TAXES PRESENT NEW TWISTS THIS YEAR... AND NEW MARKETING OPPORTUNITIES

 

ENVESTNET PRACTICE MANAGEMENT SERIES

 

As 21st century fi nancial professionals, we expect constant change, but this past year
has tested even the most resilient of us. We have been blasted by nothing short of the
stock market meltdown. And now, with the recent stimulus bill and the proposed new
budget, tax rules are also changing.

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Prospect High Net Worth Clients with Tax Overlay

You can leverage an understanding of the overlay strategy into an excellent tool to prospect for high net worth clients. Business owners who want to sell are looking at two key factors: sales price and taxable gains. Add value by showing that using the overlay process to accrue losses now means they can be used to offset capital gains at the time of the sale.

You can also present the overlay concept to investment bankers and share prospects as you develop a relationship and aim toward an ultimate sale transaction.

For advisors, this opens the door to new ways to add value for your clients. In fact, with stocks down so far from their highs, identifying tax harvesting opportunities and tax advantaged situations can help create good will with just about every investor on your roster.

• Most stockholders can reduce taxes through careful tax loss sales and tax overlay services.
• High-bracket earners are taking a “wait and see” approach until the budget passes, but conversion to a Roth IRA should be considered now.
• Mid-bracket clients can tap into the “something for everyone” changes included in the February 17 American Recovery and Reinvestment Act of 2009.
• Advisors benefi t too! Finding ways to position clients so they save on taxes, not just this year, but over many years can establish and maintain the solid relationships to grow your business.

Tax Harvesting with Overlay

Stock losses are never good news, but you can help clients fi nd the silver lining by taking a proactive approach to tax loss selling. With capital gains rates likely to go up, losses that are carried forward can be even more valuable. For clients with smaller, already-diversifi ed portfolios, this is most likely a straightforward process. However, many clients are in more complex situations. For them, take the initiative to explain and recommend a discretionary tax overlay process.

Tax Harvesting Has Become More Sophisticated

The practice of post-Thanksgiving tax-loss selling has been around for decades. In fact, a typical fi nancial news item almost always cites “tax selling” when the market is down in December.

Traditionally, advisors checked portfolios at year-end, seeking losses to offset gains taken earlier in the year or simply to reduce the client’s taxes. Replacing the sold stocks, and thus maintaining diversification and rebalancing were not necessarily a significant part of the decision.

Who can benefit from the overlay strategy?

Using an overlay service provides a disciplined, quantitative process to offset capital gains and losses, rebalance the portfolio, and build up tax losses that can be tapped for years to come (since losses can be carried forward into future years until they are needed). The resulting tax reduction improves absolute returns.

There are many reasons why people accumulate large numbers of shares with a low tax basis. High net worth families accumulate stock as the result of growth in a family-owned business or the sale of a company. The dilemma of executives who want to diversify from compensation-related stock is common. And this year, some investors have just been unlucky as some of the most widely recognized or respected companies in the U.S. are among those taking the biggest hits – including big banks and GE.

You will find candidates for tax harvesting among these kinds of clients.
• Those with a large number of low basis shares – made up of just one individual stock or with a portfolio.
• Clients with separate account strategies. These accounts were designed for active tax management but in practice that usually does not happen. An overlay strategy can manage that function.
• Clients who are consolidating multiple accounts.
• Business owners who have sold their companies or plan to sell.

Harvest all year, Versus Purchase

With a quantitative tax overlay process in place, more can be accomplished than is traditionally managed by advisors or investors themselves.

A key part of the discretionary overlay strategy is that tax losses are harvested all year, not just in December. This way, there are more opportunities to capture losses. In addition, with discretionary overlay, the versus purchase (VP) procedure looks at the purchase data of individual lots (date, price and number of shares) to identify on the tax form. That way, the stock that provides the greatest tax reduction is identified to the IRS.

Tax Overlay Supports Ongoing Rebalancing

In the exceptionally volatile 2008-09 markets, one challenge has been to maintain diversified, balanced portfolios. With daily analysis by an overlay service, rebalancing is accomplished with minimal time on your part. (You remain in control, having set parameters based on client input and the investment policy statement.)

Avoidance of wash sales is accomplished quantitatively. Highly correlated stocks are substituted for those which are sold. For example, a major oil company is traded for another major oil, or a small cap technology company is exchanged for a similar stock.

Losses in your clients’ portfolios are a chance to put (tax savings) money “in the bank.” Today’s confluence of beaten down stocks, a need to rebalance and expected higher capital gains and marginal income tax rates probably in 2011 create an unusual set of circumstances. That just might mean that 2010 is an outstanding year to take advantage of a tax overlay strategy for appropriate clients.

“High earners” may pay more, but there is time to plan
While lower- and mid-level taxpayers are being gifted with more cash right now, changes affecting higher-bracket clients will be incorporated into the budget now under discussion in Congress. These new rules, which are expected to increase the higher marginal income tax rate and capital gains tax, will likely go into effect after 2010.

