The current tax landscape and planning opportunities for clients

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1 The current tax landscape and planning opportunities for clients Christopher P. Hennessey Lawyer and CPA Member, Putnam Business Advisory Group Faculty Director, Babson College Executive Education Not FDIC Insured May Lose Value No Bank Guarantee /14

2 Topics for today Reviewing the income and estate tax landscape Longer-term outlook on taxes Planning strategies for clients How Putnam can help 2

3 The current tax landscape

4 Taxes rates increased in 2013 for some taxpayers Single Married filing jointly Income Capital gains and dividends $0 $9,075 $0 $18,150 10% 0% $9,076 $36,900 $18,151 $73, $36,901 $89,350 $73,801 $148, $89,351 $186,350 $148,851 $226, $186,351 $405,100 $226,851 $405, $405,101 $406,750 $405,101 $457, Over $406,750 Over $457, % 20% 2014 IRS tax brackets and rates. 4

5 Clients with irrevocable trusts need to be aware of low income thresholds Trusts (and estates) with more than $12,150 in taxable income in 2014 are subject to the highest marginal tax rates on investment income Applies to undistributed income Medicare surtax of 3.8% may apply as well Item Highest tax rate Bond interest 43.4% Long-term capital gains 23.8 Dividends

6 Phaseouts for itemized deductions and personal exemptions returned in 2013 Single Married filing jointly Itemized deductions Personal exemptions AGI > $254,200 AGI > $305,050 Reduced by 3% of the amount exceeding the income threshold (referred to as the Pease rule). Limited to a maximum phaseout of 80% of impacted itemized deductions. Reduced by 2% for every $2,500 of income above the threshold. Referred to as the Personal Exemption Phaseout (PEP). Fully phased out at $376,700 for single taxpayers, $427,550 for couples filing joint returns. Income phaseouts based on 2014 IRS figures. 6

7 Example of how phaseouts work Married couple with 3 dependent children (total of five personal exemptions of $3,950 each, for a total of $19,750) $75,000 in total itemized deductions subject to phaseout such as mortgage interest, charitable contributions, state and local taxes, and miscellaneous itemized deductions Income level (AGI) Itemized deductions Personal exemptions $400,000 Reduced by $2,848 Reduced by approx. 77% or $15,160 $500,000 Reduced by $5,849 Full phaseout $1M Reduced by $20,848 Full phaseout 7

8 Taxes associated with health-care reform 3.8% Medicare surtax on net investment income Affects individuals with more than $200K in income, couples with more than $250K in income* Affects interest, dividends, capital gains, annuity income, rental income, royalties Business income from passive activities is subject Retirement plan distributions and municipal bond interest excluded however, retirement plan income can push a taxpayer over the income threshold Additional payroll tax of 0.9% on workers earning salary/wages more than $200,000 ($250,000 for couples) * The threshold for the 3.8% net investment is based on modified adjusted gross income (MAGI), defined as adjusted gross income plus net foreign income exclusion amount. 8

9 Medicare net investment income surtax example: Married couple with income over $250K $50K Muni Income Not subject to 3.8% surtax $250K income threshold (MAGI) $100K Cap Gain $50K IRA income $50K cap gain subject to surtax $50K cap gain not subject to surtax Not subject to the surtax but is included in determining the $200K/$250K income threshold $150K Salary Simplified, hypothetical example designed to illustrate how the new Medicare net investment income surtax is applied. Beginning in 2013, the surtax applies to individuals with MAGI over $200,000 and married couples filing joint tax returns with MAGI over $250,000. MAGI defined as Adjusted Gross Income (AGI) plus net foreign income exclusion amount. 9

10 Summary of key income thresholds Higher income, capital gain, and dividend rates $406K $457K $254K $200K Phaseout of deductions and exemptions New health-care taxes $305K $250K Individuals Couples 10

11 Will your clients owe AMT? The AMT will impact over 4 million taxpayers in 2014 with an average AMT tax bill of $6,500* Income level Chance of owing AMT $100K $200K 2% $200K $500K 48 $500K $1M 78 > $1M 36 * Urban-Brookings Tax Policy Center, August Urban-Brookings Tax Policy Center, September

12 A closer look at the AMT Tax rates and brackets AMT exemption amount AMT exemption phaseout* Popular tax breaks disallowed for AMT Common triggers of AMT 26% on first $182,500 of AMT income, 28% thereafter $52,800 ($82,100 for couples) Begins at $117,300 of AMT income ($156,500 for couples); fully phased out at $328,500 ($484,900 for couples) Personal exemptions, standard deduction, state and local income and property taxes, miscellaneous 2% deductions, interest on second mortgages Large capital gains, incentive stock options (ISOs), interest from private activity bonds * 2014 IRS figures. The AMT exemption amount is reduced by 25% of each dollar in AMT income above $117,300 income threshold for single taxpayers and $156,500 for couples filing a joint return. 12

