A once-in-a-lifetime opportunity is about to befall astute advisors and their
clients. In 2008, certain investment income will be taxed at the 0% rate. While
not everyone will be able to take advantage of this windfall, many of your
just-retired or soon-to-be retired clients may be able to realize thousands of
dollars in tax savings.
The years 2008 through 2010 will bring a reduction in the capital gains tax
on net capital gains and qualified dividend income to those taxpayers lucky
enough to be in the 10% to 15% marginal federal tax brackets. Review these
planning tips to identify those clients most likely to benefit from this 0% tax
rate.
Tap income sources wisely
Your client is planning to retire early next year and is asking you for
advice on what available sources of income he should use for his first few
golden years. Like many prospective retirees, he could tap his Social Security
benefits, take distributions from his retirement plans, spend his dividends and
interest, or sell off investments and spend the gains.
For those clients with few or no pension benefits, their choice of income
source will dictate their tax situation. If they choose to delay distributions
from retirement plans and Social Security, they may be able to create a 15% tax
bracket for three years. In 2007, taxpayers in the 10% to 15% brackets pay 5%
capital gains tax for net capital gains and qualified dividends. Beginning in
2008 through 2010, the 0% rate for net capital gains and qualified dividends
will apply to those in the 10% to 15% marginal brackets.
Using 2008 tables,
the income threshold for a married-filing-jointly taxpayer is $65,100 for the
15% bracket. The threshold for a single taxpayer is $32,550 to remain in the 15%
bracket. If every dollar of taxable income was considered net capital gains or
qualified dividends, rather than ordinary income, the potential tax savings
would be 15% of $65,100 (or $9,765) for married-filing-jointly taxpayers, or 15%
of $32,550 ($4,883) for single filers.
These thresholds may seem low to advisors, but keep in mind that married
couples filing jointly can shelter $17,900 of ordinary income with their
standard deduction and personal exemptions. Single filers can shelter $8,950 of
ordinary income. Net capital gains in excess of these amounts could still be
sheltered by the 0% tax rate until they exceed the upper-threshold income limit
for the 15% tax bracket.
Investment strategies
Those clients with appreciated securities in taxable accounts should consider
liquidating these securities to fund the first three years. To the extent that
the net capital gains (net long-term gains minus net short-term losses) plus
qualified dividends (as long as they were not considered in the calculation for
determining deductible investment interest expense) do not exceed the income
thresholds for the 15% marginal tax bracket, the tax on this income would be
zero. The tax rate for net capital gains above the threshold would still be only
15%. This strategy also delays the drawdown from tax-deferred accounts, allowing
them to appreciate.
Many retirees also desire to adjust their portfolios prior to retirement to a
more conservative allocation requiring them to sell some equities, thus
realizing gains. If these clients have the ability to delay ordinary income for
a few years, holding off on a major portfolio restructuring until at least 2008
could save them on their taxes.
We all have those clients with a legacy position in a single stock with a
large embedded capital gain. Plan to sell off some of these shares over the next
three years to add diversification to their portfolio. Any net gain under the
income threshold for the 15% bracket will be taxed at 0%, and any net gain over
the threshold will only be taxed at 15%. This strategy assumes that Congress
resists the urge to change the law prior to 2010.
Use up loss carryovers now
If you have clients who are still carrying investment losses forward on their
tax returns, try to realize enough gains to use them up this year against net
gains that would be taxed at 5% or 15% depending on their marginal tax brackets.
It would be a shame to use prior losses to offset a gain that would be taxed at
a 0% rate.
You might even consider selling an appreciated asset to reset its basis to a
higher amount and then repurchasing it if there are sufficient carryover losses
to shelter the gain. This strategy would also be appropriate in tax years 2008
through 2010 if clients are interested in hedging against the possibility of
higher capital gains rates in the future.
Take advantage of NUA opportunities
Your retiring clients who hold appreciated employer stock in their retirement
plans have a special opportunity over the next three years. If they are able to
delay other ordinary income, they could take a lump-sum distribution from the
employer plan in 2007 or 2008. Any non-employer stock could be rolled over to an
IRA to avoid immediate taxation, while the employer stock would be distributed
directly to the retiree. Only the tax basis (value of the shares when
contributed to the plan by the employer) would be taxed at ordinary income rates
in the year of the distribution. Any gain realized upon the sale of those shares
would be taxed as long-term capital gain, even if sold within one year of
distribution.
By splitting the lump sum distribution and sale of the shares into different
tax years, it might be possible to have most of the gains taxed at the 0%
capital gains rate. There are several technical rules that must be met in order
to take advantage of this net unrealized appreciation strategy, so work with
your client’s tax advisor.
Watch out for Social Security
You may have clients living very frugally on Social Security, but who still
have investment assets. Before you advise them to sell appreciated assets in an
attempt to have the gains taxed at 0%, determine if the gains will cause more of
their Social Security income to be taxable. For a quick estimate of any
potential tax savings, assume that 85% of their Social Security benefit will be
taxable and compare it to the total deductions available to offset it. Only if
the total deductions exceed the total ordinary income, will the full 0% bracket
be available for net capital gains.
Tax-bracket management
This strategy uses traditional techniques to shift income and/or deductions
to the most optimum year for realizing them. For tax years 2008 through 2010,
the goal would be to accelerate ordinary income into 2007 or defer it into 2011.
The goal for deductions would be to bunch them into the same tax year that net
gains are realized. Some actions to consider are:
- Use certificates of deposit rather than short-term bonds to control the year
taxable interest is received - For semi-retirees, shelter earned income with additional 401(k) or IRA
contributions - Replace taxable fixed income with tax-free instruments when feasible
- Hold REITS in qualified accounts rather than taxable accounts, since the
dividends are not qualified dividend income - For older retirees, convert small IRAs to Roth IRAs to avoid required minimum
distributions in future years - Don’t prepay state income taxes if there is a possibility of receiving a
refund
Forget about the kids
In prior years, parents could gift appreciated assets to their kids over the
age of 13, who could sell them and have the gains taxed at the 5% rate. In 2006
the age was raised to 18 and under. Earlier this year, the age was raised to 19
years—or 24 years, if a full-time student and dependent on parents. This new age
limit starts with tax year 2008. The kiddie tax kicks in when children receive
over $1,800 (2008 limit) in unearned income. Above that level, the child’s
investment income is taxed at the parents’ top marginal rate.
No guarantees
Realize that there will always be surprises that can undo even the most
careful planning. For instance, mutual-fund distributions of gains are usually
unknown until the end of the year. New purchases of mutual funds prior to a
distribution date will also result in realized income. Stock mergers and
acquisitions are beyond the individual investor’s control and can often generate
ordinary income.
Alert your client to this reality and work closely with his or her tax
professional to achieve the best possible tax scenario. You’ll find that the
CPAs are very receptive to this type of planning. Just beware that sometimes
their fees can offset a good deal of the hoped-for tax savings. In cases where
the basis of a security is unknown, the client or his accountant may be facing
hours of drudgery trying to determine the cost basis and holding period.
Then there are the risks associated with letting the tax tail wag the
investment dog. A clever, sophisticated strategy to defer gains to a future year
may be undone by a market decline. There is also a very real possibility that
Congress could change the rules (after the election?), so it would be wise to
have contingency plans in mind. But if the next three years unfold as
legislated, you and your clients could realize some wonderful tax savings.
