August 2012 Newsletter

Speculating on the Future of the Federal Estate Tax

What’s the future of the federal estate tax? All we know is that no one knows for sure; it’s all speculation. So, let’s take a look at what could happen. There are five possibilities: (1) Congress could extend current tax law (commonly referred to as the “Bush tax cuts”); (2) Congress could do nothing, essentially turning the calendar back to 2001; (3) Congress could compromise, agreeing on something between the 2001 tax rules and the rules that apply in 2012; (4) Congress could enact new estate tax reform; or (5) Congress could repeal the estate tax altogether.

Note:Only a few of the estate tax laws that are affected are discussed here.

Congress could extend current tax law again, probably for two years

That would mean the top gift and estate tax rate would remain at 35%. The generation-skipping transfer (GST) tax (this is an additional tax that’s imposed on transfers to beneficiaries who are two or more generations below you) would also remain at a 35% tax rate. The gift and estate tax exemption (may also be referred to as an exclusion) would remain at $5,120,000 (plus any adjustment due to inflation) plus any deceased spousal unused exclusion amount (DSUEA).

The DSUEA is the amount of the gift and estate tax exemption that the first spouse to die does not use. This amount can be transferred from the estate of the first spouse to die to the surviving spouse. This is referred to as portability. Portability would remain.

The GST tax exemption of $5,120,000 plus any adjustment due to inflation would remain. There is no DSUEA for the GST tax (i.e., the GST tax exemption is not portable between spouses). The smart money is on this possibility. It has been Congress’s tendency of late.

Congress could do nothing

Congress could allow all or some of the provisions that sunset to expire, reverting to the 2001 tax rules. The top gift and estate tax rate would be 55% with a 5% surtax on estates that exceed $10 million but do not exceed $17,184,000. The GST tax rate would also be 55%. The gift and estate tax exemption would be $1 million. And, the DSUEA would no longer apply. The GST tax exemption would be $1 million indexed for inflation (estimated so far to be $1,360,000). Some analysts have proposed letting the Bush tax cuts expire as part of a plan to balance the budget over time.

Congress could compromise

Congress could pass a compromise bill that would set the top tax rate to 45% and the exemption amount to $3.5 million. Whether portability would expire or be extended is anyone’s guess.

President Obama supports this option. His 2013 budget plan would return the gift and estate tax, and the GST tax, to 2009 levels; the top tax rate would be 45%, the exemptions would be $3.5 million (but only $1 million for gift tax purposes), and portability would be made permanent.

Congress could enact estate tax reform

Many believe that permanent and comprehensive estate tax reform is needed. However, the political landscape is probably not currently amenable to this option. Besides, permanent tax reform does not really mean that it will be permanent (it could, of course, be modified or repealed by future legislation).

Congress could repeal the estate tax altogether The arguments for and against the repeal of the estate tax continue to wash in, like ocean waves. The tide was high for repeal a few years back, but the current economic and fiscal situation may have slowed its momentum, and the tide seems to be ebbing.

New 401(k) Plan Disclosure Rules 

You may have heard about new disclosure rules that will soon apply to 401(k) plans. Before describing what’s ahead, however, a look back may be helpful. (While we’ll refer to 401(k) plans in this article, the new rules also apply to other employer-sponsored plans that allow participants to direct their own investments, commonly referred to as “self-directed plans.”)


Most 401(k) plans are governed by the Employee Retirement Income Security Act of 1974 (ERISA) (governmental plans, owner-only plans, certain 403(b) plans, and certain church plans are not). One of the primary reasons Congress enacted ERISA was to protect retirement plan assets, and one of the important ways ERISA does so is through its rules governing the conduct of plan fiduciaries.

In general, plan fiduciaries include the plan administrator, anyone providing investment advice for a fee, and anyone who exercises discretionary authority or control over the plan or the plan’s assets. Plan fiduciaries must discharge their duties with respect to the plan prudently, and solely in the interest of participants and beneficiaries. A fiduciary who breaches his or her duty to the plan may be personally liable for any losses that occur as a result of that breach. The investment of plan assets is a fiduciary act governed by ERISA’s fiduciary standards.

Section 404(c) plans

But who is responsible for losses in a self-directed plan, where the participants themselves, and not the plan sponsor or an investment manager, select the investments for their retirement accounts? To answer this question, in 1992 the Department of Labor (DOL) issued regulations that allow 401(k) plan fiduciaries to avoid responsibility for losses in self-directed plans that occur as a result of a participant’s exercise of investment control over his or her own account, if specific requirements are satisfied.

