Wake Me Up When September Ends

Please read this article written by Andrew Friedman of The Washington Update LLC

In my legislative update early this year, I noted that ongoing acrimony between Congressional Republicans and the Obama White House likely precludes agreement on any broad new legislative initiatives this year.  Instead, Congress and the White House are likely to reach agreement only in the face of “forcing events” – deadlines that compel action to ward off a draconian result.

As it turns out, Congress appears to be arranging for all of the major deadlines to occur around a single date – September 30.  This schedule sets up a massive negotiation for September, when Congress returns from summer recess.  Investors should be aware that this negotiation is likely to lead to market volatility and some new tax changes.

I discuss the upcoming imbroglio in more detail below.  But first, two quick announcements:

  • The Affordable Care Act is affecting retiree medical costs in a number of ways, most of them adverse.  A new white paper on the site, Preparing for Rising Medical Costs in Retirement, discusses how retirees and near retirees can develop an estimate of their likely retirement medical costs and a plan to help defray those expenses.  Subscribers can access the paper here.
  • My colleague Jeff Bush recently launched a new way for you to keep with what he and I are reading each day.  You can now follow us on Facebook to see our daily must read articles:  https://lnkd.in/eJAdh88 .  This is our way of keeping you abreast of the latest happenings out of Washington, happenings that can affect your investments and your business.

Now back to the legislative outlook.  By or around September 30, Washington must reach agreement on:

  • Raising the debt ceiling:  Congressional borrowing authority ended on March 15, 2015.  Current estimates suggest the government will run out of money and need to borrow by around early October.  Failure to raise the debt limit by that time would impinge on the government’s ability to pay interest on debt outstanding, leading to default on U.S. debt.
  • Highway funding:  Funding for summer infrastructure work (road and bridge repair) runs out on May 31.  All indications are that Congress will pass a short term “patch”, funding construction through September 30.  After that date, Congress will need to find a permanent source for highway funding.
  • Government funding:  The federal government’s fiscal year ends on September 30.  By that date Congress must appropriate money to run the government next year.  Otherwise the federal government will shut down on October 1.
  • Tax extenders:  Congress wants to extend a popular group of tax provisions that expired at the end of last year.  Paul Ryan, the chairman of the House Ways and Means (tax writing) committee, said he wants to take up the extenders during the funding discussions in September.

Longtime readers will remember that Washington reached a similar September 30 impasse two years ago, causing the government to shut down for sixteen days beginning October 1, 2013.  In that instance, with the debt limit deadline approaching, Congress and the White House agreed on a plan to reopen the government and raise the debt ceiling.  That plan included caps on future spending on defense and domestic programs.

As in 2013, reaching consensus on these knotty budget issues will be challenging.  With U.S. military involvement expanding, both parties agree that next year’s defense budget must be higher than the spending caps set in the wake of the 2013 budget impasse.  The President, though, insists that any increase in defense spending be matched with a corresponding increase in spending on domestic programs.  Republicans not only oppose additional spending on domestic programs, they are looking to further cut those expenditures.

For investors, the September 30 deadline is important for two reasons.  First, as the deadline to raise the debt ceiling gets closer and Congress and the Administration (likely) continue to bicker, the markets often turn volatile.  I have long said that a market decline over concern about Congress’ impending failure to act is a buying opportunity.  Congress will act – likely at the last minute – at which point the market will recover.  It is incumbent on investors and financial advisors to keep these “forcing event” dates in mind as investment opportunities.

Second, meeting these deadlines requires funding for new government initiatives, such as additional defense spending and funding long-term highway construction.  Congress typically does not like to spend money unless it raises taxes (or cuts spending elsewhere) to defray the additional cost.  Congress thus searches for “loophole closers”– provisions in the tax code that arguably provide unduly favorable benefits.  (An example of a loophole closer that keeps arising – but has never been enacted – is to curtail the use of “stretch” IRAs and 401(k)s.)  Thus, as September approaches, investors would be wise to consider how Congress intends to fund additional expenditures.

One way to fund these new initiatives could be corporate tax reform.  As if addressing these deadlines was not enough, Chairman Ryan hopes to have a corporate tax reform plan ready by the end of the summer.  (It appears that reforming individual taxes is now recognized as too difficult politically.)  If Congress and the White House can agree on corporate reform (possible but difficult), then the funds from a deemed (Democrats) or optional (Republicans) one-time repatriation of foreign earnings could be used to fund the permanent highway bill.  Otherwise, Congress will have to find revenue raisers to pay for highway funding and extenders; Ryan says using repatriation funding without tax reform is a no go.

 

Andrew H. Friedman is the principal of The Washington Update LLC and a former senior partner in a Washington, D.C. law firm.  He speaks regularly on legislative and regulatory developments and trends affecting investment, insurance, and retirement products.  He may be reached at www.TheWashingtonUpdate.com.

