Wealthy Advised to Sell for Gains Before Unfriendly 2013

Sell.

That’s the message from some financial advisers, who are telling wealthy clients that the remainder of 2012 amounts to a last-chance sale on federal tax rates. Taxes are set to rise in January in the U.S., pushing the top rate on dividends to 43.4 percent from 15 percent and the top rate on capital gains to 23.8 percent from 15 percent.

Even if Congress averts the so-called fiscal cliff of tax increases on investments, income and estates, pressure to reduce budget deficits will mean higher taxes eventually, said Ron Florance of Wells Fargo & Co. (WFC) The answer is to take advantage of historically low rates and move taxable income and investment gains into this year, said Florance, managing director of investment strategy at the company’s private bank.

“It’s the opposite of what people normally do,” said Florance, whose clients usually have at least $1 million in investable assets. “You’re paying taxes today in anticipation of higher rates in the future.”

Advisers at companies including Wells Fargo, Bank of America Corp., Bank of New York Mellon Corp., JPMorgan Chase & Co. (JPM), Northern Trust Corp. (NTRS) and U.S. Bancorp (USB) are discussing with their wealthy clients such strategies as selling appreciated securities, relocating assets to tax-deferred retirement accounts, converting IRAs, exercising stock options and making large gifts to heirs this year.

Tax Increases

Tax cuts first enacted during George W. Bush’s presidency and extended in 2010 are set to expire Dec. 31. Unless Congress acts, the tax increases along with automatic federal spending cuts will combine to form the so-called fiscal cliff. Taxes on the top 1 percent of U.S. households would increase by an average $120,537, according to a study by the nonpartisan Tax Policy Center.

Federal taxes on ordinary income will rise to as much as 39.6 percent from 35 percent. Long-term capital gains rates will increase to a maximum 20 percent from 15 percent, plus an additional 3.8 percent for high-income earners as a result of the 2010 health-care law.

The opportunity for individuals to transfer up to $5.12 million --- or $10.24 million for couples -- free of estate taxes and gift taxes also is set to expire at the end of the year and drop to $1 million. Legislation enacted in 2010 raised the lifetime estate-and-gift-tax exclusion for 2011 and 2012.

With about 10 weeks left in the year, taxpayers waiting for a decision from Congress before making investment moves may run out of time. Lawmakers won’t address tax and spending issues until they return to Capitol Hill after the Nov. 6 election.

‘Knock-Down, Drag-Out’

“If it’s divided government, then I think it will be a knock-down, drag-out to the end of the year,” said Representative Tom Price, a Georgia Republican who has been receiving a flow of questions from constituents about tax rates. “Temporary tax policy in our country is harmful to a vibrant economy, and we’ve tried as hard as we could in the House to correct that.”

People may miss the opportunity to take gains while tax rates are low and rebalance because they’re not considering how well investments in riskier assets such as stocks, high-yield bonds and real estate have performed this year, said Florance of Wells Fargo, which is based in San Francisco.

“Most investors are in a bad mood,” he said. That’s even as the Standard & Poor’s 500 Index (SPX) has returned 18 percent this year as of Oct. 18 with dividends reinvested, according to data compiled by Bloomberg.

$100 of Stock

An investor who sells $100 of stock with a cost basis of $20 in 2012 would see proceeds -- after capital gains taxes -- of $88, said Robert Barbetti, managing director and executive compensation specialist at J.P. Morgan Private Bank. Next year, if Congress doesn’t act, earnings from the sale would drop to $80.96 if rates rise to 23.8 percent. That means the stock price would need to rise at least 9 percent for an investor to be better off selling in 2013, said Barbetti, who is based in New York.

Assets that generate long-term capital gains aren’t confined to stocks. Owners of real estate and businessesorganized as S corporations, partnerships and limited liability companies can get capital gains treatment when they sell.

