Laurel and Hardy Dancing on the Fiscal Cliff

I personally would prefer Laurel and Hardy to what we have up there presently. 

What Will The Tax Cliff Cost You?

The Tax Foundation has published an analysis on the impact of the tax cliff on a typical family in each state.

To arrive at the typical family, the Tax Foundation used Census and IRS data to estimate income and deductions for an average two-child family in each state.

They then ran those numbers through two tax calculations: the first using 2011 tax law, and the second using projected 2013 law. The rub of course is the 2013 law, as Bush-era and Obama tax cuts are expiring. It is unknown what, if anything, will take its place. This is the “taxmaggedon” you may have read about. Another key piece to 2013 is the alternative minimum tax (AMT), as the most recent AMT “patch” expires with the 2012 tax year.

The rankings go from #1 to #50, and one does not want to be #1. That dubious distinction goes to New Jersey, not exactly an economical place in which to live under the best of circumstances.

In our corner of the world, the TriState area (Ohio, Kentucky and Indiana) came in as follows:

                                                $ Increase                                 % Increase

Ohio                                          $3,437                                       4.72%

Indiana                                     $3,653                                       5.27%

Kentucky                                  $3,437                                       5.18%

So – if the politicians accomplish nothing – the tax cliff will cost the average TriStater approximately $300 per month. This is real money, folks.

Taxmaggedon

You may have read or heard about the “fiscal cliff” and “taxmaggedon.”

There are a couple of things going on here. Taxmaggedon refers to tax increases and the fiscal cliff refers to the federal budget and sequestration. The combination of the two is slated to happen in less than 3 months unless Congress and the White House act.

Let’s talk about the taxes.

There were revisions made to the tax code back in 2001 and 2003. These revisions have become known as the “Bush tax cuts,” which seems a reasonable description, and the “temporary tax cuts,” which doesn’t seem so reasonable. My daughter was in elementary school back when these tax changes were made. Today she is in college. To refer to these tax cuts as “temporary” is an abuse of the language.

Congress’ new thing is to put an expiration on tax legislation. It is somewhat like getting married but giving your spouse a term of only 5 or 7 years. At that date the marriage would be reviewed and – if found advantageous – would be extended for another period. I suppose one could stretch such a marriage out for many decades, but it seems bad form. Congress however seems to think that this is a fine way to pass tax law.

 A lot of tax law is expiring very soon. When it does, chances are that your taxes are going up. Why? There are a few items in there that we have come to take for granted, and by “we” I mean ordinary people who set an alarm clock and leave for work every day. Here are some examples:

(1)    Do you like your 10% individual tax rate? Well, that rate is going away. Sorry.

(2)    Have you managed to stash a couple of dollars in a mutual fund for your kids’ education? Tax on the dividends from that mutual fund will no longer be capped at 15%. Only rich people have mutual funds anyway.

(3)    Remember the tax marriage penalty? That used to mean that two people – if married – pay more taxes than if they had remained single. The penalty is back.

(4)    Are you selling that mutual fund when your kid starts college? If you have a gain, your tax is going up. See (2) above about owning mutual funds.

(5)    Certain credits, such as the education credits, will be reduced. The child credit, for example, will drop from $1,000 to $500 per eligible child.

(6)    Your social security withholding will increase from 5.65% to 7.65%.

Is it going to happen? I have no clue. But if it does, it will not be confined only to the “rich.” It will be all of us – at least, those of us who still pay taxes. That is one of the things that the “Bush tax cuts” did, by the way: remove millions of people from the tax rolls. There was debate at the time whether it was beneficial for society to divorce so many people from contributing to everybody’s government. It will be gallows humor to see the politicians tap dance when those millions return to the tax rolls.

Gifting And The Rest of 2012

I met with a client last week who has a child with special needs. His daughter has a syndrome I cannot remember, except that it is quite rare and was named after a physician who practiced at Children’s Hospital here in Cincinnati. He is concerned about her welfare, especially after he passes away. We wound up talking about gifting and expected changes in gift tax law.

Let’s talk about the gift tax today.

There is an opportunity to gift up to $5,120,000 without paying gift tax, but this expires at the end of 2012. If you are married, then double that amount (10,240,000). If you exceed that amount, then gift tax is 35%. The $5,120,000 is set to drop to (approximately) $1,360,000 in 2013, and the 35% rate is slated to increase to 55%. If you are in or above this asset range, 2012 is a good time to think about gifting.

Here are some gifting ideas to consider:

(1)   Use up your $13,000 annual exemption per donee. This is off-the-top, before you even start counting. If you are married, you can have your spouse join in the gift, even if you made the gift from your separate funds. That makes the exempt gift $26,000 per donee.

(2)   Let’s say that gifting appeals to you, but you do not want to part with $5,120,000. Perhaps you could not continue your standard of living. I know I couldn’t. One option is to have one spouse gift up to $5,120,000 without gift splitting. This preserves the (approximately) $1,360,000 exemption for future use by the other spouse.

(3)   By the way, gifting between spouses does not count as a taxable gift. Should one spouse own the overwhelming majority of assets, then consider inter-spouse gifting to better equalize the estates. This is more of an estate planning concept, but it may regain interest if the estate tax exemption decreases next year.

(4)   Consider intrafamily loans. The IRS forces you to use an IRS-published interest rate, but those interest rates are at historic lows. For example, you can make a 9-year loan to a family member and charge only 0.92% interest. Granted, the monies have to be repaid (or gifted), but the interest is negligible.

(5)   Consider a family limited partnership. We have spoken of FLPs (pronounced “flips”) before. A key tax benefit is being able to discount the taxable value of the gift for the lack of control and marketability associated with a minority interest in the FLP.