Neither the author of this paper, nor any law firm with which the author may be associated, is providing legal or tax advice as to the matters discussed herein.  The discussion herein is general in nature and is provided for informational purposes only.  There is no guarantee as to its accuracy or completeness.  It is not intended as legal or tax advice and individuals may not rely upon it (including for purposes of avoiding tax penalties imposed by the IRS or state and local tax authorities).  Individuals should consult their own legal and tax counsel as to matters discussed herein and before entering into any estate planning, trust, investment, retirement, or insurance arrangement.

Copyright Andrew H. Friedman 2015.  Reprinted by permission.  All rights reserved.

Investing in a Rising Tax Environment

Rising Tax Environment

We at WealthPoint are always looking for pieces that educate our readers and provide insight.  Andrew H. Friedman of TheWashingtonUpdate.com recently wrote the article attached to this post.   This white paper discusses the likely future direction of taxes, and what investors can do to minimize the tax impact on their investment returns.

Investing_in_a_Rising_Tax_Enviroment_2015

Click on the link above to view the full article (PDF)

 

Obama comments on IRA fiduciary rules

Presidential Seal[The update is of interest primarily to financial advisors.]

Last week the President gave a speech in which he focused on forthcoming Labor Department rules intended to ensure that IRA holders receive investment advice unencumbered by financial advisor conflicts of interest.  In conjunction with the President’s speech, the Labor Department will be re-issuing proposed rules addressing the extent to which financial advisors may receive compensation in connection with investments made by IRAs and other retirement accounts they advise.  The new proposed rules should be available in the next 60-90 days.

The Labor Department first issued proposed rules on this subject in 2010.  Of great concern to the financial services industry, the 2010 proposed regulations effectively would have precluded financial advisors from receiving commissions and other payments on IRA transactions and investments.  DOL withdrew the proposal in 2011 due to public pressure and concern.

The President’s comments last week contained a good bit of anti-Wall Street rhetoric (“A system where Wall Street firms benefit from backdoor payments and hidden fees if they talk responsible Americans into buying bad retirement investments – with high costs and low returns – instead of recommending quality investments – isn’t fair.”).  They make clear that the Administration is determined to continue to press this issue in some form.  At the same time, the White House material accompanying the comments states that the new proposal will “ensure that all common forms of compensation, such as commissions and revenue sharing, are still permitted.”  This language suggests that the new proposal will be more lenient than the original.

For instance, the new proposal could permit all forms of advisor compensation but require the advisor to disclose to the client conflicts of interest, such as where particular investments result in higher commissions or other payments to the advisor.

The Administration’s continued concern about arrangements that heretofore had not been thought to pose problems is worrisome from the perspective of the securities industry.  On the other hand, the fact that all forms of compensation will remain acceptable suggests that the newly proposed regulations will be at least somewhat less harsh.  My guess is that the industry is still likely to be unhappy with the new proposal, and will push back once it is announced.  The DOL has said the public will have the opportunity to comment on the proposal, including at a public hearing, before final regulations go into effect, so the matter is far from resolved.

 


Andrew H. Friedman is the principal of The Washington Update LLC and a former senior partner in a Washington, D.C. law firm. He speaks regularly on legislative and regulatory developments and trends affecting investment, insurance, and retirement products. He may be reached at www.TheWashingtonUpdate.com.

Neither the author of this paper, nor any law firm with which the author may be associated, is providing legal or tax advice as to the matters discussed herein. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. It is not intended as legal or tax advice and individuals may not rely upon it (including for purposes of avoiding tax penalties imposed by the IRS or state and local tax authorities). Individuals should consult their own legal and tax counsel as to matters discussed herein and before entering into any estate planning, trust, investment, retirement, or insurance arrangement.

Copyright Andrew H. Friedman 2015. Reprinted by permission. All rights reserved.

 

Four Reasons to Consider a Trust to Protect Your Assets

Nest EggFrom: Andrew H. Friedman

For many years, trusts have been the province of the wealthy, mysterious vehicles used to escape taxes and preserve assets for future generations. And for couples with joint assets approaching or exceeding $10.68 million — the current gift and estate tax exemption amount — a comprehensive estate plan that incorporates trusts is crucial for minimizing estate taxes.

More recently, however, families with assets well below this threshold are using trusts to help them protect assets from creditors, manage and grow assets for future generations, and ensure that their assets ultimately are distributed in accordance with their wishes to their heirs.

In setting up a trust, an individual appoints a trustee (an individual, a corporate trust company, or both) to act as a surrogate to manage and distribute assets in accordance with his or her wishes when (i) the individual later is not able to do so directly (due to, for instance, death, disability, incapacity, or geographic unavailability) or (ii) the individual wishes to shield the assets from possible later creditors. The individual sets out instructions in a trust document and appoints a trustee to act in his or her absence on his or her behalf. In this way, the trust ensures the ongoing preservation, protection, and control of assets.

Let’s consider some of the situations in which a trust can help someone control, protect, and preserve assets and address philanthropic goals.

 

Allocating assets among family members. Individuals often are concerned about leaving assets outright before heirs are ready to handle them. A child could dissipate assets too quickly, or lose assets in a later divorce. A spouse might remarry into a blended family. By placing assets in a trust, an individual can ensure that the assets are later distributed among family members in the time and manner intended.

