Imagine a client who has worked hard for 40-50 years to finally reach a point that represents the finish line of financial independence. Even after a global financial meltdown and stock market crash, this client has enough assets and income to feel secure and enjoy life. Unfortunately, there is some bad news ahead, and somebody should deliver it.
That person can be you, and here is what you may want to say: "It's possible, perhaps likely, that your income taxes will rise by 10% or more in the years ahead. As you move through retirement, you may become one of the highest taxed people in America in terms of marginal tax impact. On your last dollar earned, you could face a total tax rate above 50%."
But you also can deliver the good news - high-income seniors should be able to see what's coming and plan for it. At the least, they can make adjustments that will keep higher taxes from ripping apart their budgets and dreams. At best, you can work with their CPAs to minimize the tax impacts, using information and ideas in this article.
Because changes are evolving in pieces, it's hard for most affluent seniors to see that they are the prime targets of a rising tax trend. This article also will help you assemble pieces of the tax puzzle, so your high-income clients can appreciate just how important tax planning will be throughout retirement.
Pieces of the Tax Puzzle
As Congress turns its attention to debating expiration or extension of the "Bush tax cuts," high- income households are watching to see whether their situations will be affected positively or negatively. In reality, there are several pieces of this tax debate that could cause taxes to increase, bit by bit. So, even if the "Bush tax cut" headlines turn out positive, the devil could be in the details for affluent seniors.
Already this year, two federal income tax increases were included in 2010 health care reform legislation, both of which may have the heaviest impact on affluent retirees.
To see what may be coming, let's imagine a hypothetical couple, "The Crowleys," currently age 68 with adjusted gross income of $300,000. We'll assume they itemize deductions, take two person exemptions, and live on a combination of retirement plan withdrawals, annuity withdrawals, capital gains, interest on savings and Social Security.
Currently, they pay federal income tax in the 33% marginal bracket. Assuming a 5% state income tax impact, they face a combined marginal rate of 38%. In addition, 85% of their Social Security benefits are taxable, and their Medicare Part B premiums total $5,304 per year due to their high income (about $3,000 per year more than for retirees with average incomes). Let's estimate that the Part B premium impact pushes their marginal combined bracket up by 2%, to 40% total.
Now, let's see how tax changes could increase their marginal rate to more than 50%.
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The Obama Administration wants to let the Bush tax cuts expire on 12/31/11 for high-income taxpayers with incomes over $250,000 (joint) or $200,000 (single). If the President gets his way, this would cause the Crowleys' tax bracket to rise from 33% to 36%. The highest federal tax bracket would increase from 35% to 39.6%.
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For high-income Americans, the Administration wants to let the federal tax rates on long-term capital gains and Qualified Dividends revert to pre-tax-cut levels. This would increase the Crowleys' rate on long-term gains from 15% to 20%. Federal tax on their dividends would increase from 15% to 36%.
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Buried in the fine print of the tax debate is the scheduled expiration of relief from a 3% reduction of itemized deductions for taxpayers with Adjusted Gross Income (AGI) in excess of a threshold of about $166,800 ($83,400 if married filing separately). Partial relief was enacted for 2006-09 and full relief was available in 2010. If the provision is fully reinstated in 2011, it will increase the Crowley's marginal rate by about 1%.
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The Obama Administration has proposed limiting the tax value of itemized deductions to 28% for taxpayers in the 36% or 39.6% federal tax brackets, effective in 2011. (This proposal would require new legislation.) By reducing the value of itemized deductions from 36 cents on the dollar to 28 cents on the dollar, it could add about 2% to the Crowley's marginal tax rate, if enacted.
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If the Bush tax cuts are allowed to expire on schedule, a full personal exemption phase-out will be reinstated. Each personal exemption will be reduced by 2% for every $2,500 that AGI exceeds a threshold, which begins at AGI of about $250,200 (joint) or $166,800 (single). For each exemption claimed, expiration would about 1% to the taxpayer's effective marginal rate. We'll figure 2% marginal impact for the two exemptions the Crowleys claim.