To avoid liability, self-directed plans must provide participants with a diversified choice of investments, and must disclose very specific information about the plan and its investments (and comply with certain other requirements). While these rules are voluntary, many (if not most) 401(k) plans choose to comply, in order to shift liability for losses away from the plan’s fiduciaries. A 401(k) plan that complies with these rules is known as a “Section 404(c) plan,” after the section of ERISA that governs self-directed plans. A plan’s summary plan description (SPD) should indicate if the plan intends to be a Section 404(c) plan.

What’s changing?

As self-directed plans have grown more popular, the DOL has become increasingly concerned that participants might not have access to, or might not be considering, information critical to making informed decisions about the management of their accounts–particularly information about investment choices, fees, and expenses.

As a result, in October 2010, the DOL issued new regulations that require all self-directed 401(k) plans–both those that choose to comply with Section 404(c) and those that do not–to provide the same detailed information to participants about the plan and its investments, on a regular and periodic basis, so that participants can make informed decisions with regard to the management of their individual accounts.

Some information must be provided on an annual basis, and some information must be provided quarterly. For calendar year plans, the initial annual disclosure must be furnished no later than August 30, 2012. The first quarterly statement must be furnished no later than November 14, 2012 (for July through September 2012).

Participants in 401(k) plans that comply with ERISA Section 404(c) are already receiving most of the information required by the new regulations. In general, more detailed information about investment fees and expenses must now be disclosed to participants.

Another change is that plan investment information must now be provided in chart form, so that participants are better able to compare investment alternatives. And plans will no longer be required to automatically provide a prospectus to participants, although one must be provided upon request.

Which plans must comply with the new rules?

These new disclosure rules apply to 401(k) plans and other plans that allow participants to direct their own investments, but they don’t apply to IRAs, SEPs, or SIMPLE IRA plans. They also don’t apply to plans that aren’t covered by ERISA.

How to Raise a Saver

As parents, we naturally want what’s best for our kids. We want them to be polite, respectful, healthy, curious, and smart. And we hope that someday, they will grow into successful adults with independent, fulfilling lives. How best to accomplish this? Well, along with teaching the ABCs, 123s, and right from wrong, teaching your child the basics of financial literacy can help you raise a saver and lay the foundation for your child’s bright financial future.

The early years, 3 to 7

Children this age may think that money magically appears from special machines whenever Mom or Dad pushes a few buttons, but there is one money concept they can understand. They know people need money to buy things–chances are they’ve tagged along with you to the grocery store a few times and watched you fill up your cart. Young children often model the behavior of their parents, so on these shopping trips, when you think your child is receptive, you might say things like “I can’t buy this right now, I have to save more money and buy it next time” or “That’s great these apples are a really good price today–I can buy more.” These types of comments sink in and hopefully will get your child thinking about money and spending.

Once children can identify coins and dollar bills, give them a piggy bank or clear plastic jar to keep any money they earn or receive as gifts. Tell them they can buy something they want once they save a certain amount (make sure the item/price is appropriate and within short-term financial reach). Taping a picture of the item on the bank can provide a visual goal. Of course, children need a way to earn some money. Consider giving your child a weekly allowance and/or payment for small jobs around the house. Some parents tie an allowance to chores; others expect chores as part of everyday family life, but pay extra for “super” chores. The overall goal is to get your child excited about seeing the coins and dollar bills pile up.

The middle years, 8 to 12

These years are the sweet spot to lay a solid financial foundation. Children this age are more financially and materially aware–they have a general idea of what things cost (at least the things they want), they see (and covet) the possessions their friends have, they’re bombarded by advertising, they get asked what they’d like for their birthday, and they often have a say in the new clothes and school supplies they get every year. And they aren’t shy about pointing out the other items they want–electronics, sports equipment, room decor. It’s enough to make any parent shudder.

The first thing to do? Explain the difference between “needs” and “wants.” Continue to give your child an allowance, and encourage a 50-25-25 rule (or some variation) that earmarks 50% for immediate spending needs, 25% for the purchase of big-ticket items, and 25% for long-term savings. Consider matching a portion of that last 25% so your child is more motivated to save. Open a bank savings account for your child’s long-term savings, and explain how interest and compounding works.

Help your child set financial goals, both short-term (a skateboard or sweatshirt) and long-term (a laptop). When it comes to spending, explain–and model–the concepts of delayed gratification, prioritizing purchases, and making tradeoffs. Help your child learn to get the most value for his or her money by selecting quality merchandise, comparison shopping, waiting for sales, and discouraging impulse buying. Let your child see that you, too, can’t buy everything you want all the time.

Introduce the concept of budgeting by explaining how your family’s budget works. Without going into detailed numbers, explain how income you receive from your job must be used to pay for needs like food, housing, utilities, and clothing, and how any money left over is set aside for emergency savings, long-term savings, and for “wants” like trips to the movies, restaurants, and new toys and gadgets.

