Potential Tax Changes & Their Implications

Over the last six months, a good deal of our time has been spent studying the implications of the many tax proposals that were circulating. From the American Jobs Plan, the Made in America Plan, the 99.5% Tax Act, and others, it is still possible that some tax plan will be passed soon. The critical task for us is to better understand what the implications are and what, if anything, should be done ahead of their passage.

We must accept that funding at the level needed to get us through COVID and now infrastructure improvements will require tax increases. It would seem that Congress was looking to fund the proposed plans using sales tax (example, gasoline tax) but this would impact those earning less than what President Biden promised he would target. There seems to be some agreement on taxing businesses at 25% rather than the current 21% (though 29% is still being discussed). Close to 140 countries agreed in October on a global minimum corporate tax rate of 15% targeting the largest international firms, so that’s already baked in. Other items being considered have large implications for those who earn over $500K a year and who have a large taxable gain (home or portfolio). Those expecting to sell a business or a home with a large gain may need to prepare for alternative ways to lower their taxable income or accept the large one-time tax liability.

Current proposals include long-term capital gains taxed at 43.4% from the current maximum of 23.8% (plus state) for those in the higher tax brackets. A change in the step-up in basis on death is also likely since it makes sense with increased capital gains taxes. This is expected to apply to couples with income over $1M (singles are likely to be at $500K income). Keep in mind, if you sell your home or your business you may find yourself in these higher brackets and therefore pay taxes well over 50% of the gain in one year, making it very important to plan for single-year large capital gain realization (for the time being, there is no exception for single-year events).

These proposed changes encourage us all to annually consider the use of Roth conversions, 401K Roth contributions, charitable planning (Donor Advised funds) and estate planning strategies.

Edi Alvarez, CFP®


Tax Planning: Year-End Items to Consider

Tax planning consists of ensuring that tax liability is appropriate (given the tax code, family finances, and family goals) and that required actions are completed by the deadlines. At year-end, we identify relevant actions and relevant timeline.

Current Year actions …

  1. Estimate total earnings and total tax withholdings along with any tax-deferral that has or will be made for the current year. Use these and your deductions to estimate Federal and State tax liability.
  2. Ensure that expected tax liability has been paid either through payroll or through estimated tax payments. It is always best to pay taxes through payroll.
  3. For the self-employed, estimating taxes and ensuring that enough but not too much tax is paid throughout the year is part of tax planning. This is particularly important for businesses that have no payroll and pay their income tax and self-employment tax (i.e. Medicare and Social Security) simultaneously. Without tax planning, it is common for these businesses to underpay their Federal tax liability.
  4. Again, estimating profit from business entities (S Corp, C Corp, LLC, or sole proprietorship) allows business owners to adjust cash flow and meet tax deadlines. Business owners often create or contribute to various tax-deferral plans. The largest pre-tax contributions are for plans that have to be created prior to year-end.
  5. Any deductible contributions to H.S.A., Traditional IRAs or other accounts need to be made by their specific deadlines. These contributions might lower taxable income today (Traditional IRA, pension and 401K) or be tax free in the future (Roth) or both tax free now and in the future (H.S.A.).
  6. Year-end provides an opportunity to harvest investment accounts and therefore reduce or increase capital gain. Capital gain can be countered against capital losses to provide a net gain or loss which will either increase or decrease tax liability for any given year. We can reduce tax liability by adjusting what we buy/sell (i.e. the lot) at year-end depending on the overall tax burden. Keep in mind that tax rates differ based on taxable income. The federal tax rate for gain can be from zero to 23.8%.
  7. Estimating overall tax liability prior to year-end allows families to adjust deductions and employers to make needed capital purchases before year-end.

Actions based on next year’s rules …

Since we don’t yet know the tax rules that will apply in 2018, it will be especially difficult to fulfill the second part the year-end tax planning (where we either act or defer actions this year based on comparing the tax code in both the current and coming years).
Based on the two tax proposals (House and Senate versions) we consider acting prior to year-end if there is a high probability that a tax advantage will be lost in the new year and it plays a significant role in the person’s finances.

