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The Sunset of 2001 and 2003 Tax Cuts

We have never in modern times faced such a dangerous, ongoing imbalance between the levels of federal spending and revenues. Our Federal debt, as a percentage of our economic output, is greater than at any time since the end of World War II. The Congressional Budget Office projects that in a decade our national debt will reach 90% of GDP. The graph below shows the Heritage Foundation's calculations of the amount of tax increase per household needed to fund government mandated spending. History has shown that tax rate increases reduce economic activity, and thus tax revenues, while tax rate decreases stimulate the economy and increase tax revenues.

On January 1, 2011, if Congress takes no action, the tax cuts passed in 2001 and 2003 are eliminated. This will usher in the largest tax increase in history. While the Senate Budget Committee has passed a resolution on the 2011 fiscal year budget which would extend some of these tax benefits, Congress' inability to address the estate tax prior to its expiration in 2010 does not bode particularly well for enacting new legislation. In this issue of LVM's Wealth Management Bulletin, we examine some of the tax increases that will occur if Congress does not act, and strategies to deal with some of them.

Dividends and Marginal Rates. In 2011, the top marginal income tax rate will return to 39.6%. When the reinstated phase outs of personal exemptions and itemized deductions are factored into the mix, high income earners face a marginal tax rate in excess of 40%. The favorable 15% top tax rate on dividends paid by regular corporations will end in 2011 as well, and dividends will then be taxed at ordinary income rates. Thus, for high income individuals, taxes on dividends will more than double.

Capital Gains. The tax on long term capital gains (for assets held longer than 12 months) will rise from 15% to 20%. Short term capital gains will continue to be taxed at ordinary income rates, but tax brackets will be higher in 2011.

College Savings. Custodial accounts are a simple way to set aside property for a child. The custodian may use the account to benefit the child in any way he sees fit and also direct the investments. However, the expanded "kiddie" tax (designed to prevent income-shifting between parents and children) makes custodial accounts less attractive, and vehicles such as 529 Plans more attractive, since they are immune from the kiddie tax. Coverdell Education Savings Accounts will expire in 2011 unless Congress extends them - otherwise, we'll be back to the old $500 per year "Education IRA." To learn more about other tax benefits relating to education, IRS Publication 970, "Tax Benefits for Education" is helpful. It is available at http://www.irs.gov/.

Estate Tax. The tax has expired and carryover basis is currently in effect: Heirs can exclude up to $1.3 million of gain on sales of inherited assets, plus $3 million more for sales by surviving spouses. Next year, heirs will be able to use the date-of-death value once again for inherited assets. However, without Congressional action, the pre 2002 estate tax rules return with a $1million exemption and a maximum listed rate of 55%.

Planning for this higher tax environment is complicated. Each taxpayer has unique circumstances and planning objectives. Taxpayers and advisors must be aware of the various strategies and investment vehicles that can reduce the tax impact. The integration of financial planning and investment management will be very important as next year quickly approaches.

Taxpayers may wish to consider the follow wealth management opportunities:

• Convert IRAs to Roth and pay tax in a lower tax environment
• Realize capital gains before 12/31/2010
• Employ tax sensitive asset allocation
• Contribute the maximum to retirement plans
• Deferred compensation plans
• Review your estate plans

One area that will provide savings for seniors is Closing the "Doughnut Hole". As of June 15, the federal government began mailing one-time $250 rebate checks to Medicare beneficiaries who have hit the drug plan's coverage gap known as the doughnut hole. Seniors fall into the doughnut hole once their prescription drug costs exceed $2,830. They then must pay for 100% of their prescriptions. When their out-of-pocket costs exceed $4,550, coinsurance resumes and they have to pay only 5% of drug costs. Help with drug costs will continue in 2011 when those on Medicare will receive a 50% discount on brand-name drugs if they reach the doughnut hole. Savings will continue to increase over the years until the doughnut hole is closed in 2020.

The financial planners and investment professionals of LVM Capital are committed to serving our clients. If you have any questions or wish to discuss how the new tax environment might impact you, please call us.

The information contained in this document should not be construed as legal or tax advice. Information included comes from sources LVM Capital Management, Ltd. believes are accurate. LVM Capital is not responsible for errors of fact.