Taxpayers should get a head start on tax planning for 2007
The indexing of many features of the tax code will bring some relief to taxpayers next year, according to CCH, a Wolters Kluwer business, which recently released estimated income ranges for each 2007 tax bracket.
Unlike many changes to the tax laws that are effective for only limited periods of time, indexing has become well established within the tax code.
Inflation Adjustments. Since the late 1980s, the Code has required that federal income tax brackets be adjusted for inflation annually, and inflation adjustments have been inserted into the Internal Revenue Code in recent years with increasing frequency. For example, the Code now requires over 50 other inflation-driven computations to determine deduction, exemption and exclusion amounts in addition to the 40 separate computations needed to inflation-adjust the tax bracket tables each year. Tax legislation in 2006 added to the number of required inflation adjustments.
The adjustments are based on Consumer Price Index figures for September through August immediately prior to the adjusted year. CCH's projections are based on the relevant inflation data released Sept. 15, 2006, by the U.S. Department of Labor.
The IRS usually releases official numbers by December each year. CCH tax bracket projections are provided for illustrative purposes only, and should not be used for income tax returns or other federal income tax related purposes until confirmed by the IRS later this year.
Some items not indexed. Some items in the Code are not indexed for inflation and stay the same, while others rise by dollar amounts already written into the tax law to ensure Congressional oversight. The exemption amounts for the alternative minimum tax, for instance, are not indexed, which means that each year Congress must either increase the amounts by statute or expose additional households to the alternative tax.
By contrast, the adjusted gross income limits on the ability to make full contributions to Roth IRAs have been established by law at the $95,000 level for singles and $150,000 for joint filers since 1998. Now they have been made inflation-sensitive through 2006 legislation. For 2007, the AGI phase-out levels rise to $99,000 and $156,000, respectively.
Standard deduction, personal exemption also rise. The standard deduction and personal exemption amounts are also subject to indexing and these are projected to increase for 2007. These increases can produce lower taxes by reducing the taxpayer's taxable income.
Single taxpayers and married taxpayers filing separately could see a $200 increase over 2006 in their standard deduction, to $5,350, while the standard deduction for joint filers will increase by $400 to $10,700. Heads of households will see an increase in their standard deduction of $300, to $7,850.
The additional standard deduction for those age 65 or older or who are blind, which did not rise in 2006 from the year before, will take a $50 jump in 2007 to $1,050 for married individuals and surviving spouses, and $1,300 for single filers. The personal exemption amount will go up in 2007 by $100 to $3,400.
These inflation adjustments can add up over time. For example, since the 1987 tax year, the standard deduction for joint filers has increased more than two-and-a-half times, from $3,780 to the anticipated $10,700 amount for 2007.
Taxpayers can, however, lose a good portion of the value of personal exemptions and itemized deductions when their incomes rise above certain levels. Those "phase-out" levels are also adjusted for inflation. For 2007, married couples filing jointly will begin to lose some of the value of any itemized deductions when their adjusted gross income exceeds $156,400. Likewise, they will begin to lose some of the value of their personal exemptions when their adjusted gross income exceeds $234,600.
In 2006 and 2007, the reduction in personal exemptions and itemized deductions is scheduled to be only two-thirds of what it was in 2005. That's because "phase outs," first started under the Revenue Reconciliation Act of 1990, are themselves now scheduled to be phased out by one-third in 2006 and 2007, two-thirds in 2008 and 2009 and completely repealed for 2010.
"Kiddie" deduction, Gift tax exemption. In general, inflation adjustments are rounded to the next-lower multiple of $50, so if the adjustment produces an increase of less than $50, no increase is made. The "kiddie" standard deduction, used on the returns of children who are claimed as dependents on their parents' returns increased in 2001, from $700 to $750, and jumped next to $800 for 2004. For 2006, it increased to $850, where it will remain for 2007.
The tax code only allows the gift tax exemption to rise when the inflation adjustment would produce an increase of $1,000 or more. The last increase occurred at the beginning of 2006, when the exemption increased to its current $12,000. This year's inflation figures aren't enough to push it over the next threshold, so it will stay at $12,000 for 2007.
October 2006— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Hillebrand Financial Planning, LLC, a local member of FPA.
