Tax planning for 2012 and beyond

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1 January 2012» Putnam Perspectives Tax planning for 2012 and beyond Christopher P. Hennessey, CPA Faculty Director, Executive Education, Babson College Tax Advisor; Estate Planning Attorney Member, Putnam s Business Advisory Group William D. Cass, CFP Sr. Wealth Management Marketing Manager Global Marketing & Products Key takeaways A worsening budget deficit and an aging population create considerable uncertainty about tax policy beyond Several important tax provisions expired at the end of New taxes will be levied as a result of 2010 s healthcare reform. Major tax legislation is unlikely to be enacted before the November elections, and taxes for many investors could increase dramatically in Investors concerned about higher taxes have a number of tax-smart strategies at their disposal. With the December 2010 passage of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act, investors received much-needed clarity on tax rates through 2012, putting them in a better position to plan effectively. However, now that 2012 is here, the ongoing debate among policymakers about how best to deal with the nation s burgeoning debt and budget deficit creates considerable uncertainty about tax policy beyond this year. The U.S. debt crisis became front-page news in In April, a government shutdown was narrowly averted with the passage of a last-minute budget deal. The Budget Control Act of 2011 was passed in August, providing for $900 billion in discretionary spending cuts over 10 years and creating a bipartisan congressional super committee. The super committee was tasked with reducing the deficit by an additional $1.2 trillion, but failed to reach an agreement before its November 23 deadline. This failure effectively pushed the budget debate into the 2012 election year and magnifies the uncertainty over the longer term. The super committee was tasked with reducing the deficit by an additional $1.2 trillion, but failed to reach an agreement before its November 23 deadline. This failure effectively pushed the budget debate into the 2012 election year. PUTNAM INVESTMENTS putnam.com

2 JANUARY 2012 Tax planning for 2012 and beyond Several tax provisions expired at the end of 2011 While lawmakers continue to debate the fate of the Bush-era tax cuts, which are scheduled to expire at the end of 2012, investors should be aware that several important tax provisions expired at the end of These included: The ability of IRA account owners over the age of 70½ to make annual tax-free distributions of up to $100,000 directly to qualified charities. The alternative minimum tax (AMT) exemption amounts, which are the income levels that trigger the AMT for single and married tax filers. Unless Congress approves a patch this year to raise these income levels which it has done in the past the exemption amounts will revert back to the much lower levels that were in place in 2000 and extend the tax to an additional 25+ million taxpayers in 2012 (Figure 1). Figure 1. AMT exemption amounts Single filers Married filing jointly 2010 $47,450 $72, ,450 74, * 33,750 45,000 1Amounts if no patch is passed by Congress. A closer look at the nation s debt crisis Annual federal budget deficits have increased dramatically since 2008, driven largely by spending associated with the global credit crisis and declining tax revenues. As a result, U.S. government debt as a percentage of GDP has reached a level last seen at the end of World War II (Figures 2 and 3). Figure 2. Annual U.S. federal budget deficit, ($B) ,200-1, Source: Congressional Budget Office, Monthly Budget Review, November Figure 3. Gross federal debt as a percent of GDP, The ability of small and midsize businesses to immediately write off most or all of the cost of qualifying new and used assets in the first year they are placed into service, up to a maximum of $500, Current level of 93% is the highest since WWII The option to deduct state and local sales taxes instead 60 of state and local income taxes on a taxpayer s federal income tax return. The benefit of deducting up to $4,000 in qualified tuition expenses from income Source: Office of Management and Budget, Historical Tables, Total gross federal debt includes debt held by the public as well as intra-governmental debt such as amounts owed to Social Security and federal employee retirement programs. 2