Though neither proposal appears to “simplify” taxes, both bills make significant changes to current tax rules and may, in fact, make it ideal to take some actions before the end of 2017 (taking advantage of current rules), while delaying those that benefit from the rules in the new year.

It will now be the job of the legislative committee to reconcile the differences without inserting any new provisions which will then need to go to the House and Senate for final approval. It is still too early to take action according to one or the other proposal but exploring the impact in light of individual tax circumstances makes sense.

  1. It may be worth considering accelerating itemized deductions into 2017 that are targeted for elimination. For example State income tax is scheduled to disappear in both proposals. Nevertheless, consideration must be given to unique situations, particularly regarding AMT (Alternative Minimum Tax).
  2. Consider recognizing tax losses prior to year-end (which is a normal annual year-end tax action) but the ability to select tax lots may disappear in 2018. The new rules may require that sales “first-in-first-out” (FIFO) which results in higher tax liability as it recognize higher gains on the sale of a security. We are hoping FIFO will not survive the reconciliation process but if it does we’ll have to act quickly before Dec 31.
  3. If you are planning to transfer very large assets between family members you would be well advised to wait until 2018 when there is an increased tax exemption. This doesn’t change the annual gifting which is currently at $14K in 2017 (and will be $15K in 2018).

Though we all want to contribute our share of taxes to sustain our communities and our way of life, it is always prudent to annually evaluate and implement the best way to handle tax liability considering current and future implications.

Edi Alvarez, CFP®


Tax Penalty/Bonus? – Single, Married, Domestic Partnerships

After nearly thirty years of marriage, I would be the last person to suggest that
tax consequences are a reason for making a lifelong personal commitment. On
the other hand, I am often the first to point out that marriage is not always a
tax neutral activity. Some people work on the expectation that a “married
filing jointly” (or MFJ) tax filing will always result in a lower combined tax
liability and a marriage tax bonus (meaning taxes are reduced solely due to
filing as MFJ). They are surprised when this joint filing actually creates a
marriage tax penalty (meaning filing MFJ results in higher taxes).

So when should we expect a penalty or bonus? The literature describes that ‘in
general’ we see a tax bonus when two partners have disparate incomes and a
tax penalty when they have similar or equal income. Based on the literature I
expected that income splitting (as occurs in a domestic partnership tax filing)
could provide an additional tax bonus over MFJ since disparate incomes can
be split evenly between partners.

While exploring the new 2013 tax rules we examined some tax scenarios and
want to share some highlights with you. We found that starting at a combined
AGI (Adjusted Gross Income–the number at the very bottom of the 1040
form) of $230K filing as MFJ resulted in a tax bonus of about $2K IF the two
people had disparate incomes ($200K and $30K respectively) but a penalty of
$2K for those with similar incomes ($115K each). Therefore at this level of
AGI couples with disparate incomes do slightly better under MFJ and those
with similar AGI do slightly better filing as individuals.

With a joint AGI of $330K the single disparate earners ($300K and $30K)
receive a marriage tax bonus of about $3K. If the same joint income was
earned evenly ($165K each) they would pay $4K more filing as MFJ than as
two individuals (a $4K tax marriage penalty). Looking at these scenarios, it
became clear that those with similar incomes would annually save thousands
of dollars if they filed as individuals rather than MFJ (Note: this is not the
same as married filing separately but rather unmarried individuals). As a
corollary, those in a domestic partnership may want to verify that they will not
have a large tax increase if they marry and file as MFJ.

Finally we looked at a couple with a $530K AGI who will pay $143K in taxes if
they file as two individuals with disparate incomes ($500K and $30K) and
taxes will be about the same if they file under MFJ (there is about a $1K tax
bonus). We do see a large tax penalty if this income was earned evenly by two
individual filers ($265K each) and they file MFJ. As two individuals the tax
burden would drop by at least $15K.

Marriage does provide non-income tax related advantages for spouses and
the family which are not discussed here.