The good news is that there is time to weigh strategies and plan.

Prepare for higher marginal income tax rates. The President has called for this increase in 2011. While details are becoming more clear, some clients might want to look at moving income forward into 2009 or 2010. One option within the individual’s control could be the timing of a large IRA distribution.

Many observers expect that the estate tax exemption will freeze at the current level of $3.5 million. Once that number has been firmed up by the Budget Act, planners will have a base from which to work with as they consider options such as gifting, trusts, etc.

Consider converting to a Roth in 2010
For 2010 only, there are no income limits for conversion to a Roth IRA, although there is a tax applicable upon conversion. Qualified distributions from a Roth are not taxed, and Required Minimum Distribution rules do not apply to Roth IRAs while the owner is alive.

To prepare for a 2010 conversion, clients can make non-deductible contributions of $5,000 ($6,000 if they are 50 or older) for 2008 until April 15, 2009, and for 2009 through tax-filing day in 2010.

The Roth IRA is an effective estate planning tool. Qualified Roth distributions after the account owner’s death are tax free, which makes them preferred over traditional IRAs.   In addition, the tax triggered at conversion is removed from the taxable estate. That is, it is not included in the ($3.5 million now) estate tax exemption.

Benefits for lower- and mid-bracket clients
The first set of tax changes – the American Recovery and Reinvestment Act signed February 17 – impacts taxpayers with adjusted gross incomes of up to about $250,000 (married filing jointly). It aims to put more cash in their pockets to stimulate spending. Several key provisions have a short duration, ending on November 30 of this year or lasting just through the end of 2010, although the President would like to see extensions on many of these measures.

A 2009-2010 tax credit can add a little cash all year
Last year, stimulus checks were mailed to taxpayers. This year’s credit, calculated at 6.2% of earned income, will most likely be in the form of reduced tax withholding, so net cash from pay checks will be slightly higher.

The maximum for individual filers is $400, with a phaseout beginning at $75,000 adjusted gross income. For married filing jointly, the maximum is $800 and phaseout begins at an adjusted gross income of $150,000.

Get a new set of wheels and help the auto industry
A credit equal to the sales tax on a new automobile (or SUV, light truck, RV or motorcycle, domestic or foreign) can reduce the net cash outlay. It does have to be a new vehicle, though, and it applies against a maximum $49,500 of the purchase price and phaseouts apply.

Two key points: The deduction will be “above-the-line,” so it can be taken even if the taxpayer is not itemizing. And timing is important: It is effective for just about seven more months – through November 30, 2009.

Tax breaks benefit people in many different circumstances
Lower- and mid-level taxpayer benefits include families, students, retirees and the unemployed. Tax breaks for education include the addition of computers as qualified expenses in 529 plans and an “American Opportunity” tuition tax credit of up to $2,500 in 2009 and 2010.

If a client has never owned a home or, by some chance, has not owned one for three years, they may be eligible for a credit of 10% of the purchase price up to $8,000. Another home-related tax credit increases credits to 30% for energy efficient improvements such as a furnace or hot water boiler, up to a maximum of $1,500.

Use Tax Issues in Your Marketing Initiatives
Many people would rather brush their teeth with sandpaper than write a check to the IRS. Others are more willing to pay up to Uncle Sam. But nobody wants to pay more than his or her fair share.

You can leverage this interest as you market your services.
• Make sure your relationships with accountants and estate planners are strong and mutually beneficial. If you want to strengthen your professional alliances or start new ones, identify a couple of potential new contacts and make sure you get in touch right after tax season.
• Identify a few tax issues that are common to most of your client base. Then use email or snail mail to send a fairly detailed newsletter-style commentary. (With the market down, new issues that have emerged regarding the pros and cons of taking strategic capital losses and gains can be important to investors.)
• Get started on tax-friendly seminars and workshops that educate and encourage long-term tax thinking and planning. Invite your tax professional colleagues to speak.

Even if you are not a tax expert yourself, you need to make sure clients understand the tax provisions that are most likely to help them save money.

 

Two sources of tax information are www.irs.gov, CCH at www.cch.com and the more conceptual Tax Policy Center, www.taxpolicycenter.org.

This article is provided for informational and educational purposes only. It is not intended as and should not be used to provide investment advice and does not address or account for individual investor circumstances. Investment decisions should always be made based on the client’s specific financial needs and objectives, goals, time horizon and risk tolerance. The statements contained herein are based upon the opinions of Envestnet and third party sources. Information obtained from third party sources are believed to be reliable but not guaranteed. Neither Envestnet nor its representatives render tax, accounting or legal advice. Any tax statements contained herein are not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state, or local tax penalties. Taxpayers should always seek advice based on their own particular circumstances from an independent tax advisor. Past performance
is not a guarantee of future results.

FOR FINANCIAL ADVISOR USE ONLY. NOT FOR USE WITH END INVESTORS.