3 PUTNAM INVESTMENTS putnam.com It is unlikely that there will be a major tax deal completed before the November elections, which could lead to dramatically higher taxes for many investors in 2013 Over the long term, the growth of major government entitlement programs will push the deficit even higher. As baby boomers retire at an increasing rate and health-care costs continue to rise, Social Security and Medicare will face mounting pressure to maintain current benefit levels. And, since nearly two thirds of government spending is tied to mandatory sources, 1 it will be difficult for the federal government to solve the problem of rising deficits simply by cutting spending (Figures 4 and 5). Figure 4. Social Security, Medicare, and Medicaid spending as a percent of GDP, Entitlement spending as % of GDP Historical tax revenue as % of GDP Entitlement spending alone is projected to surpass tax revenues in 2047 Source: Congressional Budget Office, Long-term Budget Outlook, June Projections are based on CBO alternative fiscal scenario. Tax revenues are based on historical average of roughly 18% of GDP Figure 5. U.S. federal government spending by type, 2011 estimated 37% Discretionary 63% Mandatory Source: Congressional Budget Office, Reducing the Deficit, Spending and Revenue Options, March Mandatory spending types primarily include Social Security, Medicare, and Medicaid, as well as interest on existing debt. Discretionary spending includes defense and non-defense items. The outlook for tax rates Given the current economic and political landscape, investors would be wise to prepare for the risk of higher future taxes. During the past 50 years, federal income tax rates have been at current levels or lower only 10% of the time. Total tax revenues as a percentage of GDP have averaged about 18%. If tax rates were to revert back to levels prior to the Tax Reform Act of 1986, the tax savings that investors enjoyed during their working years could be more than offset by higher taxes in retirement (Figure 6). Estates are also taxed at historically low rates. The current maximum estate tax rate of 35% is much lower than the 55% maximum rate of 20 years ago. What s more, the current federal exemption amount of $5 million the amount of assets that can be passed free of estate taxes is more than eight times greater than the $600,000 investors could shelter in the 1990s. 1 Congressional Budget Office, Reducing the Deficit, Spending and Revenue Options, March

4 JANUARY 2012 Tax planning for 2012 and beyond Figure 6. Historical maximum U.S. federal tax rates, (%) Income: 35% Long-term capital gains: 15% 60 Tax rate Source: Internal Revenue Service, Figure 7. Taxes are poised to increase in 2013 Tax item Ordinary income 35.0% 43.4% Dividends 15.0% 43.4% Capital gains 15.0% 23.8% Payroll tax (employee) 4.2% 6.2% Estate and gift taxes 35.0% 55.0% Estate and gift tax exemption amounts It is unlikely that there will be a major tax deal completed before the November elections, which could lead to dramatically higher taxes for many investors in If Congress takes no action, and the Bush-era tax cuts are allowed to expire at the end of 2012, overall tax rates will increase, and a variety of tax-related provisions will change: $5.12M $1M Tax rates reflect highest marginal rate and incorporate additional taxes related to the health-care reform law. Health-care-related taxes include a surtax of 3.8% on net investment income and an additional 0.9% payroll tax affecting single filers with income in excess of $200,000 and joint filers with income in excess of $250,000. The chart assumes employee payroll tax rate of 4.2% is extended into Qualified dividends and long-term capital gains will no longer be taxed at the historically low level of 15% dividends will be taxed at higher ordinary income rates and long-term capital gains will be taxed at a maximum of 20%. Income limits on itemized deductions and personal exemptions will be reinstated, meaning these benefits will once again be phased out for higher-income taxpayers. The so-called marriage penalty, which had been eliminated by doubling the standard deduction for couples and adjusting tax brackets, will return. The maximum federal estate and gift tax rates will increase to 55%, with the exemption amounts decreasing to $1 million. The 10% income tax bracket will be eliminated. The 0% tax rate on long-term capital gains and dividends for taxpayers in the lowest brackets will be eliminated. Among education funding provisions, the American Opportunity Tax Credit will expire, the contribution limit for Coverdell Education Savings Accounts will revert back to $500, and student loan interest will no longer be deductible. 4

