The fierce Congressional floor debate over extending expiring Bush tax cuts except for the nation's top two percent of wage earners was postponed in September. But forward-thinking financial advisors have wasted no time all year long implementing strategies to protect their affluent clients' wealth. The tax cuts, enacted by the Republican Congress in 2001 and 2003, are due to lapse on Dec. 31, 2010. The fall floor debate was pushed back till after the November elections, signaling the possibility of a compromise.
In a changing tax landscape for families earning $250,000 or more, and individuals with at least $200,000 in annual income, expiration of the cuts would mean higher personal income tax (top bracket rising from 35 percent to 39.6 percent) and increased capital gains tax. Plus, come Jan. 1, 2011, the estate tax makes a comeback — after a year without any.
But that's not all: A number of other tax-relief provisions already expired on Dec. 31, 2009. That'll be a surprise to most taxpayers when they hunker down to file this year's return. These scheduled hikes, for everyone, are already in law and include numerous increases on businesses — with small business expensing chopped too. Further, charitable contributions made directly from IRAs will no longer be permitted.
The tax shake-up is widespread and significant.
"All these changes are going to impact investors, small and large, across the board — business owners, retirees. It's broader in scope than anything we've seen before. You name an area, it will be impacted — from capital gains to retirement cash flow," says Susan Hartman, tax and estate planning consultant at Raymond James, based in St. Petersburg, Fla.
For financial advisors, it is critical to map out and apply investing techniques that safeguard client assets by minimizing liability while, of course, maximizing returns. If FAs don't get busy taxwise, it could put their advisor-client relationships at risk, Hartman notes.
For starters, according to John E. Ledford, whose practice, Ledford Financial, boasts 13 CPA sub-advisors, FAs "should have a big conversation with clients about mindset. Give them a dose of reality that taxes are going up and that they need to start planning appropriately. You need to build some basis in the tax conversation rather than just jump into a strategic change," says the certified financial planner, based in Orlando, and affiliated with Commonwealth Financial Network.
But above all, both advisors and clients must focus first on the investment — second, on tax ramifications.
"Don't let the tax tail wag the investment dog," says Denver Gilliand, a Merrill Lynch private wealth advisor who heads The Gilliand Group, in Minneapolis. He holds both a law degree and a degree in tax law. "Taxes are going to take a percentage of investment depreciation, so you still need to have a good underlying investment plan that will produce positive returns. Then you want to ask: What are the tax implications of that plan?"
Everyone Pays
It isn't only the most affluent investors who should be concerned about tax hikes. Clients below the top income level sooner or later won't be spared either. Therefore, for those not participating fully in their 401(k) plans, now is the time to do so. Another tack: Convert from a traditional IRA to a tax-deferred Roth IRA.
"What has been talked about is rising income taxes on the highest brackets; but it's possible that, in time, tax rates could be increased on lower income earners as well," says Gilliand. "Whenever you have higher income taxes looming, the strategy is to either offset the timing of the receipt of income or use deferred tax techniques. That's what we're doing with our clients."
The strategy of shifting more income into 2010 rather than receiving it in 2011 will be widely employed. But in some cases, the smart approach is the exact opposite.
Former IRS auditor Garth Terlizzi, an independent advisor whose firm, GET Financial Services, in Lawrence, Kan., is affiliated with LPL Financial, says that for a number of clients, he's "accelerating some income this year into a lower tax bracket to reduce income next year."
Ledford, however, warns that in recommending pushing more income into 2010, some clients "might look at you like you have nine heads. They get a bit leery when you advise things that have a radically different curve than what they've had in the past." That's precisely why he has prepared clients upfront with that "mindset conversation."
Likewise, Tom Sedoric, managing director-investments, The Sedoric Group of Wells Fargo Advisors, in Portsmouth, N.H., launched a "drip campaign" as far back as last April recommending that clients see him for a proactive tax-planning session. Nowadays, he says, "you need to be ahead of the curve and protect clients not just from market risk but from policy issues. That type of risk management is part of our job today. Soon, tax planning will be as important, if not more important, as some of the work that [FAs typically] do."
Sedoric continues: "When it comes to investing and taxes, the thing to remember is flexibility. You don't know what Congress may do five or 10 years down the road. When you're 75 and the tax code is different from today, you want flexibility — and that's what we're building into everyone's situation going forward."
