Personal Wealth Law News

An article in the New York Times of January 22,2012 offers some ideas on how to make the tax system simpler and maybe fairer:

 1. Broaden the base and lower rates. What this means is eliminating some deductions, like mortgage interest, and reducing tax rates on the larger base. No one in Congress has seriously tried to eliminate that particular deduction, nor most others.

2. Tax consumption rather than income. The author of the article thinks we’re close to that now, with extensive deductions available for retirement saving. He suggests that an income tax, as opposed to a consumption tax, discourages saving, investment and economic growth.

3. Tax bads rather than goods. This means we should have higher taxes on things we want to discourage. A higher gasoline tax, for example, discourages excessive driving and pushes people toward more efficient methods of transportation.

4. Keep it simple. A simpler tax system makes understanding and compliance easier and less expensive.

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An article in the New York Times of April 17, 2011 notes that the three largest tax breaks are: the employer-provided health insurance exclusion ($264 billion of lost revenue last year), the home mortgage interest deduction and the 401(k) contribution exclusion           ($52.2 billion). Lower tax rates on capital gains ($36.3 billion), lower rates on dividends ($31.1 billion) and the IRA exclusion ($12.6 billion) are also significant. Although the first two have long been viewed as untouchable, the sheer cost of them might tempt both parties to consider cutting them back, at least. All of them tend to reward higher income people disproportionately, so restricting them might be an acceptable alternative to raising rates on higher income levels.

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A provision of the Tax Relief Act of 2010 (which has a longer name but, alas, no acronym) extends through the end of 2011 the ability to make a direct trustee to trustee transfer from an IRA to a qualified charity without tax consequences (that is, no recognition of income and no tax deduction). The donor must be at least age 70 1/2 and the limit on the amount that may be transferred is $100,000 per year. The transfer must be from a traditional or Roth IRA; it can’t be from a SEP-IRA or a SIMPLE plan.

 One additional benefit: transfers made through January 31, 2011 can be treated as if made by December 31, 2011. 

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At the beginning of this year (2010), there was discussion in the press and in legal publications about the ability to convert IRAs and qualified plan accounts to Roth IRAs. This conversion involved paying taxes now and then being free of them thereafter, plus avoiding the necessity of minimum distributions during life. In effect, for those people who really didn’t need the amount being converted, conversion was a very effective multi-generational planning technique. To the extent you believe income tax rates will be higher in the future (a good bet), conversion makes sense. There’s a choice you can make when converting, whether to pay taxes this year at this year’s rates or over the next two years at whatever the rates will be then. Some people prefer to pay this year, because they like knowing what the tax rates will be.

Another advantage of conversion now is that security values are still low. The stock market is still far off its high values of a few years ago, so conversion now, before (we hope) the stock market recovers, is a good idea. Conversion is not for everyone. It requires some thinking about the future and personal planning. But there is still time to begin that process.

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Is it possible that Congress will do nothing for the rest of the year to restore the federal estate tax? Given the other items on its agenda, and the fact that this is an election year, it’s very possible. But then what? At the end of the year, the so-called Bush tax cuts expire. That means that the estate tax will return, at its earlier rates and exemption level: a maximum graduated rate up to 55% and an exemption of only $1,000,000 (as compared to the $3,500,000 that was in effect in 2009). Many more people will be subject to federal estate tax, and that will affect the planning they should be doing now.

In addition, the lower income tax rates that were in effect will expire. Capital gains rates will return to their prior, higher levels, and regular income tax rates will also rise. Congress has the ability to extend the lower rates, but it must take some action to do that. And we have seen that on tax issues, it’s difficult to get changes enacted. What if Congress does nothing, or if efforts to extend the lower tax rates fail? Higher taxes. It’s probably a good idea to start planning with respect to income taxes now, in anticipation of eventual higher tax rates: possibly postponing deductions to next year and accelerating income into this year. All of this could change, but it’s probably wiser to assume that nothing will happen.

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The alternative minimum tax, which grew from an effort to provide some level of taxation on those who used various tax-avoidance techniques into a monster that threatens to swallow the entire federal income tax system, is the subject of tax relief in the recently-signed stimulus legislation. The exemption from AMT is scheduled to fall each year and engulf many millions of taxpayers, unless a “patch” is applied. The patch temporarily increases the exemption, and is reenacted every year. In the stimulus legislation, the patch was increased to the following levels:

• Single and head of household  $46,700
• Married filing jointly  $70,950
• Married filing separately  $35,475

The rates remain the same: 26% on the first $175,000 of AMT taxable income ($87,500 if married filing separately), and 28% on the balance.

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The U.S. Senate has just passed a cloture motion, which means that the stimulus bill will continue to advance to likely Senate passage, followed by negotiations with the House and an eventual compromise bill. The new legislation will contain a number of tax-cutting provisions. As soon as we know what the final provisions will be, another article will be posted on this website to explain the changes.