5 PUTNAM INVESTMENTS putnam.com There will be two new taxes levied on higher-income taxpayers resulting from the health-care overhaul that was passed in Additionally, there will be two new taxes levied on higher-income taxpayers resulting from the health-care overhaul that was passed in For individuals earning at least $200,000 ($250,000 for couples), there will be a 3.8% Medicare surtax on investment income such as interest, dividends, and capital gains above individuals or couples income threshold. 2 These higher-income taxpayers will also face an increase in Medicare payroll taxes from 1.45% currently to 2.35% (Figure 7). What to watch for in 2012 The failure of the congressional super committee to reach an agreement on debt-reduction triggered automatic, across-the-board spending cuts that are slated to be implemented over the next 10 years, beginning in January However, it is likely that legislation will be introduced to counteract these spending cuts, partly due to concern about reductions in defense spending. Prospects for changes in these automatic cuts may be remote since there are indications that the administration would oppose and potentially veto measures to delay or reduce them. In March, the U.S. Supreme Court will review the constitutionality of the 2010 health-care reform legislation, with particular focus on the individual mandate. The law currently requires individuals and families to obtain health insurance coverage by 2014 or face a tax penalty (up to $695 for individuals, $2,085 for families by 2016). If the high court rules that this provision is unconstitutional, it likely would have a profound effect on other aspects of the health-care law. Congress is expected to negotiate a full-year extension of the payroll tax cut, which was extended for two months in December At issue is continuing the current 4.2% payroll tax levied to fund Social Security, rather than allowing it to return to 6.2%, its rate prior to An extension of certain unemployment benefits 2 Net investment income is not applied to retirement plan distributions or municipal bond interest payments. and Medicare payments to providers (often referred to as the doc fix ) will be part of the discussions as well. Tax planning strategies for investors In light of these and other potential developments in 2012, and the risk of higher taxes in the future, there are a variety of tax-smart strategies that investors can incorporate into their overall financial plan. With the help of financial and tax advisors, investors are likely to find that many of the strategies discussed in this section of the report may help to reduce their tax burden and increase their net after-tax income. Strategy: Accelerate income While today s historically low tax rates remain available, investors may want to consider recognizing more income in One strategy for accelerating income is to convert a traditional IRA to a Roth IRA. Any type of tax-deferred IRA, including traditional, rollover, SIMPLE, 3 SEP, and SAR-SEP, can be converted to a Roth IRA. Taxes on the amount converted are generally due in the year of the conversion. After conversion, investment earnings compound tax free and can be distributed tax free during retirement. Additional ways to accelerate income include: Taking distributions from a traditional IRA (only advisable for investors over age 59½, in order to avoid the 10% tax penalty) Realizing long-term capital gains to take advantage of the 15% tax rate and avoid the 3.8% Medicare surtax beginning in This may be especially attractive to investors who own appreciated stock or mutual funds in taxable accounts, or are contemplating a major transaction such as the sale of real estate or business interests Business owners may want to consider increasing their salary, if feasible. It is critical to consult with a tax professional before accelerating income. 3 SIMPLE IRAs may not be converted until two years from the date the account owner first began participating in the plan. 5

6 JANUARY 2012 Tax planning for 2012 and beyond Strategy: Accelerate deductions In addition to accelerating income, it may also make sense for investors to accelerate deductions during 2012, since itemized deductions will not be phased out for higher-income taxpayers. Examples of ways to accelerate deductions include: Prepay mortgage interest or property taxes Make charitable contributions Schedule elective medical procedures if they will entail significant out-of-pocket expenses Bundle miscellaneous deductions together such as unreimbursed employee expenses, educator expenses, and expenses related to job searching An important caveat on accelerating deductions into a specific tax year: It is important to determine your AMT status. That is, if you are subject to the AMT, many common tax deductions, such as the deduction for property taxes, are unavailable. Mortgage interest is one of the few deductions available in calculating AMT liability and regular income tax liability. Strategy: Review estate plans Investors should consider reviewing their estate plans to ensure that all elements are in place and up to date. Are basic documents such as wills, powers of attorney, health-care directives, and revocable trusts drafted and current? Are beneficiary designations for retirement accounts, annuities, and life insurance policies up to date? Review existing trusts in light of the current $5 million federal exemption, recognizing that this threshold could be lowered in For many investors, 2012 may be an opportune time to consult with an attorney on more complex wealth-transfer strategies, such as those involving irrevocable life insurance trusts, charitable trusts, or grantor retained trusts. Strategy: Consider lifetime gifts for efficient transfer of wealth The $5 million exemption applies to lifetime gifts as well as transfers at death. As a result, in 2012, investors can gift up to $5 million in assets without paying gift taxes. Keep in mind that individuals may gift up to $13,000 per beneficiary ($26,000 for couples) annually without utilizing the lifetime gift allowance. Gifting assets now removes those funds, as well as any future appreciation, from an investor s estate, avoiding potentially higher estate taxes and lower exemption amounts in the future. Since the $5 million gift tax exemption is scheduled to revert to $1 million in 2013, affluent investors and families may benefit from completing gifts now. Strategy: Hedge against the uncertainty of future tax rates by pursuing tax diversification Tax diversification involves allocating assets across accounts and investment vehicles that are taxed differently taxable, tax deferred, and tax free. Taxable accounts include regular brokerage accounts, mutual funds held outside of retirement plans, savings accounts, and so forth. Tax-deferred accounts include traditional retirement accounts such as 401(k)s and IRAs, as well as annuities. And tax-free accounts/investments include Roth IRAs and municipal bonds. Depending on your tax situation and life circumstances, tax diversification offers several distinct benefits, including the flexibility to draw income from different sources to gain the most tax benefit (Figure 8). It also allows investors to hedge their portfolios against higher future tax rates, and may help assets last longer. Tax diversification does not assure a profit or protect against loss. 6

