As the first quarter of 2016 drew to a close investors could be excused for feeling like they were disembarking from the world’s longest rollercoaster ride. The U.S. stock market, as measured by the S&P 500, finished the quarter up a modest 1.35% and the U.S. bond market, represented by the Barclays Aggregate Index, was up a healthy 3.03%. But the story of the first quarter was not the destination, but the tumultuous journey markets took over the preceding three months.
From the very first trading day of the year, January 4, it appeared that markets would see a continuation of the cycle of concern and volatility that marked so much of 2015. Equity markets opened the year down and proceeded to sell off with great enthusiasm over the next six weeks. By February 11 all of the major U.S. stock indices were down more than 10% for the year. That day the S&P 500 ended down 14.2% from its May 2015 high and seemed well on its way to bear market territory of ‐20%.
But then a strange thing happened. The concerns that had been plaguing the markets began to be addressed one by one. The seeds of this market rebound were probably planted on January 27 when Federal Reserve chair Janet Yellen failed to raise rates and acknowledged the economic warning signs emanating from overseas. February 11, the stock market nadir, was also the date that oil prices bottomed, reaching a 13‐year low of $26.21 per barrel. When oil prices stabilized and started to rise it provided some much needed relief for stressed energy firms as well as to banks and other lenders that had exposure to the country’s energy complex. Over the ensuing weeks markets continued to receive a steady stream of supportive news. Stronger than expected economic data in the U.S. and additional stimulus measures from the European Central Bank seemed to be particularly important contributors to more positive market sentiment. This string of bullish news was topped off by Fed chair Yellen in mid‐March when she guided markets to a lower number of planned interest rate hikes in 2016.
While U.S. large cap stocks and the U.S. bond market ended up with reasonably good performance in the first quarter, other asset classes weren’t quite able to claw their way back to even by quarter’s end. As has been the case for some time now, large cap stocks outperformed small cap stocks for the quarter, though small cap stocks did rally more in March. The Russell 2000 was up 8% in March leaving the index down 1.52% for the quarter. The U.S. market also continued to outperform foreign developed markets with the MSCI EAFE Index down 3.01%. One big change in the first quarter was the performance of emerging markets. A combination of strong performance in Latin American markets and a weakening U.S. dollar led to strong emerging markets performance for U.S. investors (up 5.71%).
Every February, the President formulates a budget request for the Federal government, which Congress then considers in coming up with its own budget resolution. While this publication, commonly referred to as “the Greenbook,” outlines the President’s recommendations on appropriations for various government agencies, the proposals often include a variety of tax law changes. The historical reality is very little of this type of legislation will pass in a Presidential election year. However, the President’s so called “wish list” does provide us with an indication of what’s on the radar screen in Washington. This year’s Greenbook includes a variety of potential crackdowns and loophole closers on individuals.
ELIMINATION OF BACK DOOR ROTH CONTRIBUTIONS
When income limits on Roth IRA conversions were removed in 2010, high income individuals who were not previously eligible to contribute to Roth IRA accounts used this rule to break into Roth IRAs through a “back door.” Under this strategy, high income individuals would contribute to a non-deductible traditional IRA and complete a Roth conversion of those dollars. The President’s proposal would limit a Roth conversion to only the pre-tax portion of the IRA. As a result, any non-deductible, or after-tax, contributions to a traditional IRA would no longer be eligible for a Roth conversion.
SIMPLIFY MINIMUM REQUIRED DISTRIBUTION (MRD) RULES
This proposal would “harmonize” the application of the MRD requirements for holders of Roth accounts by generally treating Roth IRAs in the same manner as all other tax-favored retirement accounts, i.e., requiring distributions to begin shortly after age 70½, without regard to whether amounts are held in designated Roth accounts or in Roth IRAs. This would avoid continued income tax deferred growth since Roth accounts are after tax dollars. In addition, individuals would not be permitted to make additional contributions to Roth IRAs after they reach age 70½, thereby avoiding additional income tax sheltering.
