With all of the financial turmoil we have experienced over the past year or so, many of us find ourselves asking a lot of questions, such as: What should I do about my portfolio? Should I have my will, trust, and other financial documents reviewed by an attorney? How should I evaluate the performance of my investments over the past year, three years, or five years? Do I have a viable investment policy, or is it time for a change? What impact will the changes to tax laws have on my investment and estate plans going forward?
These are just a few of the tough questions many will try to answer as we end 2009 and look ahead to the new year; a year after which we will see the Bush tax cuts “sunset,” meaning they will expire, unless new legislation is passed. In this week’s column, I will try to answer some of these important questions, and to provide some guidance and insight into the possible changes to the tax law, and how they might affect financial and estate planning decisions.
This is the perfect time to review all of your financial and estate planning documents. If you don’t already have a financial plan and estate plan, this is a great time to prepare one. In my opinion, every person, regardless of age, income, assets, or financial situation, should have a will, trust, and a financial and estate plan.
If you are young, the financial plan is most important, since you must maximize the growth potential of your investments to plan for retirement and other expenses. If you are nearing retirement, the retirement planning aspects of your financial plan gain in importance, as you will need to analyze your available assets in the context of their ability to provide you with the lifestyle you desire during retirement. If you are somewhat older and already in retirement, or if you have substantial assets, your estate plan will typically be most important, as it will address your wishes with regard to asset disposition upon your death, as well as the needs of your family members, your charitable intent, and personal and/or family legacy issues.
Because so much has happened in the financial markets over the last year or so, it may be difficult for some to get a handle on whether or not their investments are properly allocated. The question of proper asset allocation is critical to successful investing, as studies have shown that up to 90 percent of total portfolio performance can be attributed to how investment dollars are divided amongst the various asset classes, such as stocks, bonds, real estate, commodities, cash, etc, and within each of these broad categories as well. Unless investors have been actively tracking asset value changes within their portfolios during the previous several quarters, it is highly likely that asset allocations have drifted far from long-term targets. (If you do not have a well-defined asset allocation strategy for your investment portfolio, I strongly suggest you develop one, or that you work with a professional skilled in this area.)
If asset allocations have changed materially from targets, this is a good time to reallocate. A thorough examination of current economic and market conditions, coupled with more specific research on the prospects for each asset class and sub-class should be undertaken to determine the best asset allocation for portfolios, in the context of the investor’s individual investment objectives and risk tolerance—what you are trying to accomplish with your investments and how much risk you are willing to take to achieve these objectives.
Depending on the amount of time the investor has to invest—until retirement, throughout their life expectancy, or transcending multiple generations for wealthy investors with substantial assets—asset allocations must be adjusted on an ongoing basis to reflect the time horizon and shifting risk tolerance for the portfolio.
In 2001 and 2003, President George W. Bush proposed, and Congress passed, a series of tax cuts. Due to what is known as the Byrd Amendment (where tax bills that lose revenue are limited to 10 years in duration) these tax cuts will expire on 12/31/2010, unless extended by an act of Congress. While there were many individual tax provisions in the final version of the bill that passed into law, the key items that I believe could have a major impact on the economy (and you and me) are the income tax rates, the dividend tax rate, and the estate tax exemption amount and rate.
Currently, the highest individual income tax bracket is 35 percent (for single people or couples filing jointly, earning over $372,950). The 2009 estate tax exemption amount is $3.5 million per individual ($7 million per couple), and the maximum tax rate on estates for amounts above these figures is currently 45 percent. You also have a lifetime gift tax exclusion amount of $1 million, which is part of your individual $3.5 million total exemption amount (in 2009).
According to Paul Graziano, Partner and attorney with Allen & Kimbell, every individual can transfer up to $13,000 in cash or other assets to as many donees as they like on an annual basis totally outside the gift tax system, meaning no gift tax returns are required to be filed, so long as the gifts qualify as present interest gifts. Basically, a present interest gift is one where the donee has control or absolute access to the gift immediately.
As currently written, in 2010, the estate tax is repealed for one year. The annual exclusion and lifetime gift tax provisions remain unaffected, however. If you happen to die next year, you can pass-on all of your assets to your children (if you want to), or anyone else, with no taxes at all. The problem is that on January 1, 2011, unless Congress passes new legislation, income tax rates will revert back to the pre-Bush tax cuts levels, with the maximum individual tax rate at 39.6 percent, the rate on dividends also at 39.6 percent (from the current 15 percent for qualified dividends), and the estate tax exemption goes back to $1 million per individual ($2 million per couple) and a maximum tax rate on assets above those levels of 55 percent.
Just this past Thursday, the House voted to make the current, 2009 estate tax rules permanent. While it is unlikely that the Senate will have time to pick-up this issue before December 31st, I would expect something to get passed that kills the 2010 unlimited exemption.
These potential changes have massive implications, both for the economy and for decisions on investments. For example, investments currently paying qualified dividends will be far less attractive, meaning that their values will likely decline. Further, investors currently holding these investments must make a difficult choice to either hold them, receiving far less in after-tax income (assuming they are in a high tax bracket), or sell the investment, possibly at an unattractive price. The question for this investor then becomes, “How do I replace the lost income?”
One place to look would be municipal (tax-free) bonds, which will likely increase in value if these income and dividend tax rates increase. The sticky part is finding municipal bonds that will not suffer from possible defaults by municipalities struggling to meet their financial obligations with lower tax revenues from plummeting real estate values, sales tax revenues, etc.
From an estate planning perspective, the potential for the estate tax exemption changing poses some serious challenges. For one, if existing estate plans have been developed using assumptions that the current, more favorable tax rates and exemption amounts will continue indefinitely, these plans will need to be revised to reflect the new law, once known. Depending on the amount of assets an individual or couple may have, there could be dramatic changes to estate plans, resulting in some complex trust structures that only an expert attorney who specializes in this area can address.
The best course of action is to review all documents as well as portfolio structure to ensure that you have a well-defined, coordinated and comprehensive Investment policy, and financial and estate plan. If you don’t, my advice is to seek the assistance of professionals to help you gain control of your finances.