Heeding tax winds, advisers chart new financial tactics for clients

Potential higher levies on ordinary income, capitals gains and estates have revved up financial planning discussions, turning tax strategies into almost an obsession for investment advisers and their clients.

“It’s a conversation we have in every meeting,” said Karen DeRose, managing partner at DeRose Financial Planning Group.  

Advisers are engaging clients on the possible implications of President Joe Biden’s tax proposals that aim to collect more from companies, high earners and wealthy Americans to cover $4 trillion in human and physical infrastructure investments. 

“The risk of a change is so great, you can’t wait,” said Robert Keebler, owner of the CPA firm Keebler & Associates. “Most people don’t want to end up on the wrong side of an increase in the estate tax.”

Or of any other tax boost.

“The pending changes are enormous and require a lot of preplanning in 2021, assuming they go into effect in 2022,” said Robert Wermuth, senior partner at Legacy Planning. “Every one of those changes is going to cost my clients more money.”

Republicans almost certainly will be unified in their opposition and can sustain a Senate filibuster to stop legislation incorporating Biden’s spending and tax plans. If Democrats use a parliamentary maneuver called reconciliation to get around a filibuster, every one of the 50 Senate Democrats must be on board. Under that scenario, moderate Democrats who resist raising taxes would present an obstacle for Biden.

But for advisers and their clients, political prognostications of precisely what will pass is not as important as preparation for potential tax increases.

“Having the conversations early is paramount. You don’t want to be caught flat-footed if they do happen,” said Nicole Gopoian Wirick, president of Prosperity Wealth Strategies. 

FUNDING FAMILIES

In an April 28 speech to a joint session of Congress, Biden outlined his American Families Plan. The approximately $1.8 trillion package includes spending and tax breaks to expand childcare, nutrition, education and health care programs and establish national paid family and medical leave, among other initiatives. That’s on top of the $2.2 trillion American Jobs Plan the president announced weeks earlier that includes climate change prevention, transportation investments and elder care support. 

The plan would be funded by raising the highest ordinary income tax rate to 39.6% on income above $400,000 for a family. Capital gains would be taxed at the highest individual rate — plus a 3.8% Medicare surcharge on investment earnings — for households making more than $1 million annually.

Biden also would eliminate the so-called step-up in basis so that heirs would have to pay a capital gains tax on appreciation of more than $1 million on inherited assets. In his address to Congress, Biden said he wants the wealthy to pay their fair share of taxes to “reward work, not just wealth.”

“We’re going to get rid of the loopholes that allow Americans who make more than $1 million a year and pay a lower rate on their capital gains than Americans who receive a paycheck,” Biden said. “We’re only going to affect three-tenths of 1% of all Americans by that action.”

That puts clients of most financial advisers right in the cross hairs of the tax proposals and has advisers scrambling to come up with protection plans.

One of the most popular methods is a Roth IRA conversion. This occurs when funds are taken out of traditional individual retirement accounts and put into Roth IRAs. In this move, funds that were tax-deferred going into an IRA are removed, taxed and then transferred to a Roth account, where distributions can be taken tax-free. It’s a long-term play and clients must take a tax hit now to avoid a bigger one if they keep the money in a traditional IRA and are taxed on distributions during retirement.

Kevin Lao, founder of Imagine Financial Security, said Roth conversions are happening very frequently right now. 

“There’s no denying the math on it. Tax rates could stay the same, and you’re still better off” after a switch to a Roth, he said.

Most advisers and clients are convinced that tax rates are as low today as they ever will be again. For one thing, regardless of whether Biden’s tax proposals are approved by Congress, many tax breaks incorporated in the 2017 tax reform law will sunset in 2025.

Beyond that, the government has spent about $5.3 trillion on pandemic relief and economic stimulus, and the federal debt has reached record levels. Taxes eventually will have to go up, advisers have concluded.  

“It’s not ‘if,’ it’s ‘when,’” said Noah Rosenfarb, founder of Freedom Family Office.

Wirick recommends some clients combine a Roth conversion with a contribution to a donor-advised fund. In a DAF, an investor can combine several years’ worth of charitable donations, get a tax break and then distribute the money over a number of years.

“The two strategies paired together are really nice for a client with a charitable intention,” Wirick said.

SUNSET PROVISIONS

Although Biden didn’t propose lowering the estate tax exemption from the current $11.7 million level for individuals, it is headed down to about $5 million in 2026 thanks to a sunset provision in the 2017 tax-reform law. Rosenfarb recommends some clients use a spousal lifetime access trust as a strategy to reduce estate taxes. Under a SLAT, one spouse sets up an irrevocable trust and makes gift payments into the fund for the benefit of the other spouse, who can access the money tax-free.

“The estate tax is optional if you’re willing to do the planning,” Rosenfarb said. “If you have $50 million or less, you can get around the estate tax.”

Some advisers are recommending irrevocable life insurance trusts to minimize estate tax exposure. Under an ILIT, a client gifts money to a trust that then buys a life insurance policy. The death benefit paid out by an ILIT is not subject to state or federal estate taxes. Steve Resch, vice president for retirement strategies at Finance of America Reverse, is a believer in ILITs, which he said are enjoying a resurgence in popularity.

He also recommends reverse mortgages to reduce estate tax exposure. He said that it makes sense to tap home equity, for instance, to pay the tax bill incurred by a Roth conversion.

“It’s a very interesting strategy that is beginning to take off,” Resch said. “You’re basically leveraging an asset that’s really not doing that much for you other than giving you a place to live, and using it to enhance and protect your estate down the road.”

During his presidential campaign and his first months in office, Biden has emphasized that he will raise taxes only on people making more than $400,000. In a May 2 interview on NBC’s “Meet the Press,” Treasury Secretary Janet Yellen said that amount applies to a household. The $400,000 threshold is central to many conversations about client income and how it can be managed.

An income of $400,000 “is not that wealthy today,” DeRose said. “Trying to get under the 400 is important.”

With tax increases looming, people who have the potential to make a lot of money in a given year through the sale of a business or some other event should plan carefully,  Keebler said. “The key to this is smoothing out income.” 

Taxes are becoming so important that Wermuth recommends hiring a tax manager, which is an investment management firm that specializes in reducing tax costs in portfolios. He said their input on how to lower a tax bill pays off.

“It’s a material difference,” he said. “It will bring true extra return for the client.”

Of course, not all investment decisions can be based on the tax implications. 

For instance, Glen Goland, a senior wealth strategist at Arnerich Massena, said he is helping his clients sort out whether to sell or hold stocks based on their own investment time frames and the potential direction of the capital gains tax. But the final decision is made based on the value of the holding.

“We want to look at the investment first, and whether we believe in the underlying investment, and the tax implication second,” Goland said. “We try to remind our clients to keep their perspective. For most investors, this stuff is at the margin.”

Despite the intense focus on tax increases over the past few months, some advisers are letting the political dust settle before making moves, such as gifting assets, that can’t be undone.

“We’re taking a wait-and-see approach,” said Brett Fry, a wealth adviser at Forteris Wealth Management. “We’re trying to keep our clients from having a knee-jerk reaction to what they’re reading in the media.”