Children: Suppose you have children who are young or irresponsible and might squander assets they receive outright. You can instruct your trustee when to distribute income and principal to each child. Such instructions can be based on age or on a specified accomplishment (e.g., college graduation). In this manner, you can seek to influence your children’s behavior even after your death.

Future generations: Suppose you wish to ensure that your assets remain available for future generations of your family, and that intervening generations do not squander assets to the detriment of generations that follow. For instance, if assets are left to a son, he might later give them to his wife, either voluntarily or in a later divorce, rather than leave them to your grandchildren. A dynasty trust ensures that each generation will receive sufficient income to live but be unable to divert remaining assets from future generations.

Surviving spouse: Suppose you want to preserve your assets for your offspring in the event you predecease your spouse. If you leave your assets to your spouse outright, he or she will have the power to determine their later distribution, perhaps giving them to a prior or later spouse’s offspring. By putting the assets in trust and providing for distributions to your spouse to maintain lifestyle, you can ensure that remaining assets go solely to your children. This planning can be particularly important if you have children from a prior marriage.

Education: An education trust can set aside assets to be used solely for educating or your children or grandchildren.

Special needs child: A special needs trust can be used to provide funds for an incapacitated child after the parent is no longer able to do so.

 

Provide for professional management. Individuals might be concerned that their heirs’ lack of financial sophistication – or the heirs’ divergent interests and needs — will preclude the effective management of the assets. A trust allows an individual to ensure that assets continue to be managed properly and to grow.

Incapacity: A trust can ensure that your assets are managed properly and your family’s financial needs are met in the event you suddenly become incapacitated. By specifying elements of incapacity in the trust document, your family typically can avoid a lengthy court proceeding. Providing for a smooth transition in the event of incapacity is particularly important for non-financial assets, such as real estate or a family business, where ongoing management is crucial.

Unsophisticated investors: Suppose your surviving spouse and/or your children are not sophisticated investors and will have difficulty managing assets to provide a reasonable return. By placing assets in trust, you can provide broad instructions as to how the assets are to be invested and identify a professional financial advisor to manage them.

Squabbling heirs: Often heirs cannot agree on how to manage a family asset, such as a home or business. By putting the asset in a trust, you can appoint a trustee to manage the asset and distribute income to your heirs per your instructions, helping to preserve family unity.

Shifting fiduciary duty: Naming one of your children to administer assets for all your children could expose the managing child to a suit by the others for breach of fiduciary duty if they do not approve of his or her actions. Naming a professional manager alleviates this concern by shifting the management duties away from a family member.

 

Preserve assets. Individuals in certain professions or businesses often are concerned that they might lose assets to creditors rather than preserve the assets for family members. Assets held in trust frequently are beyond the reach of creditors, allowing the assets to be preserved for heirs.

Creditor protection: Suppose you are a professional (such as a doctor) who might be sued for alleged mistakes. Or you are concerned that your business operations could expose you to financial risk in the event of an economic downturn. By placing your assets in trust before the actions giving rise to a suit or downturn occur, you can shield the assets from future creditors.

Children: Suppose your child has incurred significant debt, or you are concerned your child may do so in the future. Assets placed in trust for the child’s benefit are kept out of the reach of creditors seeking to collect on debts the child has incurred. A trusteed IRA program is designed to provide the same protection for your qualified assets.

Divorce protection: Placing assets in trust in some circumstances may shield the assets from split upon a later divorce property settlement.

 

Facilitate philanthropy. Individuals might wish to donate the bulk of their assets to a charity, but still provide needed income for family members and heirs. A charitable trust can accomplish these goals.

• Suppose you want to ensure that a portion of your assets goes to a charity, either during your life or upon your death (or both), while still providing income to you or your dependents. You can achieve this result by putting your assets in a charitable trust. Properly structured, a charitable trust also can provide immediate benefits, such as an income tax deduction for contributions to charity, and tax-free growth for future investment income.

 

Revocable vs. Irrevocable Trusts

A trust can be either “revocable” or “irrevocable”. An individual placing assets in an irrevocable trust cannot later reclaim the assets or make significant changes to their disposition. Thus, the donor must be comfortable with the arrangement at the time assets are placed in the trust. In contrast, a revocable trust can be changed at any time as long as the individual setting up the trust is alive and healthy. Upon the individual’s death or incapacity, the trust becomes irrevocable.

Which trust makes sense depends on the particular situation. Many individuals prefer the flexibility of the revocable trust. However, an irrevocable trust often is necessary for certain functions, such as estate tax minimization or asset protection. 

In choosing the type of trust, there are other considerations to keep in mind: 

State taxes. For purposes of applying their state inheritance tax, some states have adopted – or have suggested they will adopt — a gift tax exemption amount below the federal exemption of $5.34 million. Thus it is important to consider state tax consequences before undertaking any gift or estate plan. For states with lower exemptions, use of an irrevocable trust can help minimize state taxes.

