2013 tax reform update

7/29/2019 2013 Tax Reform Update

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Keeping an Eye on Tax Reform March 2013

Though changes are on the horizon, there is much that can be donetoday to help clients maximize available opportunities, say JanussMatt Sommer and Morgan Stanleys David Kemps

With major budget issues driving the short-term agenda inWashington, well soon see whether Congress is willing to

work in a bipartisan fashion on big issues like tax reform,

says David Kemps, executive director of tax and retirement

at Morgan Stanley. But there are things we can anticipate,

he notes, and things Financial Advisors and their clients

should be thinking about now. Matt Sommer, director of

the retirement strategy group at Janus, believes its a good

time for clients to review their current portfolios with an eye

toward achieving the best possible aftertax returns, using

both asset allocation and asset location to control what you

can control. Sommer and Kemps recently spoke withMorgan Stanleys Tara Kalwarski about how they see

Washington budgetary issues affecting tax reform and

retirement plansand what kinds of tax opportunities clients

can take advantage of now. The following is an edited

version of their conversation.

TaraKalwarski: Theres a lot happening in Washington

right now. What will it all mean for tax reform in both the

short and long term?

DavidKemps: The entire budgetary process kicked off with

the imposition of sequestrationthe automatic cuts across

discretionary spending for defense and non-defense

functions within the federal government that went into effect

on March 1. Combine that with the March 27 expiration of

the continuing resolution that currently funds the daily

operations of federal agencies, and it means that Congress

has to act or the federal government will shut down for lack

of funds to run day-to-day operations.

Then you have the debt-ceiling-limit suspension put intoeffect in February. It runs through May 18, at which point

Congress must again address the debt-ceiling limit or risk a

government default on its obligations.

These dates are important because the actions around them

will not only dictate what happens on the budgetary front

with regard to the federal government and federal

operationsthey will also tell us whether Congress is

willing to work in a bipartisan fashion on some other big

issues, like tax reform.

Short term, these major budget issues are going to drive the

agenda in Washington. However, there is also the long-term

fiscal issue of entitlements eating up a greater share of the

federal budget every year, and Congress must at some point

address the revenue needs, coupled with spending reforms,

that will be required to help maintain the solvency of those

programs and the benefits they promise.

Were going to need some sort of tax reformwhether its

goal is increasing revenue to help fund changes to the

entitlement programs or whether its designed to foster

economic growth, which proponents will say brings inadditional revenue that can help with some of the problems

were anticipating with entitlement programs.

Kalwarski: Where are taxes today compared with where

theyve been historically? Is it fair to assume that over the

long term, individuals can expect higher taxes?


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Kemps: The conventional wisdom is that taxes will be going

up in the coming years, although that is not an absolute

certainty.

As for tax reform, the goal of the chairman of the House

Ways and Means Committee, Dave Camp of Michigan; and

the chair of the Senate Finance Committee, Max Baucus of

Montana; is to simplify the tax laws and, to the extentpossible, actually lower marginal tax rates on individuals

and on corporations.

But in order to pay for it in a revenue-neutral fashion,

meaning the federal government takes in the same revenue

as it did before tax reform, the idea is to lower the marginal

tax rate but broaden the base. So I think youre going to

potentially lose a lot of deductions, exclusions and

exemptions you currently enjoy today.

Im not sure the tax-writing committees view increases in

tax rates as a priority; they view increasing revenue as the

ultimate goal. And in their view, its not achieved through

increasing rates but through economic growth fostered in

part by a much simpler Internal Revenue Code.

Kalwarski: How are taxes different for individuals in 2013

compared with 2012?

MattSommer: The American Tax Relief Act of 2012,

enacted on Jan. 2, in effect maintained the current rates for

approximately 99% of the population. For married couples

whose adjusted gross income is greater than $450,000, somethings have changed: The 39.6% rate has been reintroduced

on income above those thresholds, up from last years 35%.

Also, the long-term capital gains rate of 15% has increased

to 20%.

One other tax that was part of the health-care legislation

enacted in 2010 is a 3.8% surtax on whats called net

investment income, or NII [consisting of capital gains,

dividends, interest, royalties and passive income]. The tax

does not apply to IRA distributions, pension distributions or

muni-bond interest. The 3.8% tax will apply on the lesser of

a taxpayers NII or the amount of his or her modified

adjusted gross income that exceeds $250,000 if married or

$200,000 if single.

Higher-income taxpayers are also looking at the return of the

phase-out of itemized deductions and personal exemptions.

It kicks in at $300,000 if youre married.

Now is a good time to take another look at your portfolio

and what investments are held in different types of accounts

so you can achieve the best possible aftertax returns. What

matters is aftertax cash flow, not pretax investment balances.

Kalwarski: What tax strategies should Financial Advisors

and their clients think about for the short term?

Sommer: One good strategy for 2013 is the qualifiedcharitable distribution for IRA clients who are 70 or older.

It allows people in that age group, who are subject to

required minimum distributions, to essentially gift

distributions up to $100,000 from an IRA to a charity of

their choosingwithout having to recognize that

distribution as income. That is set to expire at the end of

2013.

Also for 2013 only, there are provisions the legislation

extendedbecause they were set to expire in 2012that

allow business owners quicker write-offs or depreciation of

capital investments so that the business can reap the tax

savings sooner.

There is some good news on the gift and estate-tax exclusion

that was scheduled to revert to $1 million in 2013 from

$5.12 million. The applicable exclusion has been made

permanent at $5.25 million per person, indexed for inflation.