“We have a number of people contemplating selling their businesses,” said Jere Doyle, senior wealth strategist at New York-based BNY Mellon Wealth Management. “They’re trying to jam it through before year-end to take advantage of the capital gains rates.”

Capital Gains

The last time there was a significant increase in the capital gains tax rate -- in 1986 -- positive realizations spiked 91 percent to $328 billion from $172 billion a year earlier, according to the Tax Policy Center. Most investors waited until December to sell, according to a 1994 report in the National Tax Journal.

Executives with stock options expiring between now and 2015 should analyze whether to exercise them this year, Barbetti said. They should consider the stock’s dividend and volatility, he said. Stock options generally are part of compensation and treated as ordinary income for tax purposes.

People should look at how much the underlying security would need to appreciate to “cut through the headwind of a potentially higher tax,” when deciding whether to exercise options this year, said Mitchell Drossman, national director of wealth planning strategies at U.S. Trust, a unit of Charlotte, North Carolina-based Bank of America.

Stock Options

An executive exercising 5,000 stock options with a strike price of $30 and a fair market value of $42 would recognize $60,000 in income and pay $21,000 at the top rate of 35 percent this year, Drossman said. The underlying stock would need more than a 3.5 percent rate of return in 2013 to make it more favorable to wait and exercise the option next year, he said.

That assumes that the 2001 and 2003 tax cuts expire, pushing the top rate to 39.6 percent, and the 0.9-percentage- point rise in the Medicare tax on wages of high earners starts as scheduled in 2013.

Investors with dividend-paying stocks should revisit where they hold them with the potential jump in levies on that income, said Doyle of BNY Mellon. One strategy is to sell the securities this year if they are in a taxable brokerage account and move them into a tax-deferred individual retirement account, he said.

People also should look at the types of accounts they are using for their retirement savings, said Suzanne Shier, director of wealth planning and tax strategist at Chicago-based Northern Trust. “We’re asking people to take a hard look at Roth conversions again,” she said.

Roth IRAs

Savers who switch their IRAs to Roth IRAs must pay taxes up front in exchange for tax-free withdrawals in the future. In 2010 Congress lifted income restrictions and allowed taxpayers earning more than $100,000 a year in adjusted income to convert to Roth accounts, which led to many wealthy people to consider it. Distributions from regular IRAs are required of those age 70½and older and taxed as ordinary income.

People with illiquid investments, such as private equity and hedge funds, in their IRAs should consider moving them into a Roth IRA and paying the ordinary income tax on the value this year, said JPMorgan’s Barbetti. Those assets can then appreciate tax-free and pass on to heirs as an estate-planning strategy, he said.

Doyle and other advisers are telling clients not to panic and to watch what Congress does between now and the end of the year, as the laws may change.

Gift Rules

Wealthy families looking to take advantage of generous estate-and-gift-tax rules shouldn’t wait, said Raymond Radigan, managing director of trust for the East region of U.S. Bank’s wealth management unit. The threshold for transferring assets tax-free during one’s lifetime is set to drop from $5.12 million this year to $1 million in 2013.

“If a client is in a position to make a gift, now is the time to do it,” Radigan said.

President Barack Obama proposed in his most recent budget to set the federal parameters at a $1 million gift-tax exemption and $3.5 million estate-tax exclusion, as they were in 2009. Republican presidential nominee Mitt Romneyhas proposed repealing the estate tax.

People are considering how much they can give and what assets to transfer, Radigan said. Most are setting up trusts, which help protect the beneficiary from spousal claims in a divorce or from creditors, he said.

“Whoever wins this election, one outcome isn’t going to be utopia and the other Armageddon,” said Wells Fargo’s Florance. “You need to be tax-smart, not tax-paranoid.”

To contact the reporters on this story: Margaret Collins in New York at mcollins45@bloomberg.net; Richard Rubin in Washington at rrubin12@bloomberg.net

To contact the editor responsible for this story: Jodi Schneider at jschneider50@bloomberg.net