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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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Equity securities prices may fluctuate in response to specific situations for each company, industry, market conditions and general economicenvironment. Companies paying dividends can reduce or cut payouts at any time.
Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally, the longer a bond's maturity, the more sensitive it is to thisrisk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduledmaturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amountoriginally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer.
Interest in municipal bonds is generally exempt from federal income tax. However, some bonds may be subject to the alternative minimum tax(AMT). Typically, state tax-exemption applies if securities are issued within ones state of residence and, local tax-exemption typically applies ifsecurities are issued within ones city of residence. The tax exempt status of municipal securities may be changed by legislative process, which couldaffect their value and marketability.
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