Hedge Now: Tax Hikes Likely in Coronavirus’s Wake

Hedge Now: Tax Hikes Likely in Coronavirus’s Wake

How much has the coronavirus outbreak cost the US federal government?

Hard answers are in short supply – ideology and politics affect the estimates, and anyway, the final bill isn’t in. Add in the expenses incurred by the states, consider the damage done to ordinary citizens and their savings, try not to look directly at the economic dislocation costs – whatever the number, the final bill will be sky high.

Sticking inside the beltway, if only to limit the dizziness, we see federal tax increases in the offing. The White House is unlikely to countenance a major rise in middle-class rates, given the suffering endured by average citizens via the viral crisis. The administration opposes high taxes on principle, in any case, arguing that economic growth is the path to balanced budgets. The Clinton administration’s record, whereby the tech revolution wiped out the deficit, if only for a time, supports their argument. But Mr. Clinton never had to deal with a pandemic or an unprecedented economic shutdown. In the coming months, something may have to give.

Where could the tax axe fall? The middle class is strapped, although they may face peripheral increases in consumption levies, for example the gasoline tax, and state governments can always increase the sales tax. Average earners should perhaps be concerned rather than fearful, and in response, we counsel adoption of a tax mitigation strategy. This always makes perfect sense, and if adopted today, it can help refill drained coffers and limit the tax burden. Whatever is coming in the next months or years, it’s best to be prepared.

High net worth clients are more vulnerable: these days, they’re the usual suspects when the government’s accounts run dry. Taxes on income, capital gains and estates are all reasonable targets for an immediate rise. As the economy begins its snail-paced reopening, a window appears to align financial and estate plans to face a tax-averse environment – dispassionate words to describe a reality of the most nausea-inducing kind.

What might happen? For years, the step-up in basis provision has been in the sights of tax and estate law reformers. Clients are sometimes befuddled by the concept, which is simple enough, but often explained in convoluted ways. Your aunty loved you very much, so in her will, she left you 1,000 shares of a famous gumdrop manufacturer, maker of the confection that lay eternally petrified in her candy dish. She paid $1/share, and at her unhappy demise, they were worth $10 each. Perhaps you need cash, so you sell the stock immediately, pocketing $10,000. Thanks to the step-up in basis, you’ll pay no capital gains tax. That’s because the tax basis is calculated based on the market value of the inherited asset at the moment your aunty dies, not the moment, and price, of purchase. This provision saves beneficiaries a lot of tax.

While felicitous to some, others see the provision as arcane, illogical and unfair. A commonly heard proposal argues for eliminating the step-up and lowering the capital gains tax to a reasonable level. An unjust tax loophole would be filled, they argue, at a reasonable cost to beneficiaries.

We think this reform could find traction in the coming months. If it does, we encourage tax and financial professionals, as well as potentially impacted individuals, to engage with their Congressional representatives to assure the lower capital gains tax – a provision that might be forgotten in the flurry – is part of any plan to eliminate the step-up provision.

For most clients, tax and estate planning meet in a defined-contribution plan administered by their employer, most commonly the near-ubiquitous 401(k). The employee’s contributions enter the plan pre-tax, thereby reducing the year’s taxable income. Everyone likes this arrangement, but clients should know that when they retire and start taking withdrawals from the account, that money counts as income and is taxable. Careful calculations must be made long before the event in order to ensure that clients don’t end up in a disadvantageous tax bracket in retirement.

IRA and Roth IRA accounts are equally popular retirement planning instruments. The IRA’s tax break works similarly to a 401(k): when contributing to the plan, you take a tax deduction for the same year, and pay income taxes when funds are withdraw in retirement. The Roth IRA works in mirror image: you pay taxes now, while you’re working, but can safely ignore the tax man when you take withdrawals after retiring. The Roth IRA also features flexible early withdrawal rules and comes with no minimum distribution requirement, the bane of many traditional IRA holders.

Permanent life insurance, whether universal or whole life, carries a cash value component that offers tax advantages to policyholders. Your monthly premium is divided into three: one portion funds the death benefit, another covers the insurer’s costs, and a third increment is deposited in an interest-bearing cash value account. Whole life insurance pays a fixed rate, while universal life policies offer rates keyed to current money market rates or some other external benchmark. The cash component rises in value tax-free, and after expiration of a preliminary period, can be borrowed against or even withdrawn, although the death benefit will shrink by an equivalent amount, until the loan is repaid or the withdrawal returned.

Statistical studies reveal that top-bracket tax rates change about every three years. Whether tax increases are in the offing cannot be predicted with certainty, but history suggests they’re coming, sooner or later. In the current case, we predict rain – so don’t let yourself get soaked.

Shifting Sands: Coronavirus, Regulatory Changes and the Insurance Business For HNW Clients, Cash Value Life Insurance Offers Solid Planning Value