Tax on trust income. Investment income earned within a revocable trust typically is taxed at the donor’s tax rate. Virtually all investment income earned within most irrevocable trusts, however, is taxed at the highest tax rate. Taking into account all surtaxes, that tax rate currently is 23.8% on dividend income and long-term capital gains and 43.4% on other types of investment income. To achieve both estate tax and income tax efficiencies an irrevocable trust should invest in assets that generate income exempt from tax or taxed at low rates. For this reason, life insurance can be a good investment within an irrevocable trust. When investing trust assets, a professional management strategy that seeks to enhance after-tax return by balancing investment and tax considerations is exceedingly important.

Stepped-up basis. In most cases, when a donor gifts an appreciated asset to an individual or an irrevocable trust during his or her lifetime, the recipient assumes the donor’s basis in that asset. Thus, the recipient will be taxed on any appreciation when the asset is later sold. By way of contrast, most assets transferred at death (including through a revocable trust) receive a “stepped-up” basis, relieving the heir of income tax on existing appreciation upon a later sale. Thus, the benefits of placing assets in an irrevocable trust during life must be balanced against the additional income tax a recipient might pay when the gifted asset is later sold.

Choosing between an irrevocable and revocable trust can be critical depending on the circumstances. For this reason (and others, including tax minimization and effective creditor protection), it is important to consult with a qualified attorney when establishing a trust, gifting assets, or considering any of the techniques described in this paper. Individuals establishing trusts also should retain a qualified professional fiduciary to assist in managing and administering the trust and directing the investment of trust assets.

 

Conclusion

A comprehensive estate plan, which typically involves the use of trusts, is crucial for couples with joint assets approaching or exceeding $10 million. But trusts also are important for couples or individuals with fewer assets, allowing them to protect assets from creditors, manage and grow the assets effectively, and distribute the assets to heirs or charities in accordance with their wishes when they are no longer able to do so themselves.

 

 

Andrew H. Friedman is the Principal of The Washington Update LLC and a former senior partner in a Washington, D.C. law firm. He speaks regularly on legislative and regulatory developments and trends affecting investment, insurance, and retirement products. He may be reached at www.TheWashingtonUpdate.com.

Neither the author of this paper, nor any law firm with which the author may be associated, is providing legal or tax advice as to the matters discussed herein. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. It is not intended as legal or tax advice and individuals may not rely upon it (including for purposes of avoiding tax penalties imposed by the IRS or state and local tax authorities). Individuals should consult their own legal and tax counsel as to matters discussed herein and before entering into any estate planning, trust, investment, retirement, or insurance arrangement.

 

Copyright Andrew H. Friedman 2014. Reprinted by permission. All rights reserved.

Congress Raises the Debt Limit: Is This the End of the Budget Battles?

From Andrew Friedman

Last week Congress — faced with an impending snow storm and a desire to get home for the Presidents Day holiday — hastily passed legislation permitting the federal government to continue to borrow funds through March 15, 2015. Coupled with the agreement reached last December to fund the government through September 30, 2015, this action eliminates the prospects of additional fiscal showdowns for at least the remainder of 2014.

While Congress can congratulate itself for keeping the government open and functioning (something it has not always been able to do), the fact is that these actions fail to addresses the fundamental fiscal issues facing the country. In particular, the compromises do not:

  • Change the growth of entitlement spending: A new report from the non-partisan Congressional Budget Office makes clear that mandatory spending (spending on entitlements such as Social Security, Medicare, and Medicaid as well as interest payments on the federal debt) continue to compose almost two-thirds of all U.S. spending. The Budget and Economic Outlook: Fiscal Years 2014 to 2024, Congressional Budget Office (Feb 2014). And that percentage will increase as the baby boomers age, the costs of Obamacare begin to accrue, and (at some point) interest rates rise. Indeed, the rate of increase is a considerable concern; the CBO estimates mandatory spending to grow at a rate in excess of seven percent annually – double the projected growth rate of the economy.
  • Bring in additional tax revenue or close tax loopholes: Tax reform remains on the agenda, but there has been no groundswell in Congress or encouragement from the Administration to move forward in a serious way.
  • Meaningfully reduce the deficit: The compromise did not reduce the near- or intermediate-term federal deficit beyond the sequestration spending cuts approved in 2011.
  • Change the trajectory or amount of outstanding federal debt: Outstanding debt continues to climb inexorably as the United States borrows more money each year to cover that year’s deficit. Debt as a percent of GDP does fall for a few years due to the sequestration cuts, but then that measure too rises as the increased entitlement costs kick in.
  • Replace the bulk of the sequester cuts: The indiscriminate across-the-board cuts to discretionary spending are unpopular with both parties, yet the compromise does little to replace them.

Some believe that the Republican agreement to extend the borrowing authority without a corresponding concession from the Democrats marks the end of the budget battles going forward. That is not my view, however. Although the fiscal battles will be quiescent this year, by the time next year that the debt ceiling has to be raised and the government funded again, a new class of House Republicans – likely fortified by new Tea Party members – presumably will want to take up the cudgel again to fight for fiscal restraint.

Extenders bill: Congress does have one more piece of unfinished fiscal business this year. A number of tax provisions expired at the end of 2013, as they do every year or two unless Congress renews them. An example is the IRA / charitable contribution provision that permits qualifying individuals to make tax-free annual contributions of up to $100,000 from their IRA to charity.

