By Carolyn S. Ellis
Jim Johnson, JD, CLU, ChFC, is vice president of Advanced Sales at Allianz Life. He assists financial professionals in meeting their clients’ goals for financial, estate, and retirement planning. We spoke with Jim about The American Taxpayer Relief Act and its impact for agents and advisors.
L&HA: With new tax legislation signed by President Obama on the books, Americans and their financial professionals are facing many changes.
JJ: Think of it this way: “Out of complexity comes opportunity.” We were in crisis mode on December 31, and now we have complexity mode. There’s no level of income or wealth that isn’t affected by what is called The American Taxpayers Relief Act of 2012. Note the word simplification is not in that title. Some of the things in the Act affect 2012 taxes. The rest are 2013 and ongoing, and while the Act calls them permanent they could always be changed by Congress.
L&HA: What opportunities are here for financial advisors?
JJ: Tax losses, that is, paying more taxes than necessary because of poor planning, reduce overall net worth. Early this year make contact with clients and begin working with them and their CPAs or other tax advisors to determine how they should take income for the least tax impact. In my view this is the future of the financial planning industry.
L&HA: What are the key issues with the new tax act?
JJ: There are at least five trigger points for different taxation. Starting with the FICA payroll tax, its level is $113,700 on which we all now pay 6.2% if we’re an employee. Consider this the termination of the 2% FICA “holiday” we had; the rate was 4.2% last year. The Medicare tax increase of 0.9% comes on top of the 1.45% for a total of 2.35% for high-income earners. It kicks in for singles at $200,000 and for married couples, at $250,000. That’s missed by a lot of advisors. Additionally, the top income bracket has a tax of 39.6%; this was what Congress was trying to get for the tax on the wealthy. That kicks in at $400,000 for individuals and $450,000 for joint married.
L&HA: Where are we with the personal exemption phase-out (PEP)?
JJ: PEP limitations supposedly apply only to high income earners but they kick in at $250,000 for single and $300,000 for joint. (Here we’re pushed back to those magic numbers $250,000 and $300,000 that we heard all through the election cycle.) Under the phase-out, the total amount of exemptions that can be claimed by the taxpayer will be subject to a limitation which is reduced by 2% for each $2,500 or portion thereof over adjusted gross income (AGI). For a married couple with $300,000, that 2% for each $2,500 actually phases out at $425,000. They wouldn’t have any personal exemption at all.
The PEASE impact, which is really the itemized deduction impact, also kicks in at $300,000 for married couples. The allowable deduction is reduced by 3% of the amount the AGI exceeds the threshold. For these taxpayers, allowable deductions of $50,000 (home, charity, etc.) move to a standard deduction of $12,200 at approximately $1,600,000 of AGI. It’s complex, so clients need to start planning in January or February their deductions for the year.
L&HA: Let’s hope for capital gains. It’s not quite so complex.
JJ: Taxpayers who are subject to 25% or greater rate on ordinary income but who fall below the $400/450,000 thresholds will still be subject to the 15% rate on capital gains and dividends. In the $400-450,000 bracket capital gains are at 20% and with the 3.8% Medicare tax, investment income could be taxed as high as 23.8%. Each threshold of income may result in another issue. It is more complicated than this without defining the “applicable income tax bracket,” and that is why it’s important to have the tax advisor included in the planning prior to the sale of capital assets when capital gains could be taxed at the highest level.
L&HA: There was tremendous concern about the estate tax.
JJ: First the good news. The $5 million exemption was originally going to go back to $1 million, but surprise, they kept it at $5 million. And they indexed it, so for 2013 it’s at $5.25 million. Portability is still a feature, so the estate of the first-to-die can transfer his or her unused exclusion to the surviving spouse. The bad thing is the tax rate went from 35% to 40% (above the exclusion amount).
L&HA: These provisions must affect clients in different ways.
JJ: We’re looking to three levels of clients. The first level is a client with moderate wealth, under $10 million. There are a lot of people with $2-3 million as a family, who don’t own a business but have enough assets for retirement. Advisors should work with their attorneys to get the proper credit shelters and things of that nature should they want to do planning for siblings and others.
Look carefully at the second group, the potential high net worth class. I’ll use myself as an example. With an exemption of $10 million, my wife and I won’t be subject to federal estate taxes. However, we live in Minnesota which like many states has decoupled their state estate tax from federal levels and has a $1 million exemption. Advisors have to keep that in mind.
For folks who are ultra-high net worth, their attorneys, CPAs and advisors will have to use all the tools they can — asset protection planning, divorce planning, and so on. Trust-owned life insurance, irrevocable life insurance trusts, and things of that nature will always be important.
L&HA: Where do annuities fit in the picture?
JJ: Annuities in a qualified environment have always been used for the protection they afford and the guarantees. For folks with lots of non-qualified money, the tax drag inside annuities is still extremely good when you take in the combination of all of these different taxes out there today. We suggest life insurance with tax deferral of cash values and annuities; these can be especially helpful for the right client.