13 Taxation for estates and gifts Exemption amount Maximum tax rate Portability Annual gift exemption $5.34 million for estates, gifts, and generation skipping transfers (GST) 40% Allows surviving spouse to utilize deceased spouse unused exemption (DSUE) $14, IRS figures. 13

14 Understanding portability Allows surviving spouses to utilize any unused exemption amount of last deceased spouse (up to $5.34 million in 2014) The Deceased Spousal Unused Exclusion amount (DSUE) applies to the last deceased spouse only IRS form 706 (U.S. Estate and Generation-Skipping Transfer Tax Return) must be filed following the death of the first spouse to claim the unused exemption amount 14

15 A longer-term look at taxes

16 Total debt remains high based on historical norms 100% Federal debt held by the public (% of GDP), % Percentage of GDP 60% 40% 20% 0% Source: Congressional Budget Office, Updated Budget Projections: Fiscal Years 2013 to 2023, May 2013; does not include intra-governmental debt. 16

17 The budget picture has improved but will worsen due to interest rates and mandatory payments (%) 26 Historical federal government revenues and outlays (% of GDP), Percentage of GDP 20 Projected Spending 22.6% Revenue 19.1% Source: Congressional Budget Office, Updated Budget Projections: Fiscal Years 2013 to 2023, May

18 Most government spending is on auto-pilot U.S. federal government spending by type, 2013FY Social Security $809B Defense $631B 35% Discretionary Mandatory 65% Medicare $496B Medicaid $265B Interest $223 Other $450B Non-Defense $582B Source: Congressional Budget Office, May 2013 projections; Mandatory spending types primarily include Social Security, Medicare, and Medicaid, as well as interest on existing debt. Discretionary spending includes defense and non-defense items. Other mandatory items include certain veteran s benefits, retirement benefits for federal employees, Supplemental Nutrition Assistance Program (SNAP), unemployment, and other government benefits less offsetting receipts. 18

19 Tax preference items under scrutiny Largest federal tax expenditures ($B), fiscal years estimated Tax preference item Amount 1. Exclusion for employer-provided health care $ Reduced tax rates on dividends and capital gains Income exclusion for DC plans and IRAs Mortgage interest deduction Earned income tax credit (EITC) Deduction for state/local income or sales tax Step-up in cost basis at death Exclusion for Defined Benefit (DB) plans Tax-free treatment of municipal bond income Charitable contribution deduction 183 Source: Joint Committee on Taxation (JCT), February Does not include expenditures related to Medicare or Social Security. 19

20 Near-term potential tax and estate risks to clients Lower risk Moderate risk Higher risk Tax muni bond interest Reduce retirement plan contributions Tax investment earnings within insurance and annuities No step-up in cost basis at death Lower estate/gift exemption Limit IRAs to $3M Dividends and cap gains taxed as income Limit deductions to 28% tax bracket or a set dollar amount Buffet rule on those with $1M+ in income Mortgage deduction for primary residence only No Stretch IRA No Dynasty trusts Tax changes to Grantor Trusts Minimum term for GRATs Limit discounts on FLPs 20

21 What would a longer-term debt solution look like? Everything on the table increased revenues, cuts in discretionary spending, major entitlement reform Potential components of Social Security reform Increase wage base to cover 90% of wages from roughly 85% currently* Increase the retirement age for younger workers Utilize a different COLA formula ( chained CPI) for benefit increases Reduce benefits for higher-income recipients (i.e., means testing) Comprehensive tax reform? Less brackets, lower marginal tax rates Elimination or significant reduction in tax preference items Bowles-Simpson model not necessarily a panacea newly issued municipal bonds fully taxable, drastic reductions in tax-favored retirement plan contributions, capital gain and dividend income taxed at ordinary income rates, etc. * Social Security wage base for 2014 is $117,000. Based on analysis from the Congressional Research Service, the wage base would have to be increased to $214,500 for payroll taxes to cover 90% of all wages ( Increasing the Social Security Payroll Tax Base: Options and Effects on Tax Burdens, February 2013). 21

22 Planning strategies

23 Five income tax planning strategies for clients and prospects to consider 1. Invest in municipal bonds to generate tax-free income 2. Reduce taxable income to avoid higher tax rates or 3.8% surtax Contribute to retirement plans, IRAs, FSAs, HSAs, etc., deferred compensation Maximize use of tax deductions (charitable contributions, mortgage interest, etc.) Tax loss harvesting 3. Consider a Roth strategy (contributions, conversions, Roth 401(k)) as a way to hedge against the direction of future tax rates Are there special circumstances such as NOL carryforwards? 4. Asset location hold greater % of fixed-income assets inside tax-deferred accounts, dividend-paying investments within taxable accounts, highly appreciating assets within Roth 5. Irrevocable trusts: Highest marginal tax rates and Medicare surtax applies at income levels > $12,150 are there opportunities to reallocate trust investments or distribute more income to trust beneficiaries? 23

