Lots of talk about tax and estate planning out there right now. Consider this article....

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Advice: Taxes

Time to Stop Deferring Taxes?

Conventional investment advice has been turned on its head by changes in the fundamentals of the economy and markets. Next, fundamental changes in the government, demographics, and the economy will force changes in tax policy and tax planning advice.

The age-old advice to defer taxes whenever possible could become a thing of the past, at least for a few years. Over the years, we pointed out a few exceptions to this strategy discovered in our research. Soon, the rule for many people could be to pay income taxes as early as possible, because rates will be higher later.

The structural changes leading to this conclusion are significant:

 

Tax Articles

• We have a new President and Congress. They explicitly campaigned on promises to raise taxes, at least on the wealthiest Americans. "Wealthy" tends to be defined downward after an election, and that is likely to be the case.

• Social Security and Medicare cannot be sustained under current tax and spending policies. Either benefits must be reduced or taxes raised or both.

• The response to the financial crisis was for the federal government to bailout, subsidize, insure, and otherwise commit to spending a lot of money. There is a chance some money will be recovered from the government's "investments," but most likely the government will have net negative cash flow.

• The new government leaders plan to spend a lot more money, especially on medical care. The details are not clear at this point, but higher medical spending by the government clearly is part of the plan.

• Environmental policy is likely to include significant tax increases.

• A result of the current crisis likely will be less leverage in the economy, leading to lower economic growth. Lower growth means less tax revenue from the current tax structure.

The specific tax increases won't be known for at least months, but we have a lot of clues and can begin to plan.

Higher income individuals are likely to face higher income taxes. During the campaign the income cut off for higher taxes initially was $250,000. But at times lower numbers were used, and Congress traditionally defines “high income” much lower than $250,000. The current plan is to let the 2003 tax cuts expire after 2010, which will affect many taxpayers.

All Americans are likely to be hit with indirect and non-income taxes. These include gasoline taxes, other carbon and energy taxes, and various fees and charges.

Means-testing is another likely form of tax increase. Already upper income people receive a lower return on their Social Security taxes and pay higher Medicare premiums. Benefits from Social Security and Medicare likely will be reduced above some income level. Expect similar actions in other government programs.

Tax benefit reductions also are likely in lieu of tax rate increases. Itemized deductions and personal and dependency exemptions now are reduced at higher incomes, effectively increasing tax rates. Congress likely will search for other tax breaks to phase out as income rises. Related changes will be "closing loopholes" by eliminating deductions and income exemptions.

A long shot in the short term is imposition of a value added tax or some kind of a national sales tax. This tax can be hidden in the cost of goods and services, raised easily, and will generate a lot of money for the government.

Taxes on long-term capital gains are likely to rise above their current 15% level. A rise to 20% seems almost certain after 2010, and an increase to 28% is possible. Taxes on dividends also will rise. The question is whether they will be taxed the same as long-term capital gains or will return to being taxed as ordinary income.

The bottom line is reduced benefits, higher taxes, and fewer opportunities. Most people should plan to spend less, save more, and work longer.

A good guess is that most over age 55 won't have to deal with lower benefits from Social Security and Medicare, except those with higher incomes. Those farther from retirement likely will face changes.

What should you do?

The good news is the economic crisis prevents the imposition of higher taxes for a year or more. That gives you time to plan.
IRAs and retirement accounts likely will be hurt by future tax increases. All distributions are ordinary income, and you cannot spend the money without taking a distribution.

In the past we pointed out when it makes sense to pay taxes early on an IRA by either emptying it early or converting to a Roth IRA (if your adjusted gross income is $100,000 or less). These strategies will be profitable for more people if income tax rates rise. In 2010 and later years under current law anyone will be able to convert a traditional IRA to a Roth IRA.

More people should give serious thought to emptying their IRAs early or converting to Roth IRAs. Details are in the web site Archive and in my book The New Rules of Retirement.

It is too soon to sell capital assets to avoid higher taxes. A retroactive capital gains tax increase is unlikely. The government wants to tell investors in advance the tax will increase, because that will trigger asset sales by people seeking to benefit from the lower rate, boosting government revenue. Plan what you will sell in a year or two to avoid higher capital gains taxes, and expect lower after-tax returns from capital assets after that.

The same advice applies to dividends. There won't be much you can do to avoid the eventual increase. Factor lower after-tax income from dividends in your plans.

