Amid widespread concern about 2011 tax increases, Congress surprised taxpayers in late December by actually reducing taxes for the next two years. What should a prudent person do now, and what can we learn from the evolving tax legislation?

While income tax changes for 2011 do not ultimately have much impact on high-net-worth taxpayers, new transfer tax rules have the potential to dramatically reduce their tax burdens.

Gift And Estate Tax Changes

Facts

In recent years, the gift and estate taxes have not been unified. This meant that while an individual could leave a $3.5 million estate to his heirs without incurring any transfer taxes, he could make lifetime gifts of only $1 million before paying gift taxes, which recently ranged as high as 45 percent.

The two transfer taxes have been reunified, and the transferable amount has increased. In 2011 and 2012 only, individuals can transfer up to $5 million free of transfer taxes, either during their lifetimes or at death. If the first spouse to die does not transfer this amount to third parties, the executor can make an election on the estate tax return to allow the surviving spouse to take advantage of the unused portion. This feature, known as portability, does not apply to the amount exempt from the generation-skipping transfer tax, which affects transfers to recipients who are more than one generation below the transferor.

These changes significantly reduce the number of individuals the gift and estate taxes will impact for the next two years. However, it’s prudent to remember that the current rules apply only through the end of 2012.

Opportunities

For many people, the ability to transfer more wealth without incurring tax will shift the focus of estate planning from primarily financial motives to a greater emphasis on non-financial goals. Individuals now have more flexibility to decide who should receive which assets, and whether those assets should pass in trust or outright, without regard to the tax consequences.

The new rules also make lifetime transfers much more appealing. Because the rules are not permanent, and predicting future legislation is nearly impossible, it may be prudent to transfer as much as possible now. Under current legislation, on January 1, 2013 the $5 million that can be passed free of transfer taxes will revert to $1 million, and the top transfer tax rate will increase to 55 percent from 35 percent.

While saving tax can be a great motivator, some still hesitate to make large lifetime gifts. However, doing so can provide the donor with the additional pleasure of seeing the recipient enjoy the gift. If there is any concern about giving large amounts outright to beneficiaries who might not be ready to handle the associated responsibility, trusts can help control the beneficiaries’ access to the funds.

For the highest of high-net-worth individuals, the decision to make lifetime gifts should be easy. For wealthy individuals with fewer assets, the decision to give can be more difficult. A financial planner can run various cash flow projection scenarios to determine an appropriate amount. By considering adverse scenarios, which assume low investment returns, high spending and long life expectancies, a financial planner can help clients determine a minimum amount to retain in order to avoid outliving their assets.

Although married couples can bestow a total of $10 million free of transfer taxes, they can also use a variety of techniques, such as intra-family loans to grantor trusts, grantor retained annuity trusts, charitable lead trusts and transfers of family limited partnership interests, to greatly increase the amount of assets transferred.

Even individuals who have no intention of making gifts during the next two years should review their estate plans to ensure that their objectives are being met, given the recent changes in the law. Many estate plans developed under the old rules would, under the new rules, place more money than necessary in trusts that impose unnecessary restrictions on the assets. But if you change your estate plan, keep in mind that the law currently keeps the new rules in place only through 2012.

Lessons

Many planners, including those of us at Palisades Hudson, recommended that clients consider making taxable gifts in 2010 to take advantage of the 35 percent gift tax rate that was scheduled to increase to 55 percent in 2011. In our case, we waited until the end of the year before having our clients make any taxable gifts. This strategy proved very helpful, because when the law was changed in December, it became advantageous to delay making any taxable gifts until at least 2011. We advised therefore our clients to wait.

At the end of 2009, few anticipated that large estates would face no estate tax at all in 2010. Within the last few years, estates with very similar sizes and structures have incurred wildly different estate tax liabilities.

Given this uncertainty and tendency toward rapid change, it is important that estate-planning documents give executors as much flexibility as possible.

Income Tax Changes

Facts

The biggest news in income taxes for 2011 is not what has changed, but what has stayed the same. If the Bush-era tax cuts had expired, the top federal income tax rate would have increased to 39.6 percent from 35 percent, and the long-term capital gains tax rate would have increased to 20 percent from 15 percent.

The existing income tax rates have been extended through 2012, and although the Making Work Pay tax credit (up to $400 for individuals and $800 for married couples in 2010) has expired, a cut in payroll taxes resulted in an increase in most people’s take-home pay. For 2011 only, the Social Security withholding rate, which applies to the first $106,800 of earned income, has decreased from 6.2 percent to 4.2 percent. This cut means that, as long as a taxpayer earns more than $20,000, she will have more money in her pocket each week during 2011 than she did in 2010.

These changes, together with other small modifications to certain deductions, tax credits and miscellaneous tax rules effective in 2011, will have little overall impact on the average high-income earner. However, for self-employed individuals, a number of tax changes affecting small businesses could substantially reduce current tax burdens. The Wall Street Journal has compiled a detailed account of the 2011 changes and tax extensions, available here.

Opportunities

By extending existing income tax rates through 2012, the government provided some certainty to individuals who converted their traditional IRAs to Roth IRAs during 2010. A special rule, applicable in 2010 only, allowed taxpayers to defer the tax on 2010 IRA conversions by reporting half of the income in 2011 and half in 2012. This option was much less appealing when income taxes were scheduled to increase in 2011. Now, all else being equal, the option to spread the tax over 2011 and 2012 should be the choice for most taxpayers.

A traditional tax-planning strategy involves accelerating deductions and delaying income to minimize the amount of taxable income in the current year, and thus postpone tax payments. Conversely, when tax rates are scheduled to increase, accelerating income and delaying deductions becomes the appropriate game plan. To the extent possible, taxpayers should try to shift income to 2011 and 2012 and delay deductions until 2013. Deductions are worth more when taxes are higher, and gross income is worth less.

Despite the tough stock market from late 2007 through early 2009, investors who diligently sold positions at a loss and reinvested in similar securities to maintain their market exposure now have huge unrealized gains in many of their positions. Planning to sell these investments before 2013 could be a logical strategy in many cases. In addition, taxpayers might also consider selling their homes within the next two years, if they are contemplating moving and would recognize a large gain. Accelerating capital gains will also avoid subjecting them to a new 3.8 percent Medicare tax that will be applied to the investment income of high-income taxpayers beginning in 2013.

Lessons

Despite the expectation that income taxes might increase on the highest-income earners, many people did little during 2010 to avoid exposing their incomes to higher tax rates. While a variety of legitimate reasons exist to avoid accelerating income when there are pending tax increases, in the face of uncertainty, many people felt paralyzed and simply chose inaction instead of proper planning.

Because of Congress’s decision, this paralysis caused no damage this time around. In fact, had taxpayers acted to trigger income in 2010 before the scheduled 2011 tax increase, the strategy might have boomeranged when the December legislation extended 2010′s lower rates for two years.

But with a burgeoning national debt and chronic budget deficits, the government probably will be looking to raise taxes in the future. During this two-year reprieve, taxpayers should develop plans to minimize taxes and maximize after-tax income over the long term.

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