Tax Relief for Investors: Sunset on the Horizon
For investors, the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) made two significant tax-saving changes. First, long-term capital gains rates dropped from 20% to 15% for investors in the top four brackets and from 10% to 5% for those in the bottom brackets. Second, qualified corporate dividend income will be taxed at long-term capital gains rates for the next several years. But, these favorable changes are temporary and will expire in 2009, unless Congress enacts further legislation. Let’s take a closer look at the scheduled changes and planning opportunities.
Long-Term Capital Gains Cuts
Under JGTRRA, the long-term capital gains rate for investors in the top four
brackets (35%, 33%, 28%, and 25% brackets) is 15%. Taxpayers in the 10% and 15% brackets pay only 5% tax on long-term capital gains, reduced from 10%. These long-term
rates apply to profits on the sale of capital assets held more than one year. This provision expires in 2009, when the former rates will again take effect. taxes at their marginal rate,
which could be as high as 38.6%. Now, a dividend tax of 15% applies to taxpayers
in the top four marginal brackets who receive dividend income. This provision expires in 2009.
For an illustration of the possible savings, consider the following hypothetical lower dividend rate. Investors in the 10% and 15% tax brackets will be subject to a dividend tax rate of 5%. For these taxpayers, the dividend tax will be eliminated altogether in 2008,
and then be reinstated in 2009, when the legislation expires, at the prior rates of 10% and 15%.
Investors in the 10% and 15% brackets will experience a reprieve from long-term capital gains tax altogether in 2008, when it will be eliminated for one year. In 2009, the pre-JGTRRA rate of 10% will be reinstated. Short-term capital gains, which generally refer to investments held less than a year, experience no tax reform and, therefore, will continue to be taxed at the investor’s marginal rate.
Prior to JGTRRA, investors who received dividend income were required to pay example of Emily Fisher, who is in the highest tax bracket. Before JGTRRA, her annual dividend income of $50,000 would have been taxed at her marginal rate of 38.6%. Emily would have owed $19,300 in tax ($50,000 Å~ 38.6%) when taxed at the margin. While her marginal rate has been lowered to 35%, a new dividend tax rate of 15% applies to her dividend income. With this much lower rate, Emily experiences a significant reduction in her tax bill, owing instead only $7,500 ($50,000 Å~ 15%)— that represents $11,800
Lower income taxpayers are eligible for an even This landmark tax reform provides a number of planning options for investors, but the opportunities are temporary. For specific guidance, consult your qualified financial and tax professionals.
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Disability Income Insurance—Protecting Your Most Valuable Asset
Have you ever asked yourself how you would manage if you were to suffer a severe accident or illness that left you unable to work? How would you pay your bills and
cover your daily expenses? The likelihood of such an event may be greater than you think. According to the Insurance Information Institute (III, 2002), an individual between the ages of 40 and 65 has a greater chance of missing at least three months of work due to an accident or illness than of suffering an untimely death.
To be prepared for such a situation, it is important to plan ahead. An approach to consider would be the purchase of an individual disability income insurance policy. However, there are a few considerations to keep in mind when choosing this coverage:
• Definition of Disability. Carefully review your policy’s definition of disability.
Some policies may provide coverage only if you are unable to work in the occupation in which you were employed or for which you were trained, or if you can no longer earn as much as you once did in that field. In contrast, other policies may offer coverage only if you are unable to work in any occupation. This distinction can make a big difference if
you become disabled.
Residual Benefits or Partial Disability Coverage.
Under certain specified circumstances, if you become disabled and are only able to earn a portion of your previous income, residual benefits or partial disability coverage pays a portion of your benefits.
With this feature, the insurer cannot refuse to renew your policy or change any terms, except for premium cost, as long as you continue to pay your premiums on time.
This provision allows you to increase your monthly benefit, even if you experience health
changes that would otherwise prevent you from obtaining additional disability coverage.
- Cost-of-Living Adjustment
(COLA). This feature helps protect your benefits against the effects of inflation during
a long-term disability. The Outlook without Protection If you don’t have a disability
income policy, there are alternatives, although they all have shortcomings. For instance, you could self-insure. However, even if you save 10% of your salary each year, one year of disability could easily wipe out many years of savings. Or, perhaps your employer
provides disability income insurance. Unfortunately, employer-sponsored plans are often limited in scope and duration, and coverage is not portable upon termination of employment (except in certain executive disability policies). Workers compensation may be an option in some cases; however, it only covers injuries suffered on the job. Eligibility and benefits vary by state.
