Most advisors and CPAs are of the opinion that Congress will not do anything about the impending tax law changes, scheduled to take effect beginning in 2013. Familiarity with these changes and their impact on investing will be critical to advisors.
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What are the changes?
• Current tax rates go from 10-35% to 15-40%
• Long-term capital gains rates go from 0 -15% to 20%
• Dividends will be taxed as ordinary income
• New 3.8% “Medicare” surtax on investment income, including dividends, capital gains and IRA distributions.
Impact on investing
• Investors will be paying more tax – tax reduction or deferral strategies will be more important than ever.
• Taxation of dividends at ordinary rates can be a “game changer” for investing in high-dividend paying stocks
• Increase in tax rates on investment income: Ordinary income – 8.8% (5% increase in ordinary tax rate + 3.8% surtax), Dividends – 28.8% (40% ordinary tax less 15% old capital gain rate plus surtax), Capital gains – 8.8% (5% increase + surtax).
• Assuming taxpayer in highest brackets, increase as a percentage of 2012 tax rates: Ordinary income 8.8%/35% = 25.14% increase, Dividends 28.8%/15% = 192% increase, Capital gains 8.8%/15% = 58.67% increase.
• NOTE THAT THESE ARE HUGE INCREASES!
• Gain harvesting – Many advisors believe that recognizing gains now, while capital gains rates are at 15% is a better deal than waiting to pay 20%. I disagree with the strategy for the following reasons:
o Paying tax now rather than deferring can result in lower bottom line for clients
o Capital gains, if deferred long enough, will result in no income tax when passed on to heirs.
• Tax Loss Harvesting – Many advisors – especially those who favor gain harvesting – believe that tax loss harvesting in 2012 should be avoided. I disagree with this strategy for the following reasons:
o Clients don’t like paying taxes. Saving money now is meaningful to them.
o Capital losses can be carried forward indefinitely and will be able to offset future (higher-taxed) capital gains.
• Not deferring gains from installment sales – In spite of what I said above, if a taxpayer is realizing a large installment sale gain (for example, from selling a business), it might make sense to elect out of installment sale treatment. This would mean that all gain from the sale would be recognized in 2012 at the tax rate of 15%, rather than spreading out the tax into future years at a 23.8% tax rate. The advisor needs to determine the value of this strategy, considering time value of money, impact on overall current and future tax rates (considering AMT, deduction phase-outs), and taxpayer’s current and expected tax brackets.
• Rethinking location strategies – If 2013 tax laws occur as currently enacted, placing high-dividend paying stocks & mutual funds in taxable accounts might be a mistake. Those investments producing a high percentage of current income should likely be held in tax-deferred accounts, such as IRAs. Depending on the particular investment returns and the investor’s particular ratio of taxable to tax-deferred holdings, it might be preferable to replace bonds in the tax-deferred accounts with high-dividend stocks and use municipal bonds in taxable accounts.
• Reconsider investment strategies – advisors will need to view their asset allocations in light of these new tax laws. Is the diversification benefit worth the tax hit?
• Convert to Roth – with the tax rate increases, it might make more sense than ever before to convert IRAs to Roth. The conversion will be taxed at the lower current rates, income will be tax-free going forward, no required minimum distributions. Thus, future tax will be lower and investment income will be minimized.
Advisors should beware of making decisions now that could be costly to clients should Congress postpone these changes or lessen the increases.