A lot is being written about how much money Americans can withdraw from their investments to fund their retirement years. Now, a new research institute launched by Fidelity Investments has outlined the order in which money should be withdrawn from various tax-deferred and taxable investment accounts. Described as the ‘withdrawal hierarchy,’ the Fidelity Research Institute suggests the order, with modifications made courtesy of other financial planning experts.
1. Take your minimum required distributions (MRDs) from qualified accounts and IRAs. If you are age 70½ or older, make sure you know which of your accounts require such distributions and how large those distributions need to be, and then meet the requirements and deadlines, avoiding the application of the 50 percent income tax penalty that will be assessed if you fail to make timely withdrawals of required distributions.
2. Liquidate loss positions in taxable accounts. Some investments in your taxable accounts may be worth less than their tax basis. In addition to offsetting realized losses against realized gains, at the federal level you can usually use up to $3,000 ($1,500 for married couples filing separately) of net losses each year to offset ordinary income including interest, salaries, and wages. Unused losses can be carried forward for use in future years.
3. Sell assets in taxable accounts that will generate neither capital gains nor capital losses. Such assets generally include cash and cash-equivalent investments as well as capital assets which have not increased in value. If your withdrawals from this tier in the hierarchy largely come from cash-equivalent investments, sufficient liquid assets holdings should remain intact in order to cover short-term financial emergencies. And be especially mindful of portfolio rebalancing issues.
4. Withdraw money from taxable accounts in relative order of basis, and then qualified accounts or tax-deferred saving vehicles funded with at least some nondeductible (or after-tax) contributions, such as variable annuities and Traditional IRAs that contain non-deductible contributions. The choice depends on the circumstances, and in some cases it might make more sense to tap the tax-deferred vehicle first, but for most retirees, capital gains rates are lower than ordinary income tax rates and generally liquidating capital assets first would be beneficial.
Assuming there is a significant difference in the basis-to-value ratio of the assets to be liquidated in two accounts, the better tactic for choosing between these two types of withdrawals may be to liquidate the assets with the higher ratio. That is, the assets that have generated the smallest gain or the largest loss as a percentage of their basis. If the basis-to-value ratio of the assets to be liquidated in each account is relatively low due to significant investment gains, it often will be preferable to liquidate the assets in the taxable account. Conversely, if the basis-to-value ratio of the assets to be liquidated in each account is relatively high, it may be preferable to liquidate assets in the tax-deferred account if portfolio demands require it. Note that IRAs are generally subject to certain aggregation requirements when allocating basis. When liquidating gain positions in taxable accounts, it usually makes sense to sell assets with long-term capital gains first, since they should be taxed at lower rates than short-term gains.
5. Withdraw money from tax-deferred accounts funded with deductible (or pre-tax) contributions such as 401(k)s and Traditional IRAs, or tax-exempt accounts such as Roth IRAs. It may not make much difference which account you tap first within this category since all withdrawals from any tax-deferred accounts funded
with fully deductible (or pre-tax) contributions are taxed at the same rate. When withdrawing money from tax-deferred accounts funded with fully deductible (or pre-tax) contributions, you may wish to request that taxes be withheld.
If you believe that the withdrawals you make may be subject to different tax rates over the course of your retirement (whether due to changes in tax law or to varying tax brackets as a result of fluctuations in income) you may be better off liquidating one type of account within all of these guidelines before another. For example, it may make more sense to leave your Roth account intact if you thought your ordinary income tax rate was likely to rise in later years, increasing the value of the Roth’s tax exemption.
Estate planning considerations may also significantly impact the entire hierarchy. Generally, qualified and tax-deferred assets may be given a higher order within the withdrawal hierarchy in the case of larger estates expected to hold “excess” assets which will pass to heirs or be subject to estate taxes. Capital assets receive a step-up in basis at death, while qualified and tax deferred assets are considered to contain “income in respect of a decedent” and do not receive a step-up. A number of other issues may also have an effect on the recommended order of withdrawal, like if the retiree’s income approaches the threshold of paying taxes on Social Security income.
October 2006— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Hillebrand Financial Planning, LLC, a local member of FPA.
Sales of existing life insurance policies to third parties—often referred to as "life settlements"—have grown exponentially in recent years, and that trend appears likely to continue, according the NASD.
The NASD recently issued a notice to brokerage firms and associated persons that life settlements involving variable insurance policies are securities transactions, and firms and associated persons involved in such transactions are subject to applicable NASD rules.