The teen years

Children this age often seem to be ever-growing financial sinkholes–$10 here, $20 there, a laptop, sports equipment, an instrument, school trips, gas for the car, not to mention looming college expenses. Build on the saving, goal-setting, and budgeting lessons from earlier years. Be more specific about what things cost in your family’s budget, and explain that in addition to paying day-to-day expenses and saving for college, you’re saving for your own retirement.

When your child is old enough, encourage him or her to get a job to help pay for some typical high-school expenses and to start building a nest egg. Teach your child how to use an ATM/debit card, balance a checkbook, and wisely manage credit–skills they’ll need in college. Finally, you can introduce your child to more advanced financial concepts, such as stocks, bonds, IRAs, and diversifying investments, by looking at teen-oriented investing books and financial websites.

Can I convert my traditional IRA to a Roth IRA in 2012? 

It may be an excellent time to consider converting your traditional IRA to a Roth IRA. As a result of market volatility, some investors have seen a reduction in the value of their traditional IRAs, meaning that the tax cost of converting may have dropped significantly. Also, federal income tax rates are scheduled to increase in 2013, so converting this year may be “cheaper” than converting next year.

Anyone can convert a traditional IRA to a Roth IRA in 2012. There are no longer any income limits, or restrictions based on your tax filing status. You generally have to include the amount you convert in your gross income for the year of conversion, but any nondeductible contributions you’ve made to your traditional IRA won’t be taxed when you convert. (You can also convert SEP IRAs, and SIMPLE IRAs that are at least two years old, to Roth IRAs.)

Converting is easy. You simply notify your existing IRA provider that you want to convert all or part of your traditional IRA to a Roth IRA, and they’ll provide you with the necessary paperwork to complete. You can also transfer or roll your traditional IRA assets over to a new IRA provider, and complete the conversion there.

If a conversion ends up not making sense (for example, the value of your Roth IRA declines after the conversion), you’ll have until October 15, 2013, to “recharacterize” (i.e., undo) the conversion. You’ll be treated for federal income tax purposes as if the conversion never occurred, and you’ll avoid paying taxes on the value of IRA assets that no longer exist.

The conversion rules can also be used to allow you to contribute to a Roth IRA in 2012 if you wouldn’t otherwise be able to make a regular annual contribution because of the income limits. (In 2012, you can’t contribute to a Roth IRA if you earn $183,000 or more and are married filing jointly, or if you’re single and earn $125,000 or more.) You can simply make a nondeductible contribution to a traditional IRA, and then convert that traditional IRA to a Roth IRA. (Keep in mind, however, that you’ll need to aggregate the value of all your traditional IRAs when you calculate the tax on the conversion.) You can contribute up to $5,000 to an IRA in 2012, $6,000 if you’re 50 or older.

Can I undo my Roth IRA conversion? 

When you convert a traditional IRA to a Roth IRA, you include the value of your traditional IRA, reduced by any nondeductible contributions you’ve made, in income for federal tax purposes in the year of the conversion. But what happens if the value of your Roth IRA subsequently declines, making the conversion a bad deal from a tax perspective? No problem. The IRS lets you recharacterize (undo) a conversion, if you act in a timely fashion.

For example, assume you convert a fully taxable traditional IRA worth $50,000 to a Roth IRA in 2012. You include $50,000 in income on your 2012 federal income tax return. But shortly after the conversion, the value of your Roth IRA declines to $25,000. Now you’re suddenly faced with the proposition of paying taxes on $50,000, while your Roth IRA is worth only $25,000.

All is not lost–because of the recharacterization rules, you have until your tax return due date (including extensions) to undo all or part of a conversion if it no longer makes good financial sense. So in this example, you have until October 15, 2013, to recharacterize. (Similarly, if your conversion occurred in 2011, you have until October 15, 2012, to undo the conversion.)

When you recharacterize, you need to withdraw the amount you originally converted, plus any earnings, out of the Roth IRA and transfer it back to a traditional IRA. To simplify the calculation of earnings if you decide to recharacterize, you should consider using a new Roth IRA for each conversion. You might also consider using a different Roth IRA for each separate investment, or class of investments, you plan to make–this way, if one investment goes down but another goes up, you can recharacterize only the Roth IRA that declined in value (you don’t need to aggregate your Roth IRAs for this purpose). If you wish, you can always combine Roth IRAs later after the recharacterization deadline passes.

If you convert a traditional IRA to a Roth IRA in 2012 and then recharacterize, you’ll have to wait until January 1, 2013, to reconvert those same dollars (and any earnings) to a Roth (or, if later, the 31st day following the recharacterization). However, any other traditional IRA dollars you have can be converted to a Roth IRA without restriction.



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