Typically Congress addresses the expiring provisions in an “extenders” bill. The Senate seems eager to take up such a bill, which would extend most of these provisions through 2014 (retroactively to January 1, 2014). But the House would prefer to wait until Congress can consider comprehensive tax reform, as reform is likely to affect each of the expired provisions.

In my view, tax reform is unlikely to occur this year. Once the House acknowledges that, Congress is likely to move the extenders bill later this year. Individuals who hope to take advantage of the IRA / charitable contribution provision in 2014 thus should hold off taking required minimum distributions until later in the year when we know whether the extenders bill will pass.
________________________________________

Andrew H. Friedman is the Principal of The Washington Update LLC and a former senior partner in a Washington, D.C. law firm. He speaks regularly on legislative and regulatory developments and trends affecting investment, insurance, and retirement products. He may be reached at www.TheWashingtonUpdate.com.

Neither the author of this paper, nor any law firm with which the author may be associated, is providing legal or tax advice as to the matters discussed herein. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. It is not intended as legal or tax advice and individuals may not rely upon it (including for purposes of avoiding tax penalties imposed by the IRS or state and local tax authorities). Individuals should consult their own legal and tax counsel as to matters discussed herein and before entering into any estate planning, trust, investment, retirement, or insurance arrangement.

Copyright Andrew H. Friedman 2014. Reprinted by permission. All rights reserved.

The President’s proposed future tax changes and some questions about past ones

From Andy Friedman of The Washington Update:

The United States government has once again hit its borrowing limit. The government is permitted to borrow through May 18, after which it can continue to operate without additional borrowing for about three months. By fall, Congress will have to raise the debt limit to prevent the United States defaulting on outstanding debt.

The Republicans are demanding changes to entitlement programs – Social Security and Medicare – as a quid pro quo for their approval to raise the borrowing limit. President Obama has provisionally accepted these changes, if the Republicans agree to new taxes. In that regard, the President has proposed a number of tax changes he wants to see enacted, including taxing municipal bond interest, limiting the amount individuals may accumulate in tax-preferred retirement accounts, and reversing recent expansions of the estate and gift tax exemptions.

In addition, I’ve received a number of questions regarding the application of the tax provisions of the fiscal cliff settlement. I’ve tried to answer some of the most common questions below.

To what types of investment income does the new 3.8% tax apply? Does it apply back to the first dollar or only to amounts over $250,000? Is non-investment income included in the $250,000 threshold?

Under the health care reform law, beginning in 2013 investment income received by families with adjusted gross income over $250,000 ($200,000 for an individual) is subject to a surtax of 3.8%.

The 3.8% surtax applies only to taxable investment income, such as corporate bond and savings account interest, dividends, capital gains, and rental and royalty income The tax does not apply to investment income that is not otherwise subject to tax, such as tax-exempt municipal bond interest and life insurance death proceeds.

The surtax also does not apply to amounts received from qualified retirement plans, such as IRAs, Roth IRAs, 401(k)s, and defined benefit plans.

The 3.8% tax applies to taxable investment income only to the extent that income, plus all other adjusted gross income, exceeds $250,000 for a family ($200,000 for an individual). It does not apply back to the first dollar of income once the threshold is breached For instance, suppose a family has $200,000 of wage income and $80,000 of dividend income. Total adjusted gross income of $280,000 exceeds $250,000 by $30,000. Thus the 3.8% tax would apply to $30,000 of the dividend income.

How does the “Pease phase-out” of itemized deductions work and to whom does it apply?

The fiscal cliff settlement reinstated the “Pease” phase-out of itemized deductions to the extent a family’s taxable income exceeds $300,000 ($250,000 for individuals). Under this phase-out, total itemized deductions are reduced by 3% of adjusted gross income above the income thresholds. However, itemized deductions in total cannot be reduced by more than 80%.

The Pease phase-out is really a disguised increase in the tax rate. As income continues to increase over $300,000, tax due increases by more than expected because itemized deductions are lost at the same time. The deduction phase-out adds about one percentage point to the tax rate for family income between $300,000 and $450,000, and 1.2 percentage points for family income above $450,000.

How does the IRA / charitable contribution rule that is available this year work, and what are the advantages of using it?

The fiscal cliff settlement extended for 2013 only the ability of individuals over age 70-1/2 to make tax-free distributions of up to $100,000 from an IRA to a charity. These charitable distributions may be used to satisfy the IRA holder’s minimum distribution requirement for the year. To qualify as a charitable distribution, the funds must go directly from the IRA custodian to the charity.

The ability to make charitable contributions through tax-free IRA distributions is particularly valuable now that the deduction for conventional charitable contributions is subject to phase-out for many taxpayers. In fact, an individual need not even itemize deductions to take advantage of this provision. Thus, individuals over 70-1/2 who intend to make charitable contributions in 2013 should consider using IRA funds first (after consultation with a qualified tax advisor).