(6)   Consider income-shifting trusts to move income and asset appreciation to younger family members. A common use is with family businesses. Say that you own an S corporation, for example. Perhaps the S issues nonvoting stock and you transfer the nonvoting stock to your children using Qualified Subchapter S trusts.

(7)   Consider a grantor retained annuity trust (GRAT). With this trust, you receive an annuity for a period of years. The shortest period I have seen is 2 years, but more commonly the period is 5 or more years. The amount you take back reduces the amount of the gift, of course, but not dollar-for-dollar. I am a huge fan of GRATs.

(8)   Consider a qualified personal residence trust (QPRT, pronounced “Q-pert”). This is a specialized trust into which you put your house. You continue to live in the house for a period of years, which occupancy reduces the value of the gift. If you outlive that period then you can continue to live in the house, but you must begin paying fair market rent to the trust.  I have seen these trusts infrequently and usually with second homes, although I also can see a use with a principal residence in Medicare/Medicaid planning.

(9)   Consider a life insurance trust (ILIT, pronounced “eye-let”). This trust buys a life insurance policy on you, and its purpose is to keep life insurance out of your estate. You might pay the policy premiums on behalf of the trust, using your annual gift tax exclusion. This setup is an excellent way to fund a “skip” trust, which means the trust has beneficiaries two or more generations below you. The “skip” refers to the generation-skipping tax (GST), which is yet another tax, separate and apart from the gift tax or the estate tax.

(10)  Consider a dynasty trust if you are planning two or more generations out. This technique is geared for the very wealthy and involves an especially long-lived trust. It is one of the ways that certain families (the Kennedy’s come to mind) that family wealth can be controlled for many years. A key point to this trust is minimizing or avoiding the generation-skipping tax (GST) upon transfer to the grandchildren or great grandchildren. The GST is an abstruse area of tax law, even for many tax pros.

OBSERVATION: You could incur both a gift tax and a GST tax. That would be terribly expensive and I doubt too many people would do so intentionally.

Although not frequently mentioned, remember to consider any state tax consequence to the gift. For example, does the state impose its own gift tax? If you live in California, would the transfer of real estate reset the assessable value for property taxes?

It is frustrating to plan with so much uncertainty about tax law. We do know that – for the balance of this year – you can gift over $5 million without incurring a gift tax liability. That much is a certainty. If this is you, please think about this window in combination with your overall estate plan. This opportunity may come again – or it may not.

Thinking About The New Medicare Taxes

You may recall that Obamacare incorporated certain tax increases, albeit delayed in some cases. I have been revisiting the payroll tax changes that will kick-in in 2013. 

The High-Earnings Medicare Tax

Beginning in 2013 the employee Medicare tax will increase if the employee is high-earning, defined as $200,000 for singles and $250,000 for marrieds. One’s tax rate will go from 1.45% to 2.35%.  Remember that there is no income limit on the Medicare tax.

Note that the employee and employer will be paying different tax rates.

There are peculiar things about this tax increase. For one thing, one’s Medicare tax rate will be affected by a spouse’s income.

EXAMPLE: Al makes $175,000 and his wife makes $100,000. In 2013 their combined income is $275,000 and subjects them to the increased 0.9% Medicare tax. The tax increase is levied on the excess earnings over $250,000, which is $25,000 ((175,000 + 100,000)-250,000).

Here is the problem: how will Al’s employer (or his wife’s) know this? They won’t. The IRS has said that an employer is required to withhold only on the employee’s wages and disregard the earnings of the spouse. Therefore, as long as a married employee is below $250,000, the employer does not have to withhold the higher tax.

Here is my problem: I am going to be as popular as bedbugs when I come in at year-end and point-out the tax due to Al and his wife.

Also, since when is one’s Medicare tax affected by a spouse’s income? This is a first, to the best of my knowledge.

The Investment Income Tax

Let’s start off with the easy part: the same $200,000 and $250,000 income limits apply.

If one’s income exceeds the limit ($200,000 or $250,000), then one will have a tax hike of 3.8% on one’s net investment income. Net investment income includes interest and dividends (the classics), but it also includes net capital gains, rents (unless it is from a trade or business), royalties and some annuities. It does not include distributions from qualified retirement plans, including distributions in the form of annuities from such plans.

Let’s go with an example.

EXAMPLE: Let’s say that Jeff and Candy have combined salaries of $235,000 and combined interest and dividends of $ 32,000. Their AGI is $267,000. They have exceeded $250,000, so they are in trouble. How much is subject to the new tax? It would be the lesser of the net investment income ($32,000) or the excess over $250,000 ($17,000). Their brand-new tax for 2013 will be $646 ($17,000 times 3.8%).

Some things about this make me uncomfortable. Say that Jeff and Candy earned $213,000 instead, with the same $32,000 in interest and dividends. Their AGI is $245,000 – below $250,000 and thus avoiding the new investment income tax. However, say that they break a 401(k) to pay family medical bills or higher education expenses. Say they break $40,000. This would put their AGI at $285,000. What just happened?

Here is what happened: we have just subjected Jeff and Candy to the new tax. They will owe tax on the lesser of (1) their net investment income ($32,000) or (2) the excess of their AGI over $250,000 ($35,000). The 401(k) break just cost them $1,216 ($32,000 times 3.8%). If Jeff and Candy are under 59 ½, remember that it also cost them the 10% penalty. And income taxes on the break itself.

Again, since when have we paid Medicare tax on unearned income?

Anyway, if you are in these income ranges, you may want to start thinking about the year after next. I can immediately see the appeal of Roths and municipal bonds under this tax regime, as they will not increase one’s AGI. On a darker side, I wonder if we will see higher-income singles less willing to marry – or alternatively higher-income marrieds more willing to divorce – for tax reasons.  Taxes encourage changes in behavior. We just don’t know yet what changes these will encourage.