7 PUTNAM INVESTMENTS putnam.com Figure 8. Tax treatment of various types of retirement assets Type of asset/account Traditional retirement accounts (e.g., pensions, IRAs, 401(k)s) Roth IRAs and Roth 401(k)s Taxable investment accounts Social Security Taxability Taxable at ordinary income rates when distributed Contributions made with after-tax dollars; not taxed when distributed Capital gains and dividends: taxed at a maximum 15% rate Other income: taxed at ordinary income rates Return of principal: not taxable May be partially taxable at ordinary income rates Strategy: Invest in municipal bonds Higher tax rates will increase tax equivalent yields on municipal bonds. Additionally, affluent investors may want to consider an investment in municipal bonds since the interest on municipal bonds is not subject to the new Medicare investment income surtax. Conclusion Tax-smart strategies for investors during 2012 Accelerate income by converting a traditional IRA to a Roth IRA, taking distributions from a traditional IRA, or realizing long-term capital gains. Accelerate deductions by prepaying mortgage interest or property taxes, making charitable contributions, or scheduling elective medical procedures. Review your estate plan to ensure that all the necessary components are in place and up to date. Consider making lifetime gifts to take advantage of the $5 million federal exemption. Diversify assets across taxable, tax-deferred, and tax-free accounts and investment vehicles. Consider investing in municipal bonds to create tax-free income. Significant changes may be on the horizon in 2013, and investors would do well to keep a close eye on how such changes may affect their personal finances. As we have seen, there are numerous strategies that can help investors manage their assets in the most tax-smart ways possible. We encourage you to work closely with your financial advisor and tax professional to find ways to benefit from the continued low tax rates in 2012, and to plan prudently for the risk of higher taxes after

8 JANUARY 2012 Tax planning for 2012 and beyond There is no guarantee that any proposals or plans discussed in this material will be implemented. The views and opinions expressed are those of the authors, are subject to change with market conditions, and are not meant as investment advice. This information is not meant as tax or legal advice and should only be considered a summary of complex tax rules. Please consult with the appropriate tax or legal professional regarding your particular circumstances and the suitability of these strategies before making any investment decisions. Request a prospectus, or a summary prospectus if available, from your financial advisor or by calling Putnam at The prospectus includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing. William D. Cass is a Senior Wealth Management Marketing Manager for Putnam. He is a Certified Financial Planner and holds FINRA Series 6, 7, 26, and 63 licenses. He has a B.A. from Tufts University and has been in the investment industry since he joined Putnam in Christopher P. Hennessey is a lawyer and CPA, and is a member of Putnam s Business Advisory Group. He holds a B.S. and B.A. from Babson College, a J.D. from Suffolk University Law School, and a LL.M. in Taxation from Boston University Law School. He is a member of the American Bar Association, the Massachusetts Bar Association, the Institute of Certified Public Accountants, and the Massachusetts Society of Certified Public Accountants. Putnam Retail Management One Post Office Square Boston, MA putnam.com II /12

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