 

Andrew H. Friedman is the Principal of The Washington Update LLC and a former senior partner in a Washington, D.C. law firm. He speaks regularly on legislative and regulatory developments and trends affecting investment, insurance, and retirement products. He may be reached at www.TheWashingtonUpdate.com

Fiscal Cliff Compromise

Happy New Year.  We begin this year as we ended the last – approaching another cliff.  To start the year off right, Andy Friedman appeared yesterday on CNBC to discuss the ramifications of the fiscal cliff compromise.  You may access the segment by clicking here.

Roth IRA conversions, AMT repeal, and VAT

The Washington Update from Andy Friedman

Roth IRA conversions:  Tax rates are likely to rise at year end as Washington considers whether to permit some or all of the Bush tax cuts to expire.  On the other hand, tax reform efforts in 2013 could reduce rates.  Fluctuating tax rates provide an interesting arbitrage opportunity for Roth IRA conversions in 2012.  Investors who expect to remain in the same tax bracket in retirement might wish to convert their IRA to a Roth IRA this year so that they can receive future earnings tax-free.  If tax rates then fall next year, they can act before October 2013 to re-convert back to the traditional IRA.  A new white paper on the site discusses the rules governing Roth IRA conversions (and re-conversions) and identifies the types of investors who might be well-advised to pursue this strategy.

And now to this quarter’s mailbag:

Is there a chance that Congress will repeal or ameliorate the alternative minimum tax?

The alternative minimum tax has become a chronic headache for many taxpayers.  The AMT was enacted to ensure that wealthy individuals pay their “fair share” of taxes.  Over the years, due to tax cuts and bracket creep caused by inflation, the AMT has crept very much into the middle class, affecting an ever increasing number of taxpayers.

Given outsized federal budget deficits, the government cannot afford simply to repeal the AMT and lose the significant revenue it raises.  Although this inability may frustrate affluent taxpayers, the alternative could be worse.  If Congress were to repeal the AMT, it would need to recoup the lost revenue.  It likely would do so by raising further the taxes imposed on the people the AMT was initially intended to affect — namely, the wealthy.  So affluent taxpayers may be better off with the current system, under which middle class taxpayers contribute to the revenue raised by the alternative minimum tax.

Although Congress is unlikely to repeal the AMT as a standalone “rifle shot”, there is some prospect that next year Congress will tackle tax reform — eliminating loopholes, simplifying the tax code, and reducing the top tax rates.  Part of reform likely would be the elimination of the AMT.  Whether Congress can agree on tax reform legislation in today’s partisan atmosphere is far from certain.  Absent successful tax reform legislation, the AMT is here for the foreseeable future.

Ironically, the AMT may offer affluent investors some salvation from higher tax rates.  The Bush tax cuts are slated to expire at year-end.  The Obama Administration is proposing permitting the tax cuts to expire only for families with income over $250,000 (individuals with income over $200,000).  Either way (whether the cuts expire for everyone or only affluent payers), higher-income taxpayers face the prospect of increased tax rates next year.  But many taxpayers’ alternative minimum tax will continue to exceed their regular tax, even when regular tax is computed at the new, higher rates.  These taxpayers will feel no effect from the expiration of the Bush tax cuts.  Other taxpayers will move out of the AMT position as the regular tax rates rise; that is, their regular tax computed at the new, higher rates will exceed their AMT.  Taxpayers in this position, however, are permitted to carry forward the AMT paid in prior years and offset that amount against regular taxes due.  For these taxpayers, the carryforward of prior AMT paid will blunt the effects of the tax increase.

One final point.  Every year, Congress keeps the AMT from expanding even further into the middle class by passing an “AMT patch.”  Currently, there is no patch in place for 2012.  Congress is likely to seek to enact this patch in the lame duck session at year-end or, failing that, early next year on a retroactive basis.

Are we likely to see Congress enact a value added or national sales tax?

Heightened concern about the budget deficit has led to talk of the need for a federal “consumption tax”, perhaps in the form of a value added tax (VAT) or a national sales tax.  Among other advantages, such a tax would address the revenue loss from the “underground economy” by imposing tax when unreported income is spent.

Both parties have rejected a national consumption tax, albeit for different reasons. Even small increases in the consumption tax rate would bring in billions to the federal government.  Republicans thus reject a consumption tax as a money machine that inevitably will lead to less fiscal discipline and higher government spending.

Democrats, too, have concerns about a consumption tax.  A consumption tax falls most heavily on the Democrats’ natural constituency:  middle- and lower-income taxpayers, who spend a greater portion of their income.  So Democrats do not want to tax what people spend; they want to tax what people earn that they don’t spend.  Thus Democrats want to keep the income tax and further stratify it, raising rates on the wealthy to capture some of the money they are earning but not spending.

In 2010, the Senate passed a resolution against a consumption tax by a vote of 85-13.  The Simpson Bowles deficit reduction panel viewed the enactment of a consumption tax as so politically unlikely that it did not propose such a tax in its final report.  Given this sentiment, a consumption tax is unlikely to be enacted anytime soon, regardless of which party is in power.