We know that the top tax rate is 40% for purposes of gift,

estate and generation-skipping transfer taxes. We also know

that spousal portability has been made permanent.

Kalwarski: How do you see tax reform and the budgetaryprocess in Washington affecting 401(k)s and other

retirement plans?

Kemps: Though I dont see anything happening till later this

year or early next year, one proposal, put forward by the

National Commission on Fiscal Responsibility, otherwise

known as Simpson-Bowles, was to impose limitations on the

ability to put money into a single unified 401(k)-type plan

the limit being the lesser of either $20,000 or 20% of ones

pay. Proposals like these are out there primarily as a way to

not go after, but to impose changes on, some of the larger

tax expenditure itemsthat is, those provisions in the IRS

code that cause the federal government to lose revenue

today.

On the retirement side, its just deferred income or deferred

tax revenue, so its not permanently lost like some other tax

expenditure items. But nonetheless, its a substantial hit to

federal coffers today, and that makes it an attractive target in

tax reform.

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If Congress does take a serious look at tax reform, and if

everything is on the table in order to achieve lower marginal

rates, then you could see retirement plans on the deferral

side actually imposing limitations on your ability to put what

today is a pretty generous amount into your 401(k), 403(b)

or 457 plan.

An idea thats also been around a long time is to consolidatea lot of those plans into a single 401(k)-type feature. I know

theres an effort underway by folks in the retirement industry

to essentially carve out from any tax reform proposal any

changes to the retirement side, especially on contribution

limits. But this idea of a single type of retirement vehicle is

also receiving some consideration. However, as with the

idea of limitations on contribution limits, consolidation of

retirement plans is not being met with overwhelming

support.

There will certainly be discussions about how we go about

doing tax reform in a way that is fair to everyone but that

also makes adjustments to various tax expenditure items that

allow us to have a much lower marginal rate. But at the end

of the day, I dont think retirement plans will be affected by

tax reform.

Kalwarski: Does reviewing current portfolios present any

tax-advantaged opportunities?

Sommer: Financial Advisors and clients are very familiar

with asset allocation and what goes into it. But a less

familiar subset is something we call asset location, which islooking at what sorts of investments you hold in your

various taxable as well as tax-deferred accounts.

Heres why this discussion is so important. Lets start with a

taxable bondgovernment or corporate. That bond pays

interest, and whether it is held inside a tax-deferred account

like an IRA or inside a taxable account in your own name,

the interest is subject to ordinary income taxes. So for people

at the high end, thats now 39.6%, and the 3.8% net

investment income [NII] surtax. Now think about a stock. If

you buy a stock inside of a retirement account like an IRA or

401(k), when you ultimately take a distribution, again you

pay ordinary income taxes. But if the stock was bought in

your own name, or joint name if youre a couple, then as

long as the investment has been held over a year, the sale of

the stock would constitute a long-term capital gain, with

profits taxed at the more favorable 20% for individuals in

the 39.6% ordinary income tax bracket.

What we suggest Financial Advisors and clients think about

is using tax-deferred accounts for things like fixed income,

REITs, and what I call actively managed investments

maybe a mutual fund that has a really good performance and

track record but had high turnover so it tends to kick out

capital-gains distributions toward yearend. And use your

taxable accounts for things like buy-and-hold strategies, tax-

efficient investments, where you can capture the morefavorable, long-term capital gains rateperhaps mutual

funds with low turnover and even foreign investments where

youre able to take advantage of the foreign tax credit. If you

hold those foreign investments inside of a tax-deferred

account, that credit is likely going to be lost.

Many clients have the majority of their wealth in either a

tax-deferred account or a taxable account. So you do your

asset allocation based on the clients risk tolerance, goals

and objectives. But there may not be much of an opportunity

to consider asset location. But for clients who have tax-

deferred money as well as taxable money, one way to

maximize aftertax cash flow is not to stop after asset

allocation but to give additional thought to asset location.

Kalwarski: Do you have any parting insights?

Kemps: My one parting thought is to keep an eye on tax

reform as a component of reforming the budgetary process,

including its role in helping to raise the revenue necessary to

meaningfully reform entitlement programs like Social

Security and Medicare. If tax reform does not become part

of budgetary/entitlement reform, look toward the end of thisyear for fundamental tax reform to start emerging from the

House Ways and Means Committee, where theyll be

focused on corporate taxation and individual taxation. Watch

what theyre proposing as a way to achieve much lower

marginal rates. A lot of the items investors enjoy today

such as the mortgage-interest deduction, the exemption for

state and local muni bonds, charitable giving, things near

and potentially dear to a lot of taxpayerscould be on the

table in a tax reform proposal that achieves, say, a 25%

individual tax rate as the highest rate.

Sommer: Control what you can control. There are a lot of

changes on the horizon. But there are many things that can

be done today to help maximize available opportunities.

Investors can put $17,500 in their 401(k)s, and an additional

$5,500 if they are over 50. They can put $5,500 in a

traditional IRA or a Roth IRA if they are eligible; if they are

over 50, they can put in $6,500. Business ownersthrough a

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Simplified Employer Pension (SEP) plan or a profit-sharing

plan can put even more money away.

It doesnt look as if the health-care legislation is going to be

repealed, so well now have to deal with the 3.8% surtax on

net investment income. Pay some attention, particularly on

the fixed-income side of the portfolio, to the benefits of

muni bonds vs. taxable income.

On estate planning, we already talked about the certainty. At

a minimum, it warrants a conversation between the Financial

Advisor, the client and the estate-planning attorney to see if

any changes need to be made.


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Tracking No. 2013-PS-190 03/2013

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2013 tax reform update

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