Budget plan hard on high-net-worth

President Barack Obama dealt financial advisers a double whammy in his 2014 budget proposal last week, proposing changes to how high-income clients save for retirement and how they pass on wealth to their heirs.

The president’s $3.78 trillion federal budget includes a variety of familiar measures aimed at the wealthy and would generate $580 billion in tax increases. In addition to implementing the so-called Buffett rule, which would impose a minimum rate of 30% on households earning at least $1 million a year, Mr. Obama has proposed limiting tax deductions to no more than 28% of income.

This time, however, the administration is making a bigger grab for large amounts of wealth squirreled away in individual retirement accounts and trusts. The proposal would require that individual retirement accounts and other tax-preferred retirement savings accounts provide no more than $205,000 in annual retirement income (based on an account balance that would finance an annuity of that size), indexed for inflation. For a 62-year-old, that would work out to a cap of $3.4 million, based on the current discount rate.

“I think eliminating stretch IRAs is what they’re getting at, assuming this proposal sees the light of day,” said Ed Slott, founder of an eponymous IRA education firm. Stretch IRAs can be used as a wealth transfer vehicle, as the owner can pass on the account to a younger beneficiary, who will need to take smaller required minimum distributions, thus stretching the value of the account over time.

Nevertheless, it looks as if the younger well-to-do would be the ones feeling the brunt of the proposal, rather than older, wealthy individuals.

An analysis by the Employee Benefit Research Institute found that 2.2% of workers 26 to 35 would be affected by the $3 million cap by the time they hit 65.

The effect would be even more widespread when considering that the amount of money needed to hit the $205,000-per-year income limit could fluctuate over time, depending on the discount rate. For instance, going back to 2006, the actuarial equivalent of a $205,000 annuity for a 65-year-old male was as low as $2.2 million, according to EBRI. Higher discount rates could reduce the cap further.

HARDER ON THE YOUNG

At the $2.2 million level, 6% of those 26 to 35 would be affected by the time they hit 65, compared with 0.3% of those in the 56-to-65 age bracket.

Advisers are mostly against the idea of capping the growth limits of IRAs.

Though accounts that large aren’t common, rollovers out of 401(k)s certainly could spawn IRAs with millions of dollars in them, noted Robert K. Haley, president of Advanced Wealth Management. He disagrees with the concept of imposing a cap on IRA accumulation.

“It can be counterproductive to put these limits on, because you encourage people to engage in either tax avoidance or tax evasion tactics,” Mr. Haley said.

The American Society of Pension Professionals and Actuaries raised the concern that imposing such limits could discourage small employers from maintaining a 401(k) plan in the first place, because they wouldn’t have the tax-deferred incentive of saving for themselves.

“The frustration we feel is that small-business owners have been playing by the rules all along, complying with contribution limits and making contributions for workers, and now they’re being told they can’t save anymore, because they’ve invested too successfully,” ASPPA chief executive Brian H. Graff said.

“Even though EBRI’s report indicated that only a small number of individuals would be affected, the pain for them is real,” he added.

ESTATE PLANNING

On the estate-planning side, advisers are facing a volley of proposed changes. Some of the most meaningful adjustments include the proposal to reduce the estate tax exclusion to $3.5 million, from $5.25 million, and to raise the top estate tax rate to 45%, from 40%, effective in 2018.

Estate planners are miffed at Mr. Obama’s resurrecting the issue, especially considering that wealthy clients already went through a panic in late 2012, when the fiscal cliff was looming and the possibility of the estate tax exclusion dropping to $1 million was a distinct threat.

“I can’t believe that they’d revisit that,” said Martin M. Shenkman, an estate-planning attorney at an eponymous firm. “Why would they put themselves and everyone through that again?”

In general, estate-planning experts don’t expect the provisions to stick, so advisers should not expect to tear up last year’s plans and start over.

“Don’t be overly concerned,” said David Pratt, a partner in the personal-planning department at Proskauer Rose LLP. “Practitioners shouldn’t jump the gun. This is a wish list. It’s a starting point for negotiations.”

OTHER PROPOSALS

Here’s a breakdown of some of the major proposed estate-planning changes:

• Grantor-retained annuity trusts will be subject to minimum terms. GRATs permit wealthy individuals to pass large assets to family members and save on taxes. Grantors, meanwhile, can receive an annuity for a fixed period of years from the assets within the trust.

GRAT terms are typically brief — less than two years — because if the grantor dies within the term, the assets are counted as part of his or her estate. Mr. Obama’s proposal would require that all trusts have a minimum term of 10 years and a maximum term of 10 years beyond the annuitant’s life expectancy. The value of the remainder must be greater than zero, and the annuity must not decrease during its term.

• Limits will be placed on the duration of the generation-skipping-trust tax exemption. Currently, each person has a lifetime GST exemption of $5.25 million, which can be allocated to the benefit of younger relatives who are receiving asset transfers (a wealth transfer from a grandparent to a grandchild). The grantor also can allocate his or her GST exemption to shield the assets transferred and future appreciation from GST taxes.

Mr. Obama wants to place limits on the duration of the GST exemption, making it terminate on the 90th anniversary of the creation of the trust. The 90-year limit is a big deal, considering that some states have abolished rules against perpetuity — which limit the duration of a trust — while others have lengthy periods, according to Mr. Pratt. Florida, for instance, permits trusts to last as long as 360 years.

Though this isn’t the time to leap into action, estate-planning experts noted that this is a good time to nudge individuals who were reluctant to act on estate and tax planning.

“If it does anything, it’ll make those people who missed the boat last year [on tax and estate planning] act while those structures are still available,” said Gavin Morrissey, vice president of wealth management at Commonwealth Financial Network.