By FPA member Dave Hill, CFP®
Last Updated: April 26, 2010
Supposedly the only sure things in life are death and taxes. But this year and next, the amount and type of taxes you may have to pay are no sure thing. Most — but not all — of the tax changes will affect people with high incomes and/or substantial assets.
Higher Income Taxes Coming
Currently, dividend income from stocks is taxed at a top rate of 15 percent. It will go to 20 percent in 2011. The same thing holds true for the tax on long-term capital gains on investments: the top rate will go up to 20 percent from 15 percent.
Your investment adviser and tax professional should be working together — especially this year. They can determine the best time for you to use any capital loss carryover from 2009, which many people have because of the market decline in 2008-09. For example, if you sell stock to realize gains in 2010 to avoid the higher tax in 2011, you may be forfeiting potential upside on your capital loss carryover. You may wish to be capital gain/loss neutral in 2010 and use the 2009 capital loss carryover against 2011 gains which will probably be subject to a higher tax.
However, never let tax changes spur you to make unwise investment decisions.
The Estate Tax Mess
Currently, in 2010 there is no federal estate tax. But in 2011, the law is scheduled to revert to the old $1 million threshold, meaning that any amount above $1 million is taxable, unless the recipient is the spouse. Although Congress may reinstate the estate tax, retroactive to January 2010, the question remains if and when. However, the further away from January 1, 2010 we move, the less likely the estate tax will be made retroactive to January 1.
The only thing that is currently certain is that that the step-up in basis to fair market value for inherited assets has been repealed for 2010. In other words, you may be taxed on the full gain of the value of the assets you sell which were inherited, based on the current fair market minus the decedent's original cost. There are still exclusions that allow for a partial step-up in basis, but you will need this information from the estate's executor.
Here's the way the estate tax law worked prior to 2010. Suppose a father died and his will left his $10 million business (for which he paid $1 million 20 years ago) to his son. The son would have an asset worth $10 million and a basis equal to the fair-market value, or $10 million. So, the father's estate would be liable for the estate tax on the $10 million asset (before exclusions) but the son's basis would be $10 million also. If the son were then to sell the business for $10 million, he would not be subject to any income tax.
Under the current rules for 2010, there would be no estate tax on the $10 million asset but the son's basis would be the same as the father's, which was $1 million. If the son sells the business, he would pay capital gain tax on the $9 million gain.
Because of the uncertainties surrounding estate taxes and the elimination of the step-up in basis, anyone who might be affected by the estate tax needs to make sure that all financial documents are in order. If they're not, you could be giving away more money than necessary to Uncle Sam — and add your state tax bill to that too.
Conclusion
Since the tax and estate laws are uncertain, enlist the knowledge of a financial planner and tax professional together — especially this year so that you are making the best holistic decision and making sure your money goes where you want it to, and not where the Internal Revenue Service (IRS) and your state governments would like it to go.
These laws are going to change; it is just a question of the timing. Are you prepared?
FPA member Dave Hill, CFP®, is an analyst at Brinton Eaton Wealth Advisors, a boutique wealth advisory firm based in Madison, N.J.