But what are life settlements? Until recently, the NASD reports that the owner of a life insurance policy who no longer wanted or could not afford it had two options: to let it lapse or surrender it to the issuer for its cash surrender value. But now, the emergence of a secondary market for existing life insurance policies provides a third alternative: to sell the policy to a third party for less than the net death benefit, but more than the cash surrender value. Such transactions, the NASD says, are typically referred to as life settlements. The value of a particular life settlement depends on a variety of factors, including the insured's life expectancy and the nature and terms of the policy.
According to the NASD, the life settlement market emerged as an offshoot of the viatical settlement industry that developed in the 1980s as a source of liquidity for AIDS patients and other terminally ill policyholders with life expectancies of less than two years. Unlike viaticals, however, the NASD says that life settlements involve policyholders who are not terminally ill, but generally have a life expectancy of between two and 10 years. Life settlements also tend to involve policies when the insured is older and there has been a change in health since the policy was issued. Policies with lower cash values and higher net death benefits seem to draw more interest from investors.
The life settlement market has expanded rapidly in recent years. One recent study, for instance, estimates that existing policies with a collective face value of $5.5 billion were sold by policyholders to investors in 2005, while others suggest that the potential market exceeds $100 billion. Although business models vary, in a typical scenario, an insured sells an existing policy to a life settlement provider, which either holds it to maturity and collects the net death benefit, or sells the policy or interests in multiple, bundled policies to hedge funds or other investors. The insured may contact the life settlement provider directly, or through a financial adviser, or may use a life settlement broker, which solicits bids from multiple life settlement providers on behalf of the insured. It is not uncommon to hold out for a higher bid by not accepting the first bid or by letting the providers bid against each other.
In most states, both life settlement providers and life settlement brokers are subject to licensing and other requirements, the NASD says.
According to the NASD, most life settlement providers claim to target only those policyholders who have already made the decision to surrender a policy or allow it to lapse, either because the policy is no longer wanted or needed, or because the policyholder can no longer afford to pay the premiums. However, as more providers enter the life settlement industry, the NASD reports that there is increasing competition to find policyholders who fall into that relatively narrow category. And this, says the NASD, has led some life settlement providers to aggressively encourage financial service providers, including broker-dealers, to canvass their books of business for seniors or other eligible customers who may be interested in selling their life insurance policies in the secondary market, even if they do not need to or had not previously considered surrendering or allowing their policies to lapse. Significantly, the commissions paid in connection with life settlements are typically quite high—in some cases, up to 30 percent or more of the purchase price.
Accordingly, the NASD is concerned that aggressive marketing tactics, fueled by high commissions, may lead to inappropriate sales practices in connection with these transactions.
By way of background, the NASD reports that a variable life insurance policy is a security, and the sale of such a product in the secondary market is a securities transaction subject to NASD rules. What’s more, those involved in selling or buying a variable life settlement should understand fully the issues related to suitability, due diligence, best execution, supervision and training, and compensation in connection with variable insurance contracts.
Generally, the NASD requires that, before recommending the purchase, sale or exchange of a security, members must have a reasonable basis for believing that the transaction is suitable for the customer.
The NASD reports being concerned that some of the marketing materials prepared by life settlement companies to encourage financial service providers to recommend life settlements to their customers do not present a fair and balanced view of life settlements, and may encourage broker-dealers to recommend unsuitable transactions.
A variable life settlement may be a valuable option for insured’s who otherwise would surrender their policies or allow them to lapse, the NASD says. But variable life settlements are not for everyone. There can be significant costs associated with such transactions, and NASD cautions firms that a variable life settlement is not necessarily suitable for a customer simply because the settlement price offered exceeds the policy's surrender value. Other relevant factors may include the customer's continued need for coverage, and, if the customer plans to replace the existing policy with another policy, the availability, adequacy, the underwriting, and cost of comparable coverage. Depending on the circumstances, including the customer's stated financial needs and investment objectives, firms also may need to consider the basic tax and other relevant implications of selling a variable policy. Settlements paid in excess of the cumulative premiums paid on the policy constitute ordinary income to the policy owner, compared to the death benefit which is tax-free. In order for the settlement provider or investment group to receive the death benefit, they must file a claim with the insurance company which requires an original copy of the death certificate.
October 2006— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Hillebrand Financial Planning, LLC, a local member of FPA.