The Washington Update

The Supreme Court Rules on Health Care Reform: What It Means For Investors

The Washington Update from Andy Friedman

The Supreme Court has now upheld the individual mandate, the controversial part of the health care reform law (The Patient Protection and Affordable Care Act) that requires individuals to carry health insurance.  At the same time, the Court struck down the requirement that states expand their Medicaid coverage to include more low-income families. These rulings will have significant implications on the country’s fiscal situation.  Perhaps most important for investors, the Court’s decision virtually assures that the new taxes imposed by the law will take effect on schedule in 2013.

The Law.  By way of background, the Patient Protection and Affordable Care Act has five main elements;

An employer mandate (“pay or play”):  Employers with fifty or more employees must provide health insurance to their employees (“play”) or pay a new tax (“pay”).

An individual mandate:  Every American must have health insurance.  Those individuals who do not receive coverage from their employer or under Medicare or Medicaid must either purchase it or pay a penalty for failing to do so.

Restrictions on health insurers:  Health insurers may no longer reject applicants for coverage or charge higher premiums based on pre-existing health conditions.

Exchanges:  Each state is to set up an “exchange” where people can get information about various insurance policies and compare terms and pricing.

Subsidies:  Families with income under about $88,000 will get subsidies to help them purchase insurance, and (under the law as enacted) families with income below about $30,000 will get it for free under Medicaid.

The Individual Mandate.  Most observers (and even the lawyers undertaking the oral arguments) believed that the issue before the Supreme Court was whether the Commerce Clause of the Constitution gives Congress the power to require that everyone carry health insurance or pay a penalty (the “individual mandate”).  The Commerce Clause typically allows Congress to pass laws that affect items in interstate commerce.  A majority of the Court (the four conservative justices plus Justice Kennedy, who is often a swing vote) held that Congress does not have the power to require the purchase of insurance under the Commerce Clause.  They reasoned that, while Congress has the power to regulate commerce, it does not have the power to regulate a lack of commerce (that is, a decision not to purchase a product).

Chief Justice Roberts then broke with the other conservative justices to uphold the mandate on an entirely different ground.  He concluded that the penalty imposed on people who do not buy insurance is in effect a tax.  The Supreme Court has long held that Congress’ power to tax is virtually plenary, and that Congress can determine who to tax and for what reason.  With that holding, Roberts joined the four liberal justices who concluded that the individual mandate is permissible under the Commerce Clause.  With five justices thus upholding the mandate (albeit for different reasons), the mandate survived.

Roberts’ conclusion that the mandate penalty is a tax is curious, because when it passed the law Congress went out of its way to say the penalty was not a tax.  Congress did so because it did not want to appear to be imposing new taxes, which are unpopular.  Indeed, elsewhere in his opinion Roberts concluded that the penalty was not a tax for purposes of the Anti-Injunction Act, which precludes the Court from hearing a tax case before the tax is actually paid.  Thus in the course of the same opinion Roberts concluded the penalty was a tax for one purpose but was not a tax for another.

Read closely, Roberts’ opinion suggests that he undertook this legal ju-jitsu for a higher purpose.  As chief justice, Roberts is keenly aware of his responsibility for the Supreme Court’s legacy.  He is concerned by the public perception, particularly in the wake of Bush v. Gore, that the Court has devolved into a partisan political divide.  Roberts likely felt that a decision by the five Republican-appointed justices over the four Democratic-appointed justices to overturn a law enacted by a Democratic Congress and President would have eroded support for the Court inalterably.  Thus, even though Roberts might personally have found the law distasteful, he strained to find a plausible reason to save it (“it is not our job to protect the people from the consequences of their political choices”).

By straining to find an alternative ground to uphold the law Roberts gave both sides a victory.  The President gets his signature legislation.  But the conservatives get a narrower scope to the Commerce Clause which they’ve long sought, a precedent that no doubt will serve them well in later Court challenges to other laws.

The Fiscal Implications.  The health care reform law is likely to add significantly to an already swollen federal budget deficit.  Using the government’s own numbers from the time the law was passed (the most conservative numbers), health care reform will cost a trillion dollars over ten years.  Yet, according to the official estimates, the law is “revenue neutral”, meaning it does not add to the deficit.  This conclusion rests on two other provisions in the law.

First, half of the cost of the law (about $500 billion) is recouped through new taxes that begin in 2013, the implementation of which remain undisturbed by the Court’s majority holding:

A 0.9% increase in the Medicare tax on annual family wages above $250,000 ($200,000 for individual taxpayers).

An additional 3.8% tax on taxable investment income received by families with adjusted gross income over $250,000 ($200,000 for individual taxpayers).  This additional tax applies to investment income that is otherwise subject to tax, such as dividends, interest, capital gains, rents, royalties and distributions from annuity contracts.  The tax does not apply to income that is not taxable, such as tax-exempt municipal bond interest and life insurance death proceeds, or to amounts withdrawn from qualified pension plans and IRAs.

The 3.8% tax applies to taxable investment income only to the extent that income, plus all other adjusted gross income, exceeds $250,000 for a family ($200,000 for an individual).  For instance, suppose a family has $200,000 of wage income and $80,000 of dividend income.  Total adjusted gross income of $280,000 exceeds $250,000 by $30,000.  Thus the 3.8% tax would apply to $30,000 of the dividend income.