Once you consider tax consequences of marriage, domestic partnership or
single tax filings any decision you make will work as long as you make plans to
cover the marriage tax penalty or find ways to spend the marriage bonus.
The above analysis assumed that ‘itemized deductions’ were kept constant and
that there was no AMT. These were modeled tax estimates – please consult
your tax preparers for the specific tax impact in your situation.

Edi Alvarez, CFP®


Tax Season and the Retiree

Tax Season and the Retiree

There are a lot to contemplate when considering the state in which to retire. Most want to be close to family and friends, the weather to be suitable for them, and what they hope to do in terms of activities.  A consideration this time of year are taxes — one of life’s two certainties and, one often a large expense in retirement.  It is never a good idea to seek out a retirement state based solely on tax burden but it is good to be aware which states fit your plans best for retiement.

So, find out how each state taxes your income and plan accordingly. Also consider how the state taxes your property and your consumption and you might want to consider how it taxes your estate.  That should give you a state tax burden that you’ll need to cover during retirement.

Older Americans who planned for retirement often generate income from several sources during retirement, including income from wages or self-employment; Social Security; pensions; and personal assets, including taxable and tax-deferred accounts. Taxes on those sources of income, mean less money for your care and enjoyment.  But don’t forget state and local property taxes, state and local sales and use taxes. You might pay plenty in property taxes and sales taxes.

Remember, what you save on income taxes in one state you might pay in property taxes or sales taxes. And vice versa. What you save on property and sales taxes in one state you might pay in income taxes – so calculate for your specific retirement situation.

One more note, for those who itemize deductions, there are five types of deductible non-business taxes, including state, local and foreign income taxes; state, local and foreign real estate taxes; state, and local personal property taxes; state and local sales taxes, and qualified motor vehicle taxes.

Your specific tax burden, will depend on whether you can take advantage of these deductions.

The states are listed in order of tax friendliness from an overall tax burden point of view:

1. Alaska:  Alaska doesn’t tax personal income, including Social Security benefits and pension income. And, there’s no state-imposed sales tax. This is not to say that you won’t pay any taxes in Alaska – You’ll pay other types of taxes, such as property taxes.

2. Nevada: This state doesn’t tax income, Social Security benefits or pension income. And its property taxes are reasonable, too. Its sales tax, however, is higher than the national average.

3. South Dakota: The state doesn’t tax individual income, Social Security benefits or pension income. And the overall tax burden is among the lowest in the nation.

4. Wyoming: There’s no individual income tax on Social Security benefits or pension income in Wyoming but property taxes and sales taxes tend to be higher than the national average.

5. Texas: In Texas, there’s no individual income tax. But property and sales taxes tend to be higher than the rest of the nation.

6. Florida: There are plenty of reasons why people choose to retire to the Sunshine state, the low tax burden being among those reasons. There’s no individual income tax on Social Security benefits or pension income with high property and sales taxes.

7. Washington: There’s no individual income tax on Social Security benefits or pension income. But if you plan on spending lots money while in retirement watch out for the high sales tax.

Edi Alvarez, CFP®


Fixed Annuities – apply them with care

Fixed Annuities
– A limited but essential role in some retirement plans

Fixed annuities represent a contract between an individual and an insurance company. Annuities provide a contractual way for an individual to guarantee that he or she receives income for life or for a set period of time. Other liquid financial products like equities, can pay dividends that can be used as retirement income the income is not guaranteed. A fixed annuity will guarantee an individual a stream of income as long as he or she lives or for a set number of years.

Sometimes you can start with Deferred Fixed Annuities

Like all annuities, except those that are immediate, deferred fixed annuities have two phases. The first phase is the accumulation phase. During this phase, which can be as short as a few years or as long as several decades, the annuity owner makes regular deposits into the account. These deposits are known as premiums.

All premiums contributed to a deferred annuity grow tax-deferred which means that the growth income received at retirement will be taxed as ordinary income.

