to come at an enticing time. Those whose pretax retirement accounts lost a lot of their value in the last two years might want to withdraw the money, pay tax on the amount and then put it into a Roth. For wealthy investors who do not see themselves falling into a lower income tax bracket at retirement or who believe tax rates will rise significantly, this could be a shrewd move.
But this requires a degree of omniscience that few showed with the recession that began in December 2007. “Why bother?” asked Tony Guernsey, head of national wealth management at Wilmington Trust. “Is it that much money?” He used the example of buying a Treasury bill with a week to maturity: you know the government will pay you back. But the same cannot be said for what the tax landscape — or your wealth — will look like when you retire.
The bigger benefit may come to people who plan to pass their Roth on to heirs. Unlike regular retirement accounts, there is no minimum distribution requirement with a Roth, and the tax-free treatment of its assets can be passed to an heir. “The real benefit is coming in the estate planning aspects,” said Mitch Drossman, national wealth strategist for Bank of America private wealth management. “The beneficiary must take minimum distributions. But it will be growing tax-free and distributed tax-free.”
ESTATE TAX The elephant in the room is the estate tax. Congress is unlikely to act on any changes in the tax before the end of the year. So as of now, that means the tax will disappear in 2010 before reverting in 2011 to the old rate of 55 percent for estates worth more than $1 million.
Jere Doyle, wealth strategist at Bank of New York Mellon, said the wealthy should not get their hopes up for an end to the estate tax. He pointed out that an estate did not have to submit its first tax bill until nine months after a person’s death. The Senate could wait, then, until the summer to decide on the estate tax and make it retroactive to the beginning of the year. This would wreak havoc on estate planning. Even if the Senate acted early in the coming year, it could still lead to a flurry of legal challenges on the constitutionality of reinstating a tax that had disappeared.
But there is a broader issue for moderately wealthy people. When a person dies now, the value of his or her assets gets a “step-up in basis,” which means for tax purposes the assets are valued on the day of death. Without an estate tax, this provision disappears, and the appreciated value is subject to capital gains tax.
The Internal Revenue Service will grant a $1.3 million “artificial basis” on assets of a single person and $3 million for couples if the estate tax disappears. But on the rest of the assets, the heirs will have to determine what the original cost was and pay the capital gains on the appreciated amount. For long-held stock that has split many times, this could be extremely difficult.
“If there is no estate tax in 2010, we have an income tax problem for a larger group of the population,” Mr. Kesten said. He estimated that the number of people affected would go from 6,000 to 60,000.
Still, most advisers and accountants expect that an estate tax will be reinstated, and this has pushed the wealthiest to find new ways to reduce its impact. “If we’re resigned to an estate tax existing, it’s not a call on where rates will go but an acknowledgment we won’t have a repeal,” said Janine Racanelli, managing director and head of the Advice Lab at J. P. Morgan Private Bank.
One way is through giving money to heirs above the $1 million lifetime exemption level and paying the 45 percent gift tax now. This may seem odd at first, since the estate tax is currently the same rate. But the benefit comes from how the taxes are applied: the gift tax is added like sales tax, while the estate tax is deducted like income tax. Mr. Kesten noted that a person with a $30 million estate could give roughly $20 million to his heirs during his lifetime and pay $10 million in gift taxes, or he could leave the $30 million to them and they would receive $15 million, after estate taxes.
Ms. Racanelli points out that giving money to grandchildren above the exemption rate is also better than leaving it to them through the estate. She said a person could save more than $500,000 in taxes on $1 million by giving the money now.
An option to avoid gift and estate taxes is to lend money to heirs. The Internal Revenue Service rate for such intrafamily loans in December is 0.69 percent for up to three years. The money the child makes investing above the I.R.S. rate is not subject to the higher 45 percent gift tax, but instead the lower 15 percent capital gains tax, Mr. Doyle said. If you die before the loan is repaid, however, the outstanding balance could be subject to income tax.
GIFT TAX EXCLUSION One of the most basic but highly effective estate tax strategies is the annual gift tax exclusion. The I.R.S. in 2009 allowed people to give up to $13,000 a year to anyone they wanted, tax-free. (This exclusion is separate from the $1 million lifetime exemption.)
But this is something that many wealthier people overlook, said Phyllis Silverman, vice president and senior trust adviser at PNC Wealth Management. “They’re all very busy and the idea of $13,000 per individual may not make an impact on their minds,” she said. “But when they sit down with their financial adviser, they can see how it will lower their estate costs.”
For those with an estate subject to a 45 percent estate tax, each $13,000 gift will save them at least $5,520 in estate tax, Ms Silverman said. Or consider this example: A married couple with a $10 million estate gives $13,000 a year each to six people for a decade. At the end of that time, they will have given $1.56 million tax-free. Based on the current estate tax rate, they will have also saved $702,000 in taxes by moving that money out of their estate before they die.