The remaining $500 billion cost of health care reform is to be made up by reducing Medicare reimbursement rates, lowering the payments received by doctors, hospitals, and drug companies who minister to Medicare patients.  The concern here is that reducing Medicare reimbursement rates will result in a shortage of doctors who will see Medicare patients.  Faced with the prospect of significantly reduced income, fewer college graduates will choose to undertake the financial burdens of medical school.  And more practicing doctors will take the “concierge” route, seeing only wealthy patients who can afford to pay “full price” for care.

This result will put Congress in a difficult position:  either accept de facto rationing of medical services, or contravene the new law and keep Medicare reimbursement rates at current levels.  Experience suggests Congress will do the latter.  Since the health care reform law was passed in 2009, Congress has overridden scheduled Medicare rate cuts four times, and there is every indication it will continue to do so.  If this trend continues, health care reform — far from being revenue neutral — will add $500 billion to the federal budget deficit.

And that estimate uses the government’s own numbers.  In reality, the cost is likely to be much greater because the system can be gamed.  As health care costs increase, many businesses likely will choose not to provide health insurance to employees, opting instead to pay the penalty.  The penalty on employers is only $2000 per year per employee, much cheaper than paying for insurance.  To date businesses typically have provided coverage for competitive reasons, or because employees with poor health histories would otherwise be unable to obtain it.  But these concerns disappear in a difficult job market and under a law that assures universal coverage regardless of health.  Thus, many businesses will save money by paying the penalty in lieu of providing insurance.  (Businesses with fewer than fifty employees don’t even have to pay the penalty.)  Perhaps they will use a portion of the savings to give employees additional bonuses to keep everyone happy.

If employers do not provide insurance, individuals will have to purchase it on their own.  But many healthy individuals may choose not to do so, opting to pay the penalty (or, as Justice Roberts would say, the tax).  For most families, the penalty will not exceed $2085 a year ($625 for single adults), a lower cost than paying for insurance.  Indeed, Roberts himself noted that “for most Americans the amount due will be far less than the price of insurance, and, by statute, it can never be more.”

Instead, individuals may wait until they are sick to purchase coverage, a right they are assured under the law.  Insurers cannot long survive a system where only sick people buy insurance.  Either they will have to raise premiums enormously, or more likely they eventually will exit the business.  In that event, sick people will have to obtain coverage elsewhere.  Presumably the federal government — the payer of last resort — will need to step in to provide it.

Of course, the status quo (pre-health care reform) is not acceptable either.  The United States has an aging population.  People without insurance go to the emergency room for a runny nose, a cost everyone bears.  Thus, if the health care reform law is to serve as the answer, then Congress must raise the penalties on employers and individuals high enough so they buy insurance, and find $500 billion in savings elsewhere in the federal budget.

Medicaid Expansion.  Another aspect of the Supreme Court decision may further increase the federal government’s cost of implementing the health care reform law.  As noted above, the law seeks to extend Medicaid coverage (free insurance) to all families earning less than about $30,000 a year (133% of the federal poverty level).  Currently only certain families with earnings under the poverty level (about $23,000 for a family of four) are eligible for Medicaid.  Thus the law would significantly expand Medicaid coverage to families above the poverty line, as well as to additional families below the poverty line.  The federal government will finance the full cost of this Medicaid expansion through 2016.  Beginning in 2017, the states are to fund a small part, topping out in 2020 at 10% of the total cost.

The law permits the federal government to withhold all Medicaid contributions — including those for existing programs — from states that decline to participate in this expansion of Medicaid coverage.  (Currently the federal government reimburses states for approximately 57% of Medicaid costs.)  The Court (in a 7-2 vote) rejected this part of the law, holding that the potential loss of full Medicaid funding was a penalty so great as to constitute federal coercion of state action impermissible under the Constitution.  According to the Court, the federal government may withhold from a non-participating state the federal government’s contribution to the Medicaid expansion (90% of the cost of the expansion), but it may not withhold funds previously granted to fund the existing Medicaid program.

The Court’s decision leaves the Medicaid expansion in limbo, as each state may now decide what it wants to do.  Many states are likely to expand Medicaid coverage anyway, given that the federal government will bear the brunt of the increased cost.  But some states may refuse to do so.  In that case, some low-income families may be entitled to federal subsidies to purchase insurance.  But others may simply be left without coverage.  Because such a gap in coverage would appear to be untenable, the federal government may end up funding a larger portion of the Medicaid expansion than anticipated, at least for residents of recalcitrant states.

Higher Taxes.  In upholding the bulk of the health care reform law, the Court’s decision assures that the law’s surtaxes on compensation and investment income will take effect as scheduled next year.  Thus, we now know with virtual certainty that income taxes next year will increase, regardless of whether Congress permits some or all of the Bush tax cuts to expire. My white paper, Investing in a Rising Tax Environment, provides strategies that investors can consider now to help blunt the effects of these higher taxes.

The Washington Update