When an annuity owner, who is known as the “annuitant”, decides to have distributions start, the annuity is “annuitized”. This is a critical process that converts it to an immediate annuity and you begin receiving payouts. The distributions can be paid monthly, quarterly or annually, depending on the preferences of the annuitant. An annuitant should think about his or her distribution schedule very carefully, because once it starts, it cannot be changed. An insurance company will also typically let the annuitant choose the length of time over which the distributions are paid. Guaranteed payments can be taken for life or for a specific number of years. This selection will affect the amount of each payment.  Life annuities are the only ones that will give the promised guarantee life long income.  Consider that life long income may not support your current lifestyle particularly in high inflationary periods.

Under current federal tax law, an annuity owner cannot begin taking payouts on a tax-deferred annuity prior to age 59 ½ without incurring a 10% penalty. Any tax-deferred annuity must begin in the year in which the annuitant turns age 70 ½.

What are Immediate Fixed Annuities?

An immediate fixed annuity is funded with a single premium. The premium is typically after-tax money paid as one lump sum. You can also set this up from a mandatory distributions taken on a qualified account. The distributions made by the life insurance company begin immediately, typically within 12 months of the start of the contract.

Immediate Fixed Annuities Pros and Cons

The return % paid on fixed annuity is always fixed. It could change year over year, but once it’s set for the year it will not change regardless of stock market fluctuations. This can be of great help to those on a tight retirement budget unless the market rises and therefore inflation rises. The advantage will be that you’ll know exactly the amount of each payment that will be made. While the rate paid on a fixed annuity could vary from year to year, most insurance companies will guarantee a rate of between 3% and 5%. It’s important to note, however, this guaranteed amount might not be enough to offset any cost of living increase. Inflation is a real and significant threat to retirement savings.  It is best to do immediate annuities when interest rates are high.

You could purchase a COLA (cost of living adjustment) rider that adjusts with inflation to retain some of your future purchasing power. The COLA rider is a costly component of  a fixed annuity contract, but it will increase the amount of money that is paid out each year. The amount should be enough to counteract measured inflationary pressures.  If you can afford the COLA you might consider it or consider leaving a portion of your assets in an equity portfolio so that it growth with the economy and provides a real inflation hedge.

For some, another risk factor associated with a fixed annuity is the premature death of the contract owner. If an annuitant dies before he or she has been repaid the amount he or she paid in premiums, the insurance company will keep the balance. To offset this, most insurance companies now give a guarantee of some sort on the premium.  For example, if the annuitant has an annuity worth $300,000 and dies after having only received $50,000 back, the beneficiary will receive the remaining $250,000. Or, the annuitant can choose an option called “period certain”. If he or she chooses a period of 20 years but dies during year 10, the beneficiary will receive payouts for the remaining 10 years.

I only consider premature death an important risk factor if you have beneficiaries or a legacy you want funded.  Even so, there are other ways to cover this risk factor than to purchase this type of rider – particularly if you still qualify for life insurance.

Who Should Buy Fixed Annuities?

Retired investors who need to guarantee income for life or for a set amount of time are often advised to consider a fixed annuity. Retirees who rely on equity dividends for most of their income may also want to consider a fixed immediate annuity. Dividends can provide substantial income but are not guaranteed. They can be cancelled by the company at any time should it need to conserve cash.

A retired investor may also fear that he or she will outlive the money he or she has saved. An immediate fixed annuity will also provide financial security. The payouts will be guaranteed for as long as the annuitant is alive, regardless of the amount of the premium. Even when the amount of the payouts exceeds the premium, the insurance company is obligated to make the payouts. For those in good health with few liquid assets, a fixed annuity could make a difference in their standard of living BUT they are extremely costly and impossible to exit gracefully if your situation changes.

A fixed annuity investor should always make sure he or she has enough cash for emergencies. As outlined earlier, an annuity contract cannot be cancelled except under the extreme circumstances. Once the contract is signed, the only way an investor can receive his or her money is through the payouts.

Consumers are strongly encouraged to purchase annuities only after a thorough analysis by a NON annuity sales financial professional.  This is a major investment that once signed can’t be undone – read the fine print and understand the nuances and their impact on your entire retirement before you sign.

Edi Alvarez, CFP®