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Tax legislation that was passed unanimously by both houses of Congress and quickly signed by the President offer some helpful ideas for retirement and estate planning.

First, required minimum distributions from defined contribution retirement plans and individual retirement accounts are suspended for 2009. This means that if you have reached age 70 1/2 and are required to take out a calculated minimum amount for 2009, you will not have to do so. This relief is to help account owners who suffered substantial losses in 2007 and 2008, by not requiring them to liquidate assets with depressed values to make the minimum payments. Most people who have retirement accounts and have reached age 70 1/2 need to take distributions for their living expenses, but for those who do not, this temporary change in the law might be helpful. It does have a revenue effect for the Treasury, because if less than the minimum amounts are withdrawn, less will be paid in taxes for 2009.

Second, a change has been made in distribution rules from qualified plans. This is how it works. Most qualified plans provide that if the participant dies leaving an account balance, that balance must be paid out promptly to the participant’s beneficiary. If the beneficiary is the participant’s spouse, the spouse can roll over the balance to an individual retirement account and avoid immediate taxation. But if the beneficiary is a child, for example, it was long the rule that no rollover was permissible. Therefore, the child would be taxed on the distribution immediately, rather than being able to stretch out distributions through an IRA rollover. A few years ago, legislation was passed to permit rollovers by non-spouse beneficiaries, but it appeared that this would only be permitted if the retirement plan specifically allowed it. There was confusion as to whether Congress meant that this provision should be optional, and the recently enacted tax legislation has now made it mandatory for qualified plans, beginning for plan years after December 31, 2009. This can be a very valuable planning technique for retirement benefits. It’s a good idea to find out what your employer’s plan provides at a participant’s death, and to ask that the non-spousal rollover provisions be added as soon as possible.

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On October 3, 2008, the House of Representatives passed the so-called “bailout bill”, designed to avoid a further deepening of the economic crisis, and President Bush has already signed the bill. To make the proposals more acceptable to some members of Congress, some provisions were added that affect the tax liability of individuals. Here is a brief summary of a few of those changes.

1. The provision permitting individuals age 70 1/2 or older to make direct transfers from individual retirement accounts to charities, in amounts up to $100,000 per year, has been extended to the end of 2009.

2. The ability to deduct state and local sales taxes in lieu of state and local income taxes has been extended to the 2009 tax year.

3. The deduction for qualified tuition and related expenses, within certain income limits, has been extended through tax year 2009.

4. The deduction for certain expenses of elementary and secondary school teachers has been extended through tax year 2009.

5. The exemption from the alternative minimum tax has been extended and increased. For joint filers and surviving spouses, the exemption is $69,950 for 2008, up from $66,250 for 2007. For others, the exemption for 2008 is $46,200 for 2008, up from $44,350 in 2007. Without this extension and increase, millions of additional taxpayers would become subject to the AMT.

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This was the only quote I could think of to introduce a discussion of planning with Roth IRA and retirement plan benefits. In response to this statement, Groucho Marx said: “Is Roth here too? Tell Roth to wax the Dean for a while.”

Delaware Sen. William Roth gave his name to this type of retirement benefit. It’s simple, sort of. You don’t get a tax deduction when the contributions are made, but you don’t pay taxes when the account is distributed at retirement. You give up a current tax saving in exchange for a greater one later. Is this a good deal? The answer is definitely, sometimes.

If you knew that you would pay a higher tax rate in retirement, Roth tax treatment would clearly be better. Conversely, if you knew that your tax rate would be much lower in retirement, it might be better to stay with the traditional method of planning: a deduction up front and taxation later. Opinions vary on this subject, and studies have been made to try to determine when and whether one method is superior to the other. There are some unknown elements: not only your own tax rate but tax rates in general. Who can predict what income tax rates will be 10 or 20 years from now? Or that Roth treatment will still be in effect?

For now, here are two situations in which Roth treatment makes sense. First, if you have a child who has a summer job, it makes sense that the child have a Roth IRA. In most cases, kids with summer jobs have little or no income tax liability anyway, so a deduction for an IRA contribution is of no value to them. Then, they will have many years in which the Roth IRA can grow tax-free. When the funds are distributed, perhaps 50 years later, the small contributions from summer jobs could be a large amount.

Here’s another possible benefit: Roth IRAs do not have minimum distribution rules, unlike standard IRAs and qualified plans. If an individual has other assets such that he or she won’t need the Roth money, the balance can be left in for the rest of the individual’s life and be paid out only in the next generation. This extremely long-term accumulation period, followed by no tax on distribution, can make Roth a valuable planning benefit.

People with standard benefits can convert them to Roth benefits by paying taxes on them now. After that, any distributions will be free of tax. The ability to convert is limited to those with income below certain levels, but that restriction will end by 2010. At that time, anyone will be able to convert to Roth treatment. This opens up the possibility of interesting estate planning with Roth benefits, which we’ll discuss in another blog.

Republished with permission of The Legal Intelligencer.

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