With less than 6 months remaining in 2012, and the United States Supreme Court having upheld the constitutionality of the Patient Protection and Affordable Care Act (often referred to as “Obamacare”), now is a good time to review tax increases looming in 2013 to determine if you should implement strategies today to help save your family gift, estate, and income taxes in the future.
Taxes will increase a great deal next year in what many commentators are calling “taxmageddon.” If these changes come into effect, there is a relatively small window of time remaining in 2012 to implement tax-saving techniques to decrease or eliminate the burden of increased taxes in 2013 and beyond.
The changes to the tax code set to take place in 2013 are the result of the sunset provisions in the tax laws commonly referred to as the “Bush Tax Cuts” and the tax provisions imbedded in the Patient Protection and Affordable Care Act.
Estate, Gift and Generation Skipping Taxes:
In 2012, the federal estate tax, federal gift tax, and federal generation skipping transfer tax exemptions are unified with a lifetime exemption amount of $5,120,000 per person and a maximum tax rate of 35% on transfers above the exemption amount. Barring action by Congress (which will depend on the outcome of the presidential election), on January 1, 2013, the federal estate and gift tax exemption will be reduced to $1,000,000, the federal generation-skipping exemption will be reduced to approximately $1,300,000, and the maximum tax rate will increase to 55%.
A simple example illustrates the tax savings accomplished by making taxable gifts prior to 2013. If an individual makes gifts totaling $3,000,000 in 2012, and that individual had not made any prior taxable gifts, no gift tax would result from the transfers and the assets would be removed from the individual’s estate. If that individual were to make the same gift in 2013, after expiration of the Bush Tax Cuts, the transfers would result in a $945,000 gift tax liability.
The annual gift tax exclusion (the amount you can give annually to anyone) remains at $13,000 per donee ($26,000 for a couple) in 2012. If you haven’t made annual exclusion gifts to children and grandchildren, you may want to do so before year end.
The Bush Tax Cuts remain in effect through the end of 2012. In 2012, the top marginal income tax rate is 35%. Most capital gains and dividends are taxed at 15%. Absent congressional action, on January 1, 2013, the top marginal tax rate will increase from 35% to 39.6%, capital gains rates will increase from 15% to 20%, and the tax rate for dividends will increase from 15% to a top rate of 39.6%.
Additionally, taxes imbedded in the Patient Protection and Affordable Care Act will become effective in 2013. In 2013, joint taxpayers making over $250,000 ($200,000 for individuals) will owe an additional 3.8% Medicare tax on the lesser of either their “net investment income” or modified adjusted gross income. Taxpayers will also owe an additional 0.9% Medicare payroll tax on the amount of their income in excess of the aforementioned thresholds.
Available Gifting Techniques:
Individuals can utilize the current tax exemptions to make outright gifts to family members without recognizing any gift taxes; however, there are numerous tax and non-tax advantages to gifts in trust to family members over outright gifts. One type of trust that could be utilized, often referred to as a “Dynasty Trust,” takes advantage of generation skipping transfer tax exemptions and can continue for the benefit of multiple generations without ever incurring additional estate, gift, or generation skipping taxes. Many individuals also prefer trusts because trusts can be structured to help protect trust assets from the former spouses of beneficiaries in the event of divorce and from a beneficiary’s creditors (a rising concern in the current turbulent economic environment).
The historically low interest rate environment presents other opportunities to transfer assets without incurring taxes. For August 2012, the short term (0-3 year loans) Applicable Federal Rate (AFR) is 0.25%, the mid term (3-9 year loans) AFR is 0.88%, and the long term (9 or more years) AFR is 2.23%. Individuals can take advantage of the minimum federal rates by making loans to family members or refinancing existing loans. Low interest rate loans can also be combined with gifts, resulting in larger transfers without incurring any taxes. The typical transactions that include the interest rate element are grantor retained annuity trusts (GRATs) and sales to intentionally defective grantor trusts.
Individual Retirement Accounts:
Given the tax changes in 2013, converting a traditional IRA to a Roth IRA may be beneficial even though such a conversion may trigger substantial taxes in 2012. Roth IRAs differ from traditional IRAs because taxes are paid when assets are contributed to the Roth IRA, but there is no tax on the appreciation of the assets within a Roth IRA either during accumulation or upon withdrawal.
Converting a traditional IRA to a Roth IRA in 2012 may prove beneficial for a number of reasons. First, even though distributions from retirement accounts don’t constitute “net investment income” for purposes of the 3.8% Medicare tax discussed above, distributions from such plans will result in greater modified adjusted gross income, which could trigger the additional tax if your income surpasses the $250,000 threshold ($200,000 for individuals). Second, absent action by Congress, taxpayers may pay less tax by converting to a Roth IRA in 2012 than if they convert in 2013. Finally, assets in Roth IRAs are not subject to required minimum distribution rules, so older individuals can keep assets in a tax-free vehicle for as long as they prefer.
If the Roth IRA declines in value in the year of conversion, there are techniques to re-characterize the Roth IRA to a traditional IRA and then reconvert to trigger a lower tax than the initial conversion.© MICHAEL BEST & FRIEDRICH LLP