WealthManagement Magazine

Death and Taxes Update

Capital gains cut to 20%. Hold an investment 18 months and pay a lowly 20% tax on the gain.If it were only that simple. The new tax is retroactive to May 6, 1997, so anything held more than 18 months and sold after that date gets the 20% rate. Here's where it gets complicated. If you sell after July 28, 1997, and have held the investment for more than a year but less than 18 months, you pay 28%. Acquire

Capital gains cut to 20%. Hold an investment 18 months and pay a lowly 20% tax on the gain.

If it were only that simple. The new tax is retroactive to May 6, 1997, so anything held more than 18 months and sold after that date gets the 20% rate. Here's where it gets complicated. If you sell after July 28, 1997, and have held the investment for more than a year but less than 18 months, you pay 28%. Acquire an investment after Dec. 31, 2000, hold it five years and you pay only 18%. Collectibles do not qualify for any of this, of course.

At least they didn't call it the Tax Simplification Act.

Will all of your clients rush to cash in? Probably not, say most experts. "Historically, there's been an unlocking effect [when capital gains taxes are lowered]," says Clint Stretch, director of tax policy at Deloitte & Touche in Washington, D.C. "Some people will cash in on stocks and exercise options, but there won't be a wholesale migration."

Stretch points out that a lot of savings are domiciled in tax-exempt accounts anyway, like pension plans, 401(k)s and the like.

Naturally, anything that pays returns in capital gains instead of ordinary income has become more attractive. Growth-oriented portfolios might make more sense. Funds and managers could be freer to turn over their holdings, and it's likely the industry will come up with more vehicles designed to distribute capital gains rather than dividends.

Is Deferral Good? With the winners must come the losers. Take variable annuities. While the tax deferral is nice, withdrawals from annuities are taxed at ordinary income rates. Combined taxes in a state like California could run as high as 42% or more compared to 20% plus state taxes on capital gains. Affluent investors could regret putting their money into annuities. The same is true of retirement accounts, especially non-deductible ones and non-qualified retirement plans. It may be better to pay Uncle Sam as capital gains are realized than pay later at ordinary income rates.

Estate Taxes Turned Upside Down Estate planning basics will remain the same, according to Stretch, but the numbers will change every year until 2006. This will take a lot of pressure off of current estate planning but make the review of old plans a necessity. Here's how the new estate taxes break down.

Currently, the unified credit exempts $600,000 in estate assets per person. It will increase every year until it reaches an equivalent of $1 million per person in 2006. Beginning in 1998, a special tax treatment of small businesses can be elected for "qualified family owned business interests." If the interest comprises more than 50% of the estate, and other requirements are met, the combined tax credit goes up to $1.3 million.

The law is very specific about what qualifies as a business. No passive income or investments gains are allowed as "business" income, so your client can't decide to go into the business of investing or owning real estate to bump up their credit.

The bottom line is that any estate-planning vehicle more exotic than an A-B Trust or family limited partnership might need a review. Those changing estate tax thresholds could render a current estate plan and insurance trust obsolete.

The current unified credit of $192,800, which protects an estate up to $600,000, will rise to $345,800 by 2006, enough to protect up to $1 million. The annual unified credit year by year is as follows:

Year - - Exclusion - - Unified - - - - - Credit 1998 - - $625,000 - - $202,050 1999 - - $650,000 - - $211,300 2000-01 - $675,000 - - $229,800 2002-03 - $700,000 - - $250,550 2004 - - $850,000 - - $287,300 2005 - - $950,000 - - $326,300 2006 - - $1,000,000 - - $345,800

With up to $1.3 million of business assets being sheltered from estate taxes, a mom-and-pop business, subject to quite a few restrictions, could shelter business assets of up to $2.6 million. Since many of the creative estate plans were sold to small-business owners, and life insurance agents have little incentive to go after this market if there's no insurance business to come from it, brokers may find some opportunities here--many small businesses are paying five-figures a year for insurance they no longer need.

A couple of other things: The $10,000 annual exclusion for gifts, often used in estate planning, will be indexed for inflation starting in 1999, along with a few other things like the $1 million generation-skipping transfer tax. In addition, the value of a charitable remainder trust's remainder interest must be 10% on the day of the contribution. To makea long story short, charitable remainder trusts have just become a lot less attractive because the new rule restricts what you can take out.

The new tax bill is certainly menacing but not unfathomable. It reminds some advisers of the Medicare Tax almost a decade ago. Back then, seminars on the topic were packed.

Like they say, confusion is always good for business.

By allowing an exclusion of up to $250,000 ($500,000 for couples), many investors who are "house rich" now can cash in without tax consequences. Clients and prospects who are downsizing for retirement and have been hesitant to cash out and pay taxes on their larger homes for fear of the tax bite now will be freer to move. Taxpayers don't need to buy another home--this is an outright and reusable exclusion.

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