REQUIRE NON-SPOUSE BENEFICIARIES TO TAKE INHERITED IRA DISTRIBUTIONS OVER NO MORE THAN FIVE YEARS
This proposal would effectively eliminate the “stretch IRA” technique often used to spread distributions out over a child’s lifetime, and instead require outright distribution of the plan, and thus full income taxation of traditional plans, within approximately 5 years of death of the IRA owner. There are exceptions for spouses and certain disabled individuals and minors.
LIMIT THE TOTAL ACCRUAL OF TAX-FAVORED RETIREMENT BENEFITS
After years of vilifying CEO salaries and their huge IRAs, this proposal would prohibit additional contributions or receiving additional accruals under tax favored retirement arrangements when a certain threshold is reached. The proposed threshold for an individual at age 62 is approximately $3.4 million across all types of retirement accounts.
RESTORE THE ESTATE, GIFT, AND GST TAX PARAMETERS IN EFFECT IN 2009
This proposal was part of the President’s platform in his last election, but it has had no success in passing. The proposal would make the estate, GST, and gift tax rules as they applied during 2009 permanent. A top tax rate of 45% and the exclusion amount of $3.5 million, not indexed for inflation, for estate and GST taxes, and $1 million for gift taxes.
MODIFY TRANSFER TAX RULES FOR GRATS AND OTHER GRANTOR TRUSTS
Various proposals have been made over the years to limit the effectiveness of GRATs, which are specifically created in the Internal Revenue Code and these rules have resurfaced. In addition, new rules have surfaced to limit Sales to Intentionally Defective Grantor Trusts. The GRAT reform proposes a 10 year minimum term, and adds a maximum term to avoid creative super-long-term GRATs.
LIMIT DURATION OF GENERATION-SKIPPING TRANSFER (GST) TAX EXEMPTION
Under this proposal, rather than questioning the state laws that provide for no rule against perpetuity, the GST exemption would effectively melt away. On the 90th anniversary of the creation of a trust, the GST exclusion allocated to the trust terminates. This would effectively iminate perpetual, or so-called Dynasty, trusts.
SIMPLIFY GIFT TAX EXCLUSION FOR ANNUAL GIFTS
In this proposal, the annual exclusion would remain at current levels ($14,000 per individual per year) but limit it to a total of $50,000 per year to certain trusts, a real blow to wealthy people with large families.
REFORM THE TAXATION OF CAPITAL INCOME
This proposal is in two basic parts: change the rate and then increase the scope. The proposal would first increase the highest long-term capital gains and qualified dividend tax rate from 20 percent to 24.2 percent. In addition, the 3.8 percent net investment income tax would still apply as under current law, so the maximum total capital gains and dividend tax rate including net investment income tax would thus rise to 28 percent.
Also, under the proposal, transfers of appreciated property generally would be treated as a sale of the property. This means that they would simply tax all capital gains at death (or a transfer, such as a gift) as though the individual had liquidated all holdings. Each individual would get the first $100,000 in gain excluded, and $250,000 in gain on a primary residence. There are some limits, such as exceptions for transfers to a spouse or charity, like we have under current gift and estate tax law. Nonetheless it seems this would subject a wide cross-section of America to tax at death that are not included under the current estate tax exemptions.
That is a lot of technical information to digest. Again, these are just proposals, but it gives you a clear idea of why you need to seek the help of a team of qualified advisors who stay abreast of the rules, the changes, and in this case, the potential changes, to devise solutions that make sense for your specific situation.
The proposals discussed here come from the General Explanations of the Administration’s Fiscal Year 2016 Revenue Proposals. You can find a copy online at: https://www.treasury.gov/resource-center/tax-policy/Documents/General-Explanations-FY2016.pdf if you wish to look at the details of what was outlined in this article.
Cannon Financial Institute