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The Health Care and Education Reconciliation Act of 2010 included a new 3.8% Unearned Income Medicare Contributions Tax (UIMCT), effective in 2013. The tax will be imposed on the lesser of: 1) net investment income; or 2) modified AGI (plus any excluded foreign income) over a threshold amount. The threshold amounts are $250,000 for joint filers and $200,000 for single filers. "Net investment income" includes interest, dividends, royalties, rents and capital gains. It does not include distributions from qualified plans or IRAs. According to several legal sources, non-qualified annuity income payments (or withdrawals) and taxable life insurance withdrawals will be subject to UIMCT.
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Another part of health care reform legislation, The Patient Protection and Affordable Care Act of 2010, made Medicare Part D prescription drug coverage more valuable to seniors. But to pay for an expanded drug benefit, the act imposes the same "income-relating" to Part D premiums that already exists for Part B. Effective in 2011, premiums for Part D will increase in tiers (the same income tiers used for Part B) for taxpayers with Modified Adjusted Gross Incomes above $85,000 for individuals or $170,000 for couples. Unlike Part B premiums (which are set by law), Part D premiums are set by the competitive market and individual insurance companies. An average premium is about $35-40 per person per month, so this provision will add about 1% marginal tax impact for high-income seniors like the Crowleys. (Like Part B, the higher Part D premium will be determined based on a two-year look-back: 2011 premiums will be based on reported MAGI in 2009.)
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As state governments continue to run deficits, pressures are growing for higher tax rates on upper-income taxpayers. Several states already have created new top tax brackets, permanently or temporarily. For example:
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New York has new top rates of 7.85% and 8.97% through 2011.
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Oregon, has new top rates of 9.9% and 10.8% through 2011.
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Connecticut has created a new 6.5% permanent top tax rate.
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We'll project that the Crowley's state income tax rate will increase by 1% at some point in the future.
A 54% Marginal Tax Rate - For Seniors Only
Let's begin with the Crowley's current federal/state marginal tax rate of 40% and see where they soon may be going:
| Current combined marginal rate | 40.0% |
| Impact of higher federal income tax rates | +3.0% |
| Reinstatement of itemized deduction reduction | +1.0% |
| Proposed reduction in value of itemized deductions to 28% | +2.0% |
| Personal exemption phase-out reinstatement | +2.0% |
| Exposure to UIMCT (2013) | +3.8% |
| Impact of income-relating Medicare Part D premiums (2011) | +1.0% |
| Impact of higher state income tax rates on the affluent | +1.0% |
| Total potential marginal combined tax rate | 53.8% |
The Crowley's total marginal tax rate could rise to nearly 54% -- in addition to increased taxes on their long-term capital gains and investment dividends, if the Bush tax cuts expire for high-income taxpayers.
Beyond the impact of a potential 54% marginal tax rate, several troubling trends are apparent for high-income seniors:
- Retirement taxes - A growing number of taxes apply only to retirees. They includes the tax on Social Security benefits and higher premiums for Medicare Part B and Part D. Waiting in the wings is the report of the National Commission on Fiscal Responsibility and Reform, which is due by December 1 as a first step toward addressing long-term funding shortfalls in Social Security. You can follow the Commission progress at its Website: http://www.fiscalcommission.gov
Although this bipartisan commission isn't expected to reach significant conclusions approved by the required 14 of its 18 members, it could open a door to the future income-relating of Social Security benefits, which would be another type of retire-focused tax impact.
Recommended For You
Since 2005, when the IRS and Social Security Administration legally began sharing data, the administrative machinery has been in place to income-relate Social Security benefits. See: www.freeerisa.com/news/blogs/salesinsight/article.aspx?ArticleId=20
You can see several calculations of the tax impact, prepared by the Tax Foundation, here: http://www.taxfoundation.org/publications/show/26041.html
For a quick comparison, Couple A file jointly and earns $300,000 in wages. Their Medicare tax will increase by $450 (.9% of the amount over $250,000). Couple B files jointly and earned $150,000 in wages and $150,000 in unearned income. Their Medicare tax will increase by $1,900 (3.8% of the amount over $250,000).