Reconsider plans to defer future income. Your income tax rate in the future is likely to be higher than today. You could have more money in the long-term by paying taxes today and investing the after-tax amount.

Review IRA and 401(k) contributions and deferred compensation arrangements. Those earning $50,000 or less probably won't be hit with higher income tax rates and can safely continue tax deferrals. But the higher your income is above $50,000, the greater your risk of paying higher rates in the future. Income tax rate increases might very well be retroactive, even to Jan. 1, 2009.

Forget the notion you will be in a lower tax bracket in retirement. Many of us will be in higher tax brackets, especially when all types of taxes are included.

Retirement spending plans should be revised to reflect higher costs. If you are not already retired, consider working longer and saving more. As the tax proposals become more specific and are closer to enactment, investment plans will need to be revised. We might shift strategies or simply accept lower after-tax returns from certain assets.

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Replies to This Discussion

Permalink Reply by James Kerns on December 3, 2011 at 3:07pm

Cheyenne, WOW, Thank you for posting this very well thought out plan, is this your work? Are you an insurance profesional and also a financial expert? May i print this out for my family's use?

0l1a6laz7smpfPermalink Reply by 0l1a6laz7smpf on December 3, 2011 at 4:26pm

thank you for posting this...don't have time to read all of it right now...but glad it is here to read.

A comment about 'inheritance tax"...something that some do not find out about til it is upon them to pay.   Depending on the size of an estate there may or may not be inheritance tax to pay to the IRS...but in the state of Pa. there is an inheritance tax...and with the real estate in many areas having leases with some producing...then it could be quite a cost for a beneficiary to pay to even receive the inheritance regarding that.   Especially if the Bush tax cuts are changed...regarding inheritance taxes.  And that tax must be paid within so many days of the date of the deceased.   An example is if the property is worth about 1M then beneficiaries may be expected to pay upwards about 45K right up front before receiving the property in the settlement of the estate transfer....that's quite a bit of money and if the deceased only left land and leases but not much cash then someone may be hard pressed to come up with that kind of money.

So if you have already been paid with the bonus money for your lease...and you are up in age...then consider that some money might be put aside for such for your beneficiaries, that is if you care to....and don't tie it up in the estate as that takes some time to settle and that fee is due I think within about 3 months or a penalty must be paid.

Permalink Reply by Charlie on January 5, 2012 at 11:37am

Hi VG-

 

I would like to point out a couple of things for you to consider when discussing inheritance taxes.  For 2012 alone, the federal "estate" /gift tax exemption is $5,000,000 per person and $10,000,000 per married couple. This means that a married couple can pass up to $10,000,000 of property to their heirs estate tax free if they die this year.  However, you are correct PA does charge an inheritance tax. The rate of this tax depends on the heirs relationship to the deceased party. For spouses the rate is 0%, lineal descedants (kids/grandkids) 4.5%, sibling 12.5%, others 15%.  The fee/tax is due in PA 9 months from the date of death.  I often advise clients to buy some sort of insurance in order for their estate to be "liquid" upon their death to pay the PA inheritance taxes.

 

For estate planning purposes, I would urge landowners in 2012 to consider making gifts to their heirs because it is unclear whether the $5,000,000 estate and gift tax exemption will remain in 2013 and such exemption may be quite lower, meaning that more landowners could be subject to federal estate tax upon their death. I have written previously about limited partnerships and other estate planning vechicles, but simple old fashioned gifts also work for owners who do not want to go through the time and expense of setting up a structured estate plan.

Permalink Reply by Gary P. Brewer on December 5, 2011 at 6:09am

This is a very interesting topic.  There is a product available that can be used to defer taxable income on lease bonuses.  It is the same product that is used in personal injury settlements and it's called a structured settlement annuity.  In a nutshell, if you receive a lease bonus, the entire amount is subjet to Federal, State & Local taxes in the calendar year it's received.    A structured settlement annuity allows you to defer receipt of the bonus funds and resulting taxes to a later date by way of a guaranteed stream of income.  Since many people are also recieving monthly lease payments, in addition to the bonus, they are in the highest tax bracket.  By deferring the income, it will be received at a time when the lease payments are no longer being made, or are subsantially less,  when the tax bracket is much lower.

