Seldom, if ever, in my lifetime has the outlook for taxes been so murky. Nonetheless, the odds are strong that income tax rates will go up in 2013 — especially on “ordinary” income (wages, rents and interest). Taxes on dividends and capital gains will probably increase to at least some extent, as will estate taxes.
Why do I say tax hikes are likely? Because they’re already baked into existing law. It would take action to prevent them — and Washington, in the present state of affairs, is more disposed to inaction.
Therefore, rather than wait to see what happens, you’ll be well advised to use the last three months of this year to work on lowering your 2013 tax liability, by whatever legal means you can.
Here are three of my best ideas.
#1: Make a charitable gift of appreciated stocks.
You’ll avoid income tax on the unrealized gain, and — assuming you’ve held the stock at least a year and a day — you’ll be able to take a deduction for the current (appreciated) market value of the shares, not your original cost. Next year, unless the law is changed, upper-income taxpayers will find that their itemized deductions for charitable gifts, mortgage interest and state and local taxes are “phased out.” In other words, if your income is high enough, up to 80% of your deductions could vanish!
What if you don’t think you can completely do without the income generated by the stock you intend to donate? In that case, you might buy a charitable gift annuity instead. Many colleges, religious organizations and other nonprofit groups offer these annuities, which pay you a guaranteed income for life. You get a tax deduction for a portion of the purchase price, depending on your age.
As an example, Hillsdale College in Michigan, known for its defense of free-market principles, allows you to open a charitable annuity with a minimum of $5,000 in cash or securities. At current rates, which are locked in at purchase, a person aged 65 would earn $4,700 a year for life on an investment of $100,000.
For joint lives, again age 65, the same investment would pay $4,200 a year until the second person dies. Part of your monthly income is considered a tax-free return of capital.
What to Do Now: For more details, call Bill Phillips at 800-334-8904 or visit http://www.hillsdale.edu.
#2: Convert ordinary income to capital gains.
This suggestion sounds like alchemy or trickery, but there are a few legitimate ways to do it. The safest and simplest is to buy so-called i-units issued by two master limited partnerships (MLPs), Enbridge and Kinder Morgan.
These pipeline operators have two classes of partnership units, one that pays quarterly distributions in cash and another that issues additional shares (i-units) valued at the same amount as the cash distribution. As long as you hold your reinvested i-shares at least a year and a day, any gain you realize on the sale is taxed at preferential long-term rates.
Obviously, there’s a risk here. The price of the partnership units could decline, cutting into the value of your stock dividends. However, both Enbridge and Kinder Morgan have compiled good long-term growth records (especially Kinder).
What’s more, you’re starting today at a respectable yield — the equivalent of 7% for Enbridge Energy Management (NYSE:EEQ) and 6.5% for Kinder Morgan Management (NYSE:KMR). The longer you reinvest your units at that rate, the more likely you’ll come away with not only a positive economic return but a net capital gain (for tax purposes) as well.
What to Do Now: Buy EEQ at $32 or less, and KMR at $75 or less.
#3: Transfer wealth out of your estate.
Perhaps the most sinister and little-understood tax change about to hit in 2013 is the leap in estate and gift levies. This year, a person’s lifetime exemption from gift and estate taxes amounts to $5,120,000 (or $10,240,000 for a married couple). Above that exemption, the maximum tax rate stands at 35%.
On January 1, 2013 — hold your hat! — the exemption drops to just $1 million ($2 million for couples) and the effective tax rate skyrockets to 55%. Karl Marx must be slapping his bony leg in Highgate Cemetery.
This tax “cliff” is so steep that I find it hard to believe Congress won’t act to head it off. However, President Obama, if re-elected, may well use the estate/gift tax as a bargaining chip to get concessions on other tax issues (the dividend tax, say). When all the horse trading is done, I suspect the lifetime exemption will end up considerably lower than today’s level, though probably not as low as $1 million per person.
Thus, it behooves older folks to consult with a capable estate-planning attorney without delay. If you don’t know of an estate specialist in your locale, I recommend searching the national online lawyers’directory, http://www.martindale.com/, under Trusts and Estates.
Depending on your situation, you may wish to set up an irrevocable trust (before year-end) that transfers your home or other key assets to your heirs. With a Qualified Personal Residence Trust (QPRT), you can reserve the right to live in the house for a period of years, or even the rest of your life (as long as you pay rent to the trust). If you give securities to a Grantor Retained Annuity Trust (GRAT), you can arrange to receive an income from those assets for a set number of years.
Irrevocable trusts do have their quirks and pitfalls, which an attorney can explain. For example, if you die while you’re living rent-free in your QPRT house, the property will be knocked back into your taxable estate. Ditto if you pass away while collecting income from a GRAT.
Furthermore, it’s well to remember the obvious: You can’t cancel an irrevocable trust! But would you rather hand over your money to our beloved Uncle Sam? That’s wealth irrevocably gone.