Clients' higher tax bills prompt Investment advisers to brush up on taxes

After a particularly brutal 2013 filing season, look for income tax planning to emerge as a specialty among financial advisers.

A combination of factors is elevating the importance of income tax planning with respect to high-net-worth clients. First, there's the fallout from the American Taxpayer Relief Act of 2012, which took effect on Jan. 1, 2013.

Essentially, ATRA hit the top earners the hardest. Single filers with taxable income exceeding $400,000, as well as those who are married and filing jointly with taxable income over $450,000, now face a top marginal income tax rate of 39.6%. They also are subject to a top marginal tax rate of 20% on long-term capital gains.

Beginning at the $250,000 income level for singles and $300,000 level for married-filing-jointly taxpayers, there's a tax bite in the form of the phaseout of personal exemptions and itemized deductions.

Meanwhile, those with $200,000 in income (single) and $250,000 (married, filing jointly) are subject to the 3.8% surtax on the lesser of income over those thresholds or net investment income, and the 0.9% Medicare tax on wages over those thresholds.

Though ATRA was particularly harsh on the income and capital gains side, it was a little more forgiving on the estate tax side. There, the individual exclusion for estate and gift taxes is now at $5.34 million and the tax rate at 40%.

Clients' post-ATRA income tax chickens have come home to roost in the form of higher tax bills. That, combined with the relatively high exemption for estate and gift taxes, means income tax planning is now on the front burner.

“There's a big paradigm shift,” said Charles Douglas, editor of the National Association of Estate Planners and Council's Journal of Estate and Tax Planning. “When you look at the federal, state and the 3.8% surtax on the income tax side, those can outweigh the gift transfer tax.”

That means analyzing and minimizing income taxes becomes the focal point in a number of planning scenarios. “This is about advising people on where to live for income tax purposes, where to die for estate tax purposes, as well as having trusts in other estates,” Mr. Douglas said.

It's important to remember that trusts' income in excess of $11,950 is taxed at the 39.6% rate — the highest income tax bracket. Advisers ought to guide clients to think about tax-efficient assets to hold, such as municipal bonds and life insurance, Mr. Douglas said.

With trusts, clients can also add a “sprinkle provision” to make distributions out of the trust to children and grandchildren who are in lower income tax brackets, as opposed to having the trust face the highest income tax rates, he added.

Outside of trusts, advisers can point clients to other tax-exempt investments. “There's a big opportunity in deferring the income taxes by using non-qualified annuities or cash value life insurance,” said J. Christopher Raulston, a wealth strategist at Raymond James Financial Inc. He expected he would see more individuals use annuities and save in them, with the expectation that by the time they tap them for income, they'll be retired and in a lower bracket. “You're in your earning years and making a good living — that's when you want to defer income,” Mr. Raulston said. “You're using that annuity to leapfrog the higher tax years and push income toward later years in retirement.”

There are also other vehicles to consider, such as a life insurance retirement plan, which is essentially a formalized strategy of socking money away into a life insurance policy with the intention of building cash value, according to Mr. Raulston. The cash value becomes an asset the client can tap free of taxes. But be sure to monitor the policy throughout its life: Universal life written 20 to 30 years ago has been experiencing pressure due to low interest rates.

Finally, have your clients get their charitable giving in order for the 2014 tax year. Charitable giving not only allows clients to offload highly appreciated assets, it also nets them a deduction that they can use to reduce their income taxes. Gavin Morrissey, senior vice president of wealth management at Commonwealth, notes that clients are getting a twofer deal by combining a gift of highly appreciated low basis stock to a donor-advised fund or to a charity and then using the income tax deduction to offset the taxes they'd pay on a Roth conversion.

In the long run, this also helps clients diversify the tax treatment of their pool of assets when they prepare to retire. They now have an array of accounts with different tax treatments, and they can plan their income withdrawal strategy with taxes in mind.

“One of the biggest puzzles is where do you get the income from,” Mr. Morrissey said. “If you have a Roth IRA, a non-qualified account and a traditional IRA, you'll want to control taxes. Where are you getting your withdrawals from so that you don't unintentionally run into a higher tax bracket?”