In unpredictable times, the desire to create a better tax strategy becomes more urgent, but that could result in some regrettable changes to perfectly good plans.
For example, many advisers counseled their wealthy clients in 2012 that the estate and gift taxes exemptions were going down and that the rates on those taxes were going up. But the opposite happened the next year, and people who had given away more than they might have otherwise were caught off guard.
This year, few respectable financial advisers are handicapping the election and what it might mean for taxes and investment returns next year. But that doesn’t mean they are not providing counsel.
“We can’t make predictions better than anyone else can,” said Ani C. Hovanessian, chair of the New York Tax and Wealth Planning Group at Venable, a law firm. “But if we fail to plan, we plan to fail. Individuals aren’t going to work with me because we’re frozen like a deer in the headlights.”
Here’s a look at different planning strategies that taxpayers may want to embrace, avoid or even hedge, all with an acknowledgment that no one knows what next year will bring.
WHAT TO DO
The main criterion for committing to a new plan now is that it is something you would have done eventually. Adjustments should not be something that springs to mind out of fear of the November election.
One easy change is converting an individual retirement account to a Roth retirement account. The money in a traditional I.R.A. is taxed when it is taken out. With a Roth I.R.A., you pay the tax on the deposits, and the money grows tax free. But a conversion requires the tax to be paid now, which can be a hard check to write, even if the long-term gain is better.
There are ways to offset the tax owed by claiming a loss this year. People who own rental properties that have generated passive income, or revenue that requires little to no effort to earn, can depreciate the value of the property and use that to offset the tax owed on a Roth conversion, said Stephen A. Baxley, director of tax and financial planning at Bessemer Trust.
Another simple change involves charitable giving. A provision in the CARES Act allows for 100 percent of charitable donations made in cash to be counted against your income this year. Normally, the deduction is capped at 50 percent of your income, with any amount more than that carried forward to subsequent years.
The provision was meant to spur immediate giving during the pandemic. But there are ways to comply with the spirit of the provision and not give entirely in cash.
Mr. Baxley said taxpayers could give 30 percent of their income in long-term appreciated stock and top that off with 70 percent in cash. Or they could also give 60 percent in cash to a donor-advised fund — which allows them to make grants at a later time — and 40 percent in cash to a public charity.
Pairing these charitable contributions with a Roth conversion can also offset the cost, he said.
Giving to heirs before the end of the year also makes sense as a tax strategy, said Jeremy Geller, co-head of J.P. Morgan Private Bank in New York. And as the exemption level goes up each year, he advises clients to top the gift off annually.
In a tax overhaul passed by Republican lawmakers in 2017, the exemption on the estate tax was doubled to more than $23 million for a couple (with a 40 percent tax rate on any amount over that). But that benefit expires in 2025. One concern among wealthy taxpayers is that a Democratic sweep on Election Day could bring that date forward, lowering the exemption amount back to what it was in the Obama era and increasing tax rates to pay for the ballooning federal deficit.
Whether that will happen is hard to predict, so advisers are counseling clients to make big tax-free gifts now only if they were planning to do so anyway.
WHAT NOT TO DO
Julio Castro, who runs the Florida offices of Evercore Wealth Management, said he feared “impetuous planning.”
“We don’t want people freaking out ahead of the election and implementing planning strategies that don’t make sense for them,” Mr. Castro said. “There’s always a chance that things will change.”
It is easy enough to avoid a repeat of the giving mistake of 2012: Don’t give away more than you can afford. But a fear of increased income taxes by a new Congress could prompt people to change plans that still make sense.
“The only thing worse than making a decision driven purely by taxes is to make a decision driven by speculation of what the taxes might be,” said Bryan D. Kirk, director of estate and financial planning at Fiduciary Trust International.
One strategy to avoid is selling stocks and paying capital gains tax now, out of fear that the capital gains tax rate could go up next year. There is value in those unrealized capital gains, even if the prospect of the tax rate’s jumping to more than 40 percent from 20 percent is daunting.
Advisers cautioned against changing any investment plan based on what might happen. “If it makes sense along a 10- or 15-year time period, then it’s fine,” Mr. Geller said. “It all ties back to what is your long-term objective.”
Mr. Kirk said he tried to harness his clients’ desire to do something that could be detrimental to begin a broader conversation about what they were trying to accomplish. He called concern over taxes the first step of a dozen before changing an investment plan.
“The election will happen, and we’ll know the results,” he said. “But we won’t know what the tax plan will be this year.”
WHAT TO CONSIDER
In life, having an acceptable hedge is always a bonus.
Roth I.R.A. conversions can fit in here. A good hedge would be to convert some portion now and more after the election. Another strategy would be to see how the public markets respond to the election. If stocks go down, complete the Roth conversion then; the lower market value will translate into a smaller tax bill.
There are risks. Income tax rates could actually fall, and “you could end up paying a lot of taxes you don’t need to pay,” said Kim Bourne, chief executive of Playfair Planning Services.
People looking to transfer money to heirs can make a loan to a trust now and then, depending on how the election goes, keep the loan in place or forgive it. If the loan is forgiven, that amount will count toward their gift exemption, said Alison Hutchinson, managing director at Brown Brothers Harriman.
One of her clients lent money to a trust she created for her children and grandchildren this month. The trust has to pay her a small amount of interest on the loan, but if it looks like the exemption levels for gifts are going down, her client will forgive the loan. Ms. Hutchinson said that process would be as simple as writing a letter to say she forgave it.
“We’re focused on flexible and resilient structures that can withstand different outcomes,” Ms. Hutchinson said.
The ultimate flexibility for couples is to create trusts that move the money out of one spouse’s estate but maintain the other spouse’s access to it. Called spousal lifetime access trusts, they can act as a safeguard against changes to a tax strategy that could backfire.
“You’ve completed and made a full transfer into the trust,” Ms. Hovanessian said. “You have cut off personal rights, but you can have your spouse as a beneficiary. It’s your backdoor strategy to have access to the funds.”
One downside, though, is that your spouse could die or divorce you, shutting off your access to the money. The money will go to other beneficiaries named in the trust.
Regardless of what changes you are considering, check with your adviser first.