24 Five estate tax planning strategies for clients and prospects to consider 1. Review estate planning strategies and documents Estate tax might be less of a concern with relatively high exemption amount, but are critical documents, such as wills, beneficiary designations, revocable trusts, POA, health-care directives, etc., in place? 2. Plan for potential state death or inheritance taxes 3. Evaluate whether to transfer wealth during lifetime or at death Weigh loss of control of gifting assets while living vs. benefit of sheltering appreciation post-gift from estate taxes 4. HNW families should consult with estate planning attorneys on advanced wealth transfer strategies (grantor trusts, FLPs, dynasty trusts, etc.) while these techniques are still available 5. With the portability provision, should couples still consider a Credit Shelter Trust (CST)? 24

25 A look at state death taxes State CT DC DE HI IL MA MD ME MN NJ NY OR RI TN VT WA Estate taxes $2M exemption, 12% rate $1M exemption, 16% rate $5.34M exemption, 16% rate $5.34M exemption, 16% rate $4M exemption, 16% rate $1M exemption, 16% rate $1M exemption, 16% rate $2M exemption, 12% rate $1M exemption, 16% rate $675K exemption, 16% rate $1M exemption, 16% rate $1M exemption, 16% rate $921K exemption, 16% rate $2M exemption, 9.5% rate $2.75M exemption, 16% rate $2M exemption, 20% rate State estate tax Tax rates in table above reflect the highest marginal state tax rates. Several states impose inheritance taxes, including IA, KY, NE, PA, TN, MD, and NJ. 25

26 With portability, do Credit Shelter Trusts still make sense? The case for a bypass trust Asset protection State death taxes Appreciation in trust assets occurring after the death of first spouse is outside of the last surviving spouse s estate Preserves the GST exemption, which is not portable The case for portability No special planning needed Cost and effort to establish and maintain a trust Potential adverse tax implications of holding assets within a trust Loss of step-up in cost basis at death of last surviving spouse ( 2nd step up ) if a CST is used Spendthrift protection 26

27 Closing comments Longer-term deficit pressures will prompt more discussion on potential federal budget revenue increases There will likely be uncertainty around tax policy as potential tax reform is addressed In this environment, tax diversification and tactical, tax-smart planning strategies and investment solutions will be at a premium 27

28 Resources designed to help you engage clients and prospects Client seminar and investor education pieces on the tax landscape and planning ideas Wealth Management Center blog articles and resources Putnamwealthmanagement.com Video commentary and podcasts 28

29 Contact Putnam Dealer Marketing: Advisor website: putnam.com/advisor 29

30 Appendix Opportunity with Grantor Retained Annuity Trusts (GRATs)

31 Opportunity with grantor retained annuity trusts (GRATs) in a low-interest-rate environment Type of irrevocable trust where the grantor retains a right to annuity payments from the trust over a number of years Can be an effective method for transferring wealth free of gift and estate taxes if designed properly Especially attractive right now considering historically low IRS interest rates HNW clients may want to consider acting now because of potential legislative threat 31

32 GRAT example Sally transfers $5 million in property to an irrevocable trust The trust transfers property back to Sally over the three-year term based on an annuity amount of $1.7M per year Annuity factor is based on IRS 7520 rate of 2% as of December 2013 If trust assets grow 10% annually, then almost $1M remains in the trust free of gift and estate taxes for the benefit of Sally s beneficiaries Assumes Sally outlives the three-year term for the GRAT to be an effective strategy Sally $5 million transferred $1,733,763 transferred back to Sally over next 3 years GRAT $916,244 left in trust after 3 years on transfer tax free basis Beneficiary For illustrative purposes only. 32

33 FOR FINANCIAL PROFESSIONAL USE ONLY. NOT FOR PUBLIC DISTRIBUTION. There is no guarantee that any plans or proposals in this material will be implemented. This information is not meant as tax or legal advice. Please consult with the appropriate tax or legal professional regarding your particular circumstances before making any investment decisions. Your clients should carefully consider the investment objectives, risks, charges, and expenses of a fund before investing. For a prospectus, or a summary prospectus if available, containing this and other information for any Putnam fund or product, call Putnam Dealer Marketing Services at Your clients should read the prospectus carefully before investing. Putnam Retail Management putnam.com 33

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