Of course, by far the biggest new tax on the affluent elderly is Federal Reserve's Zero Interest Rate Policy (ZIRP), which has reduced retirement income from bonds, money market funds and CDs by perhaps 50% or more nationwide. See: www.freeerisa.com/news/blogs/salesinsight/article.aspx?ArticleId=165
As a result of all these changes, the Crowleys and other retired people like them are worried. The investment income they planned for isn't what they now have. And soon, they may be giving up more than 50% of this income (at the margin) to the government. Fortunately, you can offer ideas to help them put their confidence back on track.
Ideas for Affluent Retired Clients
Roth Conversions - Clients still have time to take advantage of 2010 Roth conversions, which will allow deferral of up to 50% of the tax impact until each of 2011 and 2012. Thus far, major investment firms have reported far less Roth conversion activity than they expected in 2010. Surveys have shown that many people don't trust Congress to maintain the tax-free character of Roth distributions in the future.
The main advantage of converting now is tax arbitrage - the opportunity to prepay income taxes before rates go up. Another advantage is the flexibility to tap a Roth IRA for retirement income, as needed, to avoid pushing other income into higher marginal brackets. See: www.freeerisa.com/news/blogs/salesinsight/article.aspx?ArticleId=12
If clients are skeptical Roth tax benefits will be sustained in the future, remind them they don't have to put all their eggs into the conversion basket. A smart strategy can be to convert a portion of a 401(k) or Traditional IRA now and perhaps more later.
Exchange Traded Funds - Quietly, ETFs have created a solid track record as tax-efficient long-term investment vehicles. They offer the diversification of index mutual funds, and their creation/redemption process helps to avoid the impact of year-end distributions of realized gains. According to a recent analysis by Morningstar, only two of 27 large ETFs studied had made any capital gains distributions over the preceding five years. Equally important: Diversified portfolios of ETFs create opportunities for year-end tax loss harvesting, which can help to dampen the tax impact of any gains taken in the same year.
Stepped-up Basis at Death - If the federal estate tax returns as scheduled at the stroke of midnight on December 31, so will the stepped-up basis on capital assets held at death. This remains one of the best long-term tax-reduction strategies. By holding ETFs and individual stocks until death, capital gains taxes can be avoided by both owners and heirs. Higher federal income tax rates on affluent retirees will make all types of wealth transfer strategies, including life insurance transfers and gifts of appreciated assets, more valuable.
Plain-Vanilla Variable Annuities - The variable annuity (VA) industry has grown dependent on living benefit riders such as Guaranteed Minimum Income Benefits (GMIBs) and Guaranteed Minimum Withdrawal Benefits (GMWBs). According to an analysis by LIMRA, 60% of all VAs sold in 2009 had living benefits attached, compared to just 41% in 2007.
But for affluent retirees, living benefits come at extra costs that can only be recouped by taking steady annual income payments or withdrawals, most of which are taxable. Once living benefits begin, there's not much flexibility to change or stop them, without sacrificing long-term value.
A plain-vanilla VA (without living benefits) still delivers a combination of tax-deferred growth, no required minimum distributions, and a guaranteed death benefit - all of which can be attractive to heavily-taxed affluent seniors. Some life insurance companies are offering their most attractive investment menus only to plain-vanilla VAs, because these products don't require complex and expensive hedging strategies to offset living benefit risks. At the high end of the VA market, the trend toward wrapping VAs with living benefits should soon begin to reverse, if it has not already.
In Summary
In this article, we've imagined hypothetical clients, the Crowleys, and suggested their marginal total tax bracket could go as high as 54% in the future. But in reality, their marginal bracket could fluctuate from year to year, based on the decisions they make and planning they undertake. Given the complexities of overlapping income thresholds, surtaxes, and phase-out ranges, clients such as these will only know their annual tax bills after visiting their CPAs with year-end statements. By then, it will be too late to do much.
To help affluent retired clients manage the onslaught of higher taxes, advise them plan ahead and emphasize income flexibility. In general, it will work best for these clients to avoid heavy commitments to fixed, continuing streams of taxable income. Tax-inefficient investments, such as high-turnover hedge funds, should be avoided in favor of diversified funds with built-in tax benefits (such as ETFs) and mutual funds managed for tax-efficiency.
Now is a great time to form alliances and relationships with leading CPAs in your market and educate them about the rising tax impact on affluent retirees, while working with them to plan and implement creative strategies.
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