To qualify for Social Security disability benefits, you must be severely disabled and, even then, you will have to wait at least six months for payments to begin. Social Security disability was not intended to be an individual’s sole source of income in the event of a disability, thus benefits are often less than what you might need to cover your regular living expenses.
A debilitating illness or injury that cuts off or reduces your primary source of
income can be a financially devastating experience—one from which it can be difficult
to recover. Disability income insurance can play an important role in your overall financial program. Like most insurance policies, disability income insurance policies contain exclusions, limitations, reductions of benefits and terms for keeping them
The “A’s” and “B’s” of Asset Preservation
Asset preservation goes hand-in-hand with wealth accumulation. The federal estate tax has an uncertain future, which makes planning your estate and staying abreast of legislative changes essential.
While the federal estate tax is currently scheduled for repeal, this reprieve is temporary and will be in effect for one year only 2010 unless Congress enacts further legislation. Every estate may exclude a certain amount of property from estate tax, and in 2005 that amount is $1.5 million. The amount that may be excluded will rise over the next several years until repeal in 2010, according to the following schedule:
Thanks to the unlimited marital deduction, assets that are passed to a spouse at death do not incur any estate taxes. However, for high net worth married individuals, “over-qualifying” for the marital deduction may create a large estate tax bill at the death of the surviving spouse. If the unlimited marital deduction is used at the death of the first spouse, that spouse’s estate tax exemption ($1.5 million for 2005) is lost, and all remaining assets in the estate of the surviving spouse will be subject to estate tax at the second death (only $1.5 million would be offset by the survivor’s exemption).
Setting Up A/B Trusts
One common estate planning technique available to help both spouses utilize their estate tax exemptions is the combined use of marital and bypass trusts—the A/B trust arrangement. Here is how the A/B trust arrangement might work for a married couple with a combined estate valued at $3 million.
This example assumes both spouses die in a year when the estate tax exemption amount is $1.5 million. Let’s suppose the husband owns assets worth $2 million and his wife owns $1 million, and the husband dies first. When the husband dies, $1.5 million of his $2 million estate is funded into the “B” (bypass) trust. These assets are subject to estate tax, but there are no taxes due because the assets are offset by his estate tax exemption of $1.5 million. Furthermore, the amount in the “B” trust could be available to the wife for income and support, and upon the wife’s death would be distributed to children according to the husband’s wishes.
The remaining $500,000 funds the “A” (marital) trust, which is a trust for the sole benefit of the wife. These assets, while included in the husband’s estate, would be exempt from federal estate taxes due to the unlimited marital deduction. When the wife passes away, assets remaining in the marital trust, and also those owned outright by the wife, would be included in her taxable estate. For illustrative purposes—if we assume no appreciation, consumption, or gifting of assets at the wife’s death— there would be $1 million in her name and $500,000 in the marital trust, for a total of $1.5 million. These assets can then pass to the children free of estate tax, because her estate tax exemption of $1.5 million offsets the value of her estate.Upon death, these assets will be distributed according to her wishes.
In this simple example, using the “A/B” combination allows the couple’s $3 million (assets in the bypass trust, plus assets in the wife’s estate) to pass to the
children free of federal estate taxes. (Although there may be state estate tax consequences.) Any appreciation in the bypass trust (“B”) will also pass to the children estate tax free. However, any appreciation in the wife’s estate could be taxed. Remember, only $1.5 million of her estate will be offset by her exemption—any excess in the estate over that amount would be taxed. The estate could also be reduced if assets are consumed or gifted away.
An important distinction between the trusts is the issue of post-mortem control
of the final disposition of trust assets. While the decedent (out of whose estate
the bypass trust was created) will determine who receives the property in the
bypass (“B”) trust, the surviving spouse has post-mortem control over the property in the marital (“A”) trust. An A/B trust arrangement is but one of a variety of strategies available to help protect and preserve assets. As with any strategy, it is important to let the individual’s objectives and financial situation direct the design of the plan.
Circular 230 Notice:
The information provided herein is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any federal tax penalties.
Entities or persons distributing this information are not authorized to give tax
or legal advice. Individuals are encouraged to seek advice from their personal tax or legal counsel.