 

These annuities are only sold through a handful of major life insurance companies.  The commission paid to the broker is a one-time 4% commission and the rate of return is guaranteed for the life of the annuity.  Additionally, you can choose any payment schedule that you want.  It's a well established industry that has been in existance for over 25 years.

 

Hope this helps someone out there! 

Permalink Reply by Gary P. Brewer on December 6, 2011 at 6:17am

I've done all of the research on this type of annuity.  The 4% commission doesn't even come right off of the top.  It is paid up front by the life company out of future earnings.  In other words, all of the money that you put into the annuity starts earning interest immediately.  The commission is paid out of futre earnings that will be generated by the investment.

 

You are absultely correct in how to decide if it's a good investment using the the immediate tax bite versus the potential future tax bite.  I can tell you that the immediate tax liability of roughly 40% when the bonus and royalties put you in the highest tax bracket makes the annuity very attractive when you can defer the income to a later date when the tax bracket will be much lower.  This even takes into account potentially higher tax rates in the future.

 

The real bonus is that the money will not disappear over time since it's a fixed benefit schedule.  I know from personal experience that large sums tend to slowly turn into smaller sums over time.  It's a human nature kind of thing!

Permalink Reply by r telesz on January 5, 2012 at 5:05pm

so  how does this work..?    you take the bonus payment ,  how long do you have to get a structured settlement annuity  and  do you have to use all  or can you use part of  your bonus money ?

Permalink Reply by James Kerns on January 6, 2012 at 11:09am

Hello to all, I commented earlier on this thread and am very glad to see the subject has been brought up for conversation and is being read and commented on. By way of disclosure, among other areas of interest to me i am a State Licensed Independent Agent specializing in Life, Health, Fixed and Variable Annuity's as well as Personal Lines Insurance, meaning your Auto, Home, and Fire Insurance Products.

I have been licensed since Feb. 2006, but have not been actively working in any agency this past year for health reasons. As my heath has improved, i have again been interviewing the different Insurance companies for a good fit for myself, and to gain the trust and business of area residents, this time as an Independent Agent. 

I am interested in meeting area resident's who are in need of Honest Professional's who know the Insurance business and will do the right thing for them, the client, based on their specific needs as opposed to focusing soley on building the Agency and lining my own pocket's with their hard earned dollars. I will work to profit but will not sacrifice Honesty and Integrity in the process.

 I am now and will remain primarily a small farmer ( We raise  Four Good Children as well as Texas Longhorn cattle, Black Angus cattle, and Alpaca's.) and a landowner seeking a good Oil and Gas Lease for myself. Because i myself am looking forward to soon receiving a large check from an O&G company for an Advance Lease Payment (Bonus Money), i too have a need to re-examine my Financial Planning needs to include Retirement and Estate planning.

So i see an opportunity, as i help myself prepare for this influx of fresh new money, maybe i would be given the chance to help others with sound HONEST conservative advice,  and to discovering good Financial Vehicles, for their newfound wealth.  As i need to properly place my Bonus Money to minimize the tax burden, catch up and re-examine my retirement needs, and purchase newer equipment and update structures on my farm, so i realize that many others are also in the same boat as i.

I have concern's as many of you do, over the honesty and moral, ethical concepts of many who would offer to manage my money. I have been fortunate in that previously there were many area residents who trusted me in this regard, while i worked for several other agencies and with different insurance companies.

 So i think i will start my own Independant Agency, from a small home office on the farm. If any of you would have an interest in visiting with me over coffee, my farm or your place, to discuss your specific concerns or Insurance/ Retirement Planning need's, i would consider it an honor and my pleasure. Please feel free to email me at kernstree@yahoo.com or call 440-279-7086. I will refrain from discussing any specifics here for privacy concerns. As i learn more about specific options i think will help, i will gladly share with any who contact me, with open and honest conversation. Thanks for taking the time to read this and Good Luck to all who seek a well written and fair Oil and Gas Lease. 

Permalink Reply by Gary P. Brewer on January 6, 2012 at 1:26pm

 

The premium for the structured settlement annuity must issued to the life company at the time the bonus payment is issued.  You can use all or any portion of the bonus payment you choose.  The future benefit stream can be made any way you want and can be deferred for as long as you want.  The only requirement is that it be a fixed payment schedule that can't be altered.

 

People utilize benefit streams for college educations for their children/grandchildren, guaranteed retirement income starting at age 60, 62, 65, 70 or to simply defer income